Question

What would you conclude most managers would do if they know their performance evaluation will be based on how much absorption income they generated? (Would they be encouraged to make more than they sold or to sell more than they made in the current period?) Should managers then be evaluated using absorption costing income figures or variable costing income figures?   

Answer 1

If most of the managers will be knowing that performance evaluation will be based upon absorption costing then they will be encouraged to sell less because absorption costing is based upon the philosophy that fixed cost overhead is allocated per unit and hence all those inventory which has been lying into the stores will be having fixed cost allocated to them, and it will be leading to higher inventory value so they will be trying to keep more of the inventory in order to have a better representation of their profits because until and unless these units are sold by them these cost would not be reflected into the overall cost when ascertainment of profits.

Then the managers should be evaluated using the variable cost method because variable cost method will be trying to to assume the fixed cost in advance and it will not be allocating the fixed cost, so they will be trying to sell more units in order to generate more profits and hence it can be said that these managers will be better evaluated by variable costing under such scenario.