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How can Absorption Costing artificially increase profits? The opening decision feature of Chapter 6 is about...

How can Absorption Costing artificially increase profits?

The opening decision feature of Chapter 6 is about how Automakers such as GM and Chrysler often "flood the market" with a supply that exceeds the demand. In Chapter 6, you learn about how Absorption Costing can artificially increase profits. Why does upper management allow this to continue or is it good for shareholders as well?

Introduction to Managerial Accounting

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Expert Solution

In absorption Costing System the stock is valued at Full manufacturing cost i.e., the fixed manufacturing overheads also form part of stock valuation.

This means that the closing inventory in credit side of an income statement consists of share of fixed manufacturing cost thereby increasing the value of closing inventory which ultimately results in increase of profits.

Whereas in marginal Costing the fixed manufacturing expenses are expensed off in the year in which they are incurred thereby resulting in lower profits when compared to absorption Costing profit.

Even the upper management allows this to continue because they will reach their budgeted income which will ultimately result in incentives and also the company can project healthy financial statements.

It is basically not so good for shareholders because the management may build up closing stock at an unreasonable quantity to depict huge profits but which in reality is totally different.

ekkarill92 answered 2 years ago
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