EXERCISE 7-9 (20 MINUTES)

3. Under absorption costing, profits are affected by both sales and produc-

tion. If production exceeds sales, then a portion of the fixed manufac-

turing overhead cost of the period will be deferred to the future. In pe-

riods where these deferrals of fixed manufacturing overhead cost take

place, profits will be inflated, as in July for Warner Company. If produc-

tion is less than sales, then fixed manufacturing overhead costs that

were deferred in inventory and carried over from prior periods will be re-

leased from inventory and charged as an expense on the income state-

ment. In addition, if production in these months is less than planned,

then underapplied overhead will result, which, when added to the costs

being released from inventory through inventory reduction, will depress

Case 7-18 (continued)

In sum, with profits dependent on both sales and production under ab-

sorption costing, profits can move erratically, depending on the relation

between sales and production in a given period.