Q7-1 The basic difference relates to the handling of fixed MOH. Under absorption costing, fixed MOH is treated as a product cost, and added to the cost of goods manufactured. Under variable costing, it is treated as a period cost, and deducted in full from the current period's revenues.

Q7-2 Selling & Admin. exp are treated as period costs under variable costing, the same as under absorption costing.

Q7-3 As a company manufactures units of product, the fixed MOH costs of the period are added to the units, along with direct materials, direct labor, and variable manufacturing overhead. If some of these units are not completed or not sold by the end of the period, then they are carried into the next period as inventory. The fixed MOH cost attached to the units in ending inventory follow the units into the next period as part of their total inventory cost. When the units carried over as inventory are finally sold in the next period, the fixed MOH cost that has been carried over with the units is included as part of that period's COGS.

Q7-4 The costs that are incurred to manufacture units have future service potential. If production exceeds sales, than a benefit to future periods is created in the form of inventory that can be carried forward and sold in future periods. All of the costs of manufacturing the units - not just the variable costs - should be carried forward as assets. Also, they believe that fixed costs such as depreciation, taxes, insurance, supervisory salaries, etc. are just as essential to manufacturing products as are the variable production costs.

Q7-5 Fixed MOH costs relating to plant, machinery, and key supervisory personnel represent the capacity to produce, rather than the cost of actual production, in that such costs will still be incurred even if little or no production takes place during a period. Since fixed MOH costs can't be avoided by not producing, they should be charged against the period in which they are incurred rather than against units of product.

Q7-6 If production and sales are equal, both absorption and variable costing will show the same operating income. The reason is that under these conditions inventory will remain unchanged, and therefore there can be no deferral of fixed MOH cost to inventory, or release of fixed MOH cost from inventory, under absorption costing.

Q7-7 If production exceeds sales, absorption costing will show higher net income. The reason is that the inventory account will increase, and therefore part of the fixed MOH cost of the current period will be deferred in inventory to the next period under the absorption costing method. By contrast, all of the fixed MOH cost of the current period will be charged immediately against revenues as a period cost under the variable costing method.

Q7-8 If fixed MOH cost is released from inventory, then production is less than sales since inventory levels are decreasing.

Q7-10 By increasing the level of production, it is possible to increase operating income without increasing sales under the absorption costing method. As the production level increases and exceeds sales, units of product are added to inventory. These units carry a portion of the current period's fixed MOH costs into the inventory account, thereby reducing the current period's reported expenses and causing net income to rise.

Q7-12 Difference in reported net income between absorption and variable costing arise because of changing levels of inventory. Under JIT, goods are produced strictly to customers' orders. With production geared to sales, inventories are largely (or entirely) eliminated, thereby eliminating any shifting of fixed MOH costs between periods under absorption costing. Thus, if inventories are eliminated, absorption costing and variable costing will report the same net income figures.

E7-3 1) Under absorption costing 2) Under variable costing

DM R 100 DM R100

DL 320 DL 320

VOH 40 VOH 40

FOH 240 R460

R700

FOH per unit = $60,000 / 250 units

E7-4 1) 25 units in ending inv x $240 FOH / unit = R6,000

VCOGS directly by multiplying the # of units sold (for COGS) times the variable product cost.

1a & b) Absorption product cost = $30

- COGS (20,000 x 30) 600,000

1a) Under absorption costing 2a) Under variable costing

DM $ 20 DM $ 20

DL 8 DL 8

VOH 2 VOH 2

FOH 10 $30

$40

FOH per unit = $100,000 / 10,000 units