Question

CP uses absorption costing to compute additional compensation eligibility for managers. In December, the company experienced a considerable production overrun, resulting in increased ending inventories. Upon inquiry into the cause of the overrun by the controller, the production manager indicated that she was aware of the overrun and felt that the production team management had relaxed its controls during December runs in order to help "everyone make their year-end bonus." Since the team was aware that the overrun allowed for more overhead application in December, it would put the team in a more favorable position for bonus awards. She reasoned that if the company didn't intend for this type of activity to occur, they would not have structured the incentive compensation to be based on the absorption costing structure.

Would the production team still be able to influence their incentive compensation if the company used variable costing as a basis of additional compensation?

Answer 1

In variable costing approch only variable expenses incurred are assigned to the inventory and cost of goods sold , cost like direct material, direct labour, variable overhead are taken as the cost as a consequence of which we h ave understated cost of production.these are more importantly used for internal reporting.

Absorption costing treats all the fixed expenditure showing true picture and is used by the internal management as well as the external people like creditors , auditors etc;

in the given case of production overrun more material, labour , machine holding cost are incurred which means cost of production shooting up.so a clear picture would be available only by folowing absorption costing.

production team will not be able to influence their incentive compensation by following variable costing.