EXERCISE 7-9 (20 MINUTES)

2. Under absorption costing, the company did earn a profit for the quarter.

However, before the question can really be answered, one must first de-

fine what is meant by a “profit.” The central issue here relates to timing

of release of fixed manufacturing overhead costs to expense. Advocates

of variable costing would argue that all such costs should be expensed

immediately, and that no profit is earned unless the revenues of a pe-

riod are sufficient to cover the fixed manufacturing overhead costs in

full. From this point of view, then, no profit was earned during the quar-

ter, since the fixed costs were not fully covered.

Advocates of absorption costing would argue, however, that fixed manu-

facturing overhead costs attach to units of product as they are pro-

duced, and that such costs do not become an expense until the units

are sold. Therefore, if the selling price of a unit is greater than the unit

product cost (including a proportionate amount of fixed manufacturing

overhead), then a profit is earned even if some units produced are un-

sold and carry some fixed manufacturing overhead with them to the fol-

lowing period. A difficulty with this argument is that “profits” will vary

under absorption costing depending on how many units are added to or

taken out of inventory. That is, profits will depend not only on sales, but

on what happens to inventories. In particular, profits can be consciously

manipulated by increasing or decreasing a company’s inventories.

Problem 7-12 (continued)