Suppose fewer units are sold in year 2 than in year 1. If production exceeds sales in year 2, net operating income under absorption costing could be higher in year 2 than in year 1

Question

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If fewer units are sold in year 2 than in year 1, but production exceeds sales in year 2, there will be more inventory carried forward into the following period. Under absorption costing, some of the fixed production costs will be deferred to the following period when the inventory is sold, resulting in higher net operating income in year 2 than in year 1.

Advantages of variable costing method:
- It is simpler to use and understand.
- It can provide more accurate information regarding the contribution margin and break-even point.
- It allows for easier comparison of alternative pricing strategies and product mix decisions.

Limitations of variable costing method:
- It does not conform to generally accepted accounting principles (GAAP) which require that fixed manufacturing costs be included in inventory valuation and cost of goods sold.
- It can lead to a distortion of net income when inventory levels fluctuate.
- It does not provide information on the full cost of producing a product.

Advantages of absorption costing method:
- It conforms to GAAP and is commonly used for external financial reporting.
- It provides a more complete picture of the full cost of producing a product.
- It can provide a better measure of profitability when inventory levels fluctuate.

Limitations of absorption costing method:
- It can be more complex and difficult to understand.
- It can make product costs and profitability sensitive to changes in production volume.
- It can obscure the true contribution margin of products and make it more difficult to compare alternative pricing strategies and product mix decisions.

Suppose Fewer Units Are Sold in Year 2 Than in Year