2. a. As discussed in part (1 a) above, unit sales and variable costing net
operating income move in the same direction when unit selling prices
and the cost structure are constant. Since variable costing net operat-
ing income varied from year to year, unit sales must have also varied
from year to year. This is true even though the absorption costing net
operating income was the same for all four years. How can that be?
By manipulating production (and inventories) it may be possible for
some time to keep absorption costing net operating income rock
steady or on an upward path even though unit sales fluctuate from
year to year. However, if this is done in the face of falling sales, even-
tually inventories will grow to be so large that they cannot be ig-
nored.
b. As stated in part (1 b) above, when variable costing net operating in-
come exceeds absorption costing net operating income, sales exceed
production. Inventories shrink and fixed manufacturing overhead
costs are released from inventories. In contrast, when variable cost-
ing net operating income is less than absorption costing net operating
income, production exceeds sales. Inventories grow and fixed manu-
facturing overhead costs are deferred in inventories. The year-by-
year effects are shown below.
Year 1 Year 2 Year 3 Year 4
Variable
costing NOI
> Absorption
< Absorption
Production <
Sales Production >
Sales
Sales Production <
Inventories
grow Inventories
shrink Inventories
grow
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