Hence the drop in operating income under absorption costing, even though sales were greaterthan the computed breakeven volume: inventory levels decreased sufficiently in 2015 to cause2015’s operating income to be lower than 2014 operating income. Note that beginning and ending with zero inventories during the 2013–2015 period, underboth costing methods, Smart Safety’s total operating income was $301,600. 9-25(20 min.)Denominator-level problem.1.Budgeted fixed manufacturing overhead costs rates:DenominatorLevel CapacityConceptBudgeted FixedManufacturingOverhead perPeriodBudgetedCapacityLevelBudgeted FixedManufacturingOverhead CostRateTheoretical$ 6,480,0005,400$ 1,200.00Practical6,480,0003,8401,687.50Normal6,480,0003,2402,000.00Master-budget6,480,0003,6001,800.00The rates are different because of varying denominator-level concepts. Theoretical and practicalcapacity levels are driven by supply-side concepts, i.e., “how much can I produce?” Normal andmaster-budget capacity levels are driven by demand-side concepts, i.e., “how much can I sell?”(or “how much shouldI produce?”)2. The variances that arise from use of the theoretical or practical level concepts will signalthat there is a divergence between the supply of capacity and the demand for capacity. This isuseful input to managers. As a general rule, however, it is important not to place undue relianceon the production volume variance as a measure of the economic costs of unused capacity.3. Under a cost-based pricing system, the choice of a master-budget level denominator willlead to high prices when demand is low (more fixed costs allocated to the individual productlevel), further eroding demand; conversely, it will lead to low prices when demand is high,forgoing profits. This has been referred to as the downward demand spiral—the continuingreduction in demand that occurs when the prices of competitors are not met and demand drops,resulting in even higher unit costs and even more reluctance to meet the prices of competitors.The positive aspects of the master-budget denominator level are that it is based on demand forthe product and indicates the price at which all costs per unit would be recovered to enable thecompany to make a profit. Master-budget denominator level is also a good benchmark againstwhich to evaluate performance.