4. As shown in the reconciliation in part (3) above, $45,000 of fixed manu-
facturing overhead cost was deferred in inventory under absorption
costing at the end of July, since $18 of fixed manufacturing overhead
cost “attached” to each of the 2,500 unsold units that went into inven-
tory at the end of that month. This $45,000 was part of the $560,000
total fixed cost that has to be covered each month in order for the com-
pany to break even. Since the $45,000 was added to the inventory ac-
count, and thus did not appear on the income statement for July as an
expense, the company was able to report a small profit for the month
even though it sold less than the break-even volume of sales. In short,
only $515,000 of fixed cost ($560,000 – $45,000) was expensed for
July, rather than the full $560,000 as contemplated in the break-even
analysis. As stated in the text, this is a major problem with the use of
absorption costing internally for management purposes. The method
does not harmonize well with the principles of cost-volume-profit analy-
sis, and can result in data that are unclear or confusing to management.
© The McGraw-Hill Companies, Inc., 2006. All rights reserved.
Solutions Manual, Chapter 7 373
Problem 7-15 (45 minutes)
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