Variable vs. absorption costing. The Zwatch Company manufactures trendy, high-quality, moderately priced watches. As Zwatch’s senior financial analyst, you are asked to recommend a method of inventory costing. The CFO will use your recommendation to construct Zwatch’s 2007 income statement. The following data are for the year ended December 31, 2007:

Beginning inventory,January 1, 2007 Ending inventory, December 31, 2007 2007 sales Selling price (to distributor)

Variable manufacturing cost per unit, including direct materials Variable operating cost per unit sold Fixed manufacturing overhead Denominator-level machine-hours Standard production rate Fixed operating costs 85,000 units 34,500 units 345,400 units

$ 26.40 per unit

$ 6.12 per unit

$1.10 per unit sold

$ 1,440,000 6,000 50 units per machine-hour

$ 1,080,000 Assume standard unit costs are constant. Also, assume no price, spending, or efficiency variances.

Required 1. Prepare income statements under variable and absorption costing for the year ended December 31, 2007.

2. What are Zwatch’s operating incomes under each costing method (in percentage terms)?

3. Explain the difference in operating income between the two methods.

4. Which costing method would you recommend to the CFO? WTy?