EXERCISE 7-4 (CONTINUED)

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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Solutions Manual, Chapter 7 353