Criticisms of Absorption Cost Systems: Incentive to Over-produce Chapter Ten Criticisms of Absorption Cost Systems: Incentive to Over-produce McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Outline of Chapter 10 Criticisms of Absorption Cost Systems: Incentive to Overproduce Variable (Direct) Costing Problems with Variable Costing Beware of Unit Costs

Connection to Other Chapters Chapter 10’s theme: Traditional absorption costing can result in poor operational decision making in a manufacturing firm. Chapter 1: No single accounting system can satisfy decision making, decision control, and external reporting. Chapter 2: Accounting costs include fixed and variable costs. Chapter 9: Described mechanics of absorption costing

Incentive to Overproduce Under absorption costing, manufacturing managers can defer recognition of fixed manufacturing costs by building ending inventory rather than deducting those fixed costs in the year incurred. Ending Inventory  Asset  Unexpired cost  Expense deducted when items are sold next year Period cost  Expired cost  Expense deducted in year incurred

Increasing Production Reduces Average Costs Absorption costing treats fixed manufacturing costs as product costs. When more units are produced than sold and absorption costing is used, some of the fixed costs are allocated to ending inventory (asset account) and become recognized in a future period’s cost of goods sold (expense account). Reconciling case 1 and 2: Net Income Ending Inventory Case 1: 2000 produced, 2000 sold $ 4,000 $ 0 Variable cost in ending inventory 1,000 Fixed cost in ending inventory 909 909 Case 2: 2200 produced, 2000 sold $ 4,909 $ 1,909 Also see Self Study Problems.

Reducing Overproduction: Performance Evaluation To reduce overproduction, modify the performance evaluation system. Inventory holding charge against divisional profits Residual income technique from Chapter 5 Variable instead of absorption costing Variable costing is discussed.

Reducing Overproduction: Decision Rights To avoid the overproduction incentive of absorption costing, reduce the decision rights of the production managers. Senior managers strictly monitor inventory levels Remove production manager’s right to build inventory level greater than amount authorized by top management. Just-In-Time (JIT) production so that customer orders drive inventory Remove production manager’s right to build inventory level greater than amount ordered by customers. See Chapter 14.

Variable Costing: Defined Variable costing treats all fixed manufacturing costs as period costs to be deducted from net income (expensed) in the period incurred. Under variable costing, only variable manufacturing costs flow through to the inventory accounts. Variable costing is also known as direct costing since the variable manufacturing costs consist of direct materials, direct labor, and variable overhead. Variable costing is one of the methods of setting transfer prices. See Chapter 5.

Comparing Absorption and Variable Costing Similarities: Under both methods all fixed and variable manufacturing costs will eventually become expenses deducted in computing net income. Variable manufacturing costs flow through the finished goods inventory account and are expensed in the period goods are sold. Differences: Under absorption costing, fixed manufacturing overhead is a product cost and flows through inventory account and is expensed when goods are sold. Under variable costing, fixed manufacturing overhead is period cost and expensed in period incurred.

Example Comparing Absorption and Variable (extension of Year 2 example in Table 10-5) Absorption Variable Cost Revenue (10,000 units) $110,000 $110,000 Direct materials and labor - 20,000 - 20,000 Variable Mfg OH - 30,000 - 30,000 Fixed manufacturing overhead - 36,364 - 40,000 Net income $ 23,636 $ 20,000 Ending inventory (1,000 units): Variable costs $ 5,000 $ 5,000 Fixed manufacturing overhead 3,636 none Ending inventory cost $ 8,636 $ 5,000

Problem with VC: Classifying Fixed vs. Variable Overhead Under both absorption and variable costing, managers have an incentive to defer costs by getting more costs into ending inventory rather than cost of goods sold expense in current period. To defer costs under variable costing, managers can: Classify more overhead as variable rather than fixed so that variable cost per unit increases. Produce more units than sell so that ending inventory increases and the variable costs associated with that ending inventory are deferred until next period. Do both of the above.

Problem with VC: Opportunity Cost of Capacity Variable costing does not adequately measure the opportunity cost of using plant capacity for other purposes. Although opportunity costs are inherently hard to measure, they are usually best estimated as a combination of fixed and variable costs. However, note that if the firm has excess capacity, using fixed charges in unit costs overstates opportunity cost and discourages the use of excess capacity.

Problem with VC: Absorption Required for External Reports Absorption costing for products is required for: External financial reporting Match cost of goods sold to revenues from sale of those goods. US federal income tax reporting The government tax collectors want taxpayers to defer deduction of fixed costs to raise current taxable income and taxes paid. Reconciling between variable costing for internal purposes and absorption costing for external purposes is costly. If benefits of separate systems are not great, use one costing system for both internal and external reports.

Beware of Unit Costs Unit costs are average costs that include some directly traceable costs and some allocated variable and fixed costs incurred. Unit costs  opportunity costs because opportunity costs are estimates of foregone benefits from actions that could, but will not be undertaken (Chapter 1). Unit costs  marginal costs because marginal costs are the cost of producing one more unit rather than the average cost (Chapter 1).

Beware of Historical vs. Future Costs As the firm expands or contracts into areas of its cost curve where it has not been before, there is no historical information regarding the level of costs in these unexplored regions. Example: Natural gas prices are $0.20 per cubic yard up to 500,000 cubic yards and then $0.30 per cubic yard thereafter.