EXERCISE 7-9 (20 MINUTES)

4. The increase in production in Year 2, in the face of level sales, caused a

buildup of inventory and a deferral of a portion of Year 2’s fixed manu-

facturing overhead costs to the next year. This deferral of cost relieved

Year 2 of $60,000 (5,000 units × $12 per unit) of fixed manufacturing

overhead cost that it otherwise would have borne. Thus, net operating

income was $60,000 higher in Year 2 than in Year 1, even though the

same number of units was sold each year. In sum, by increasing produc-

tion and building up inventory, profits increased without any increase in

sales or reduction in costs. This is a major criticism of the absorption

costing approach.