Chapter Ten

Criticisms of Absorption Cost

Systems: Incentive to Overproduce

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Outline of Chapter 10
Criticisms of Absorption Cost
Systems: Incentive to Overproduce
 Incentive to Overproduce

 Variable (Direct) Costing

 Problems with Variable Costing

 Beware of Unit Costs

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 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

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 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

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 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.

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 Reducing Overproduction:
Performance Evaluation
 To reduce overproduction, modify the performance
evaluation system.

 Inventory holding charge against divisional profits

 Residual income technique from Chapter 5

 Based on external stock price instead of financial

accounting
 Not good if privately-held or many different plants

 Variable instead of absorption costing

 Variable costing is discussed.

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 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.

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 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 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.

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 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.

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 Effect of Inventory Buildup
 Situation Net Income (NI) Inventory Change
 Units produced Absorption NI Absorption defers some fixed
 > units sold > variable cost NI fixed costs in ending inventory.

 Units produced Absorption NI If fixed cost per unit is

unchanged,
 = units sold = variable cost NI total inventory $ are
unchanged.

 Units produced Absorption NI Absorption takes more fixed

costs
 < units sold < variable cost NI out of beginning inventory
than are added to ending
inventory. Thus, prior period
fixed costs reduce current
period NI.

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Example Comparing Absorption and
Variable (extension of Year 2
example in Table 10-5)
Absorption Variable
 Revenue (10,000 units) $110,000 $110,000
 Direct materials and labor - 20,000 - 20,000
 Variable manufacturing overhead - 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

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 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.

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 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 overstated opportunity cost and
discourages the use of excess capacity.

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 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.
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 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).

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 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.

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