EXERCISE 7-4 (30 MINUTES)

1. a. By assumption, the unit selling price, unit variable costs, and total

fixed costs are constant from year to year. Consequently, variable

costing net operating income will vary with sales. If sales increase,

variable costing net operating income will increase. If sales decrease,

variable costing net operating income will decrease. If sales are con-

stant, variable costing net operating income will be constant. Since

variable costing net operating income was $510,600 each year, unit

sales must have been the same in each year.

The same is not true of absorption costing net operating income.

Sales and absorption costing net operating income do not necessarily

move in the same direction since changes in inventories also affect

absorption costing net operating income.

b. When variable costing net operating income exceeds absorption cost-

ing net operating income, sales exceed production. Inventories shrink

and fixed manufacturing overhead costs are released from invento-

ries. In contrast, when variable costing net operating income is less

than absorption costing net operating income, production exceeds

sales. Inventories grow and fixed manufacturing 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 Production <

Sales

Inventories

grow Inventories

shrink Inventories

shrink