Question

Celebration Party Supplies 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

Solution:

Production team will not be able to influence their incentive compensation if the companuy used variable costing as a basis of additional compensation. The reason is, under absorption costing, fixed manufacturing overhead is absorbed on the number of unit produced and if number of unit produced is not sold at year end then fixed manufacturing overhead absorbed by ending inventory will not reflect in income statement. On the other hand, under variable costing, fixed cost is charged to income statement irrespective of level production. It is considered as a period cost and does not form part of product cost, therefore does not become part of ending inventory.

Hence from above we can say that, production team will not be able to influence their incentive compensation if the company used variable costing as a basis of additional compensation