Question

John Smith, president of Furman Enterprises, remembers from his first accounting course that to calculate unit cost you divide total cost by the number of units produced. In reviewing a recent production report, he noticed that fixed overhead per unit was higher than he expected. He has ordered the production department to increase production in the coming months by 15% so that the overhead costs are spread over more units, which will lower the unit cost. He believes that this action will result in a higher gross margin per unit and increase the company's profitability.

He brings his idea to you, the production manager. Do you think his suggestion is a good one? Why or why not?

Answer 1

The U.S. GAAP requires the use of absorption costing in external financial reporting. Under this costing method, direct materials, direct labor, and both variable and fixed overhead are included in product costs and therefore when a company increases the number of units it produces, this would result in increased net income as the fixed overhead is allocated to more units. The suggestion of the president is not good because it is not only unethical but also misrepresentation of true costs and therefore violates GAAP when the president recommends increasing the number of units produced so that earnings per share are manipulated.