Question

Suppose you serve on the board of directors of SkyBeam, a manufacturer of kitchen appliances that recently adopted an lean production philosophy. Part of your responsibility is to develop a compensation contract for May Tagg, the vice-president of manufacturing. To give her the incentive to make decisions that will increase the company's profits, the board decides to give Tagg a year- end bonus if SkyBeam meets a target operating income.

Required:

Write a memo to Chairperson of the Board, Justin Amana, explaining whether the bonus contract should be based on absorption costing or variable costing method. Explain your reasons to support your recommendation.

Answer 1

13 Oct 2019

To:         

Justin Amana

Chairperson

Board of Directors

SkyBeam

Recommendation on Compensation Contract for May Tagg (the vice-president of Manufacturing)

Background

Develop a compensation contract for May Tagg, the vice-president of manufacturing. This Compensation Contract will give Tagg a year-end bonus if Sky Beam meets the target operating income. This compensation package is to motivate and encourage May Tagg (the vice-president of Manufacturing) in making decisions that will increase the Company’s profits. Tagg will be entitled to receive an year-end bonus if Company meets the target operating income.

Recommendation

Our company has recently adopted Lean Production Philosophy and look forward to eliminate non value added activities and cost associated with the same. With this Lean Production Methodogy we focus avoid non value added cost and thus bring cost efficiency. Out Operating Income percentage is expected to increase significantly with Lean Production Philosophy.

Given the context of cost efficiency with the new Production methodology, we should not only keep Operating Income as a criteria for rewarding Management Executives like May Tagg. Our focus should be also towards the Operating Income Percentage which considers both Income and Cost efficiencies achieved through the new Production Methodology.

With the recent adoption of Lean Production Philosophy, our manufacturing units should focus on eliminating non value added production process and focus on cost efficiency. An ideal way of measuring this is by using Absorption Costing which indicates that all of the manufacturing costs have been assigned to the units produced.

Conclusion

Focusing on Lean Production Philosophy, the bonus contract for May Tagg (the vice-president of Manufacturing) should be based on Absorption Costing method.