EXERCISE 7-9 (20 MINUTES)

1. Under absorption costing, the net operating income of a particular pe-

riod is dependent on both production and sales. For this reason, the

controller’s explanation was accurate. He should have pointed out, how-

ever, that the reduction in production resulted in a large amount of un-

derapplied overhead, which was added to cost of goods sold in the sec-

ond quarter. By producing fewer units than planned, the company was

not able to absorb all the fixed manufacturing overhead incurred during

the quarter into units of product. The result was that this unabsorbed

overhead ended up on the income statement as a charge against the

period, thereby sharply slashing income.