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Chapter Ten
Criticisms of Absorption
Cost Systems:
Incentive to Overproduce
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

Incentive to Overproduce

Variable (Direct) Costing

Problems with Variable Costing

Beware of Unit Costs
10-2
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
10-3
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
10-4
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:
Case 1: 2000 produced, 2000 sold
Variable cost in ending inventory
Fixed cost in ending inventory
Case 2: 2200 produced, 2000 sold
Net Income
$ 4,000
909
$ 4,909
Ending Inventory
$ 0
1,000
909
$ 1,909
Also see Self Study Problems.
10-5
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.
10-6
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.
10-7
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.
10-8
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.
10-9
Example Comparing Absorption and
Variable (extension of Year 2 example
in Table 10-5)









Absorption
Revenue (10,000 units)
$110,000
Direct materials and labor
- 20,000
Variable Mfg OH
- 30,000
Fixed manufacturing overhead - 36,364
Net income
$ 23,636
Ending inventory (1,000 units):
Variable costs
Fixed manufacturing overhead
none
Ending inventory cost
Variable Cost
$110,000
- 20,000
- 30,000
- 40,000
$ 20,000
$ 5,000
3,636
$ 5,000
$ 8,636
$ 5,000
10-10
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.
10-11
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.
10-12
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.
10-13
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).
10-14
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.
10-15