Under absorption costing, how can net income be affected by changes in inventory levels?

• A. Absorption costing results in lower net income when inventory levels rise.
• B. Absorption costing can inflate net income when inventory levels increase because fixed overhead is allocated to inventory.
• C. Absorption costing and variable costing always yield the same net income.
• D. Absorption costing ignores fixed manufacturing overhead.

Answer: (B)

Under absorption costing, fixed manufacturing overhead is treated as a product cost and allocated to units produced. The amount of fixed overhead that actually hits the income statement in a period depends on how much of that overhead is in ending inventory versus how much is expensed in cost of goods sold.

When inventory rises, more fixed overhead is carried in ending inventory rather than expensed in the period. That means COGS for the period is lower (fewer fixed overhead costs are recognized as an expense), which increases reported net income for that period. If inventory declines, fixed overhead previously absorbed into inventory is released to COGS, increasing expenses and lowering net income.

For example, if fixed overhead is fixed at 100 and you produce more than you sell, part of that 100 is tied up in ending inventory rather than being expensed, boosting net income relative to periods with lower or decreasing inventory. This is why absorption costing can inflate net income when inventory levels rise.