Question

1. Which of the following is not a method to mitigate the incentive to overproduce in an absorption costing system?

1. Charge managers inventory holding costs
2. Evaluate managers on residual income
3. Require senior management approval for all inventory purchases
4. Institute a Just-in-time (JIT) production system

Answer 1

The correct answer is C. Require senior management approval for all inventory purchases

Explanation:

There are several ways to mitigate the incentive to overproduce-

1. The first is to charge managers for inventory holding costs. If a manager is evaluated based on residual income instead of net income, managers are charged the cost of capital for holding inventory. If the manager overproduces, inventories increase, and residual income falls. Residual does not eliminate the incentive to overproduce. It does, however, make it less profitable to the manager.

2. A second method is a strict senior management policy against building inventories.

3. The third method, in a single-plant, publicly traded firm, compensation can be used on stock prices instead of on accounting earnings, which removes the incentive for managers to overproduce.

4. A fourth possibility is to use JIT production systems to reduce inventory levels.

5. A fifth and final option is to change the costing system.