Question

Absorption costing income statements are typically used for external financial reporting to comply with generally accepted accounting principles (GAAP). Variable costing income statements are used for internal decision making only as variable costing is not consistent with GAAP. As your authors describe, variable costing better enables CVP analysis, explains changes in net operating income, and supports decision making. (Please read "Misguided Incentives in the Auto Industry.")

Read the scenario below, and address the subsequent requirements.

Because your division has a high amount of fixed costs, you are aware that a way to increase the current year’s profits is to overproduce. That is, a lower fixed cost per unit could be obtained by spreading the division's fixed costs over a larger amount of output than is needed to meet customer demand. Sure, you'd end up with excess inventory, but a good portion of your fixed costs would be deferred into the inventory balance sheet account. This would also lower the cost of goods sold, thereby increasing net operating income for the year. By producing 10% more output than is needed, your division’s profits would reach the current year’s targeted level, on which your bonus is based.

Required::

Share your responses to the following questions with your classmates:

1. What are some of the ethical and accounting issues you identified as you've learned about variable and absorption costing?
2. What are the risks involved in overproducing to meet short term profit targets?  

Answer 1

The use of the costing method would be decided on the basis of purpose, so following issues comes up which are to be considered:

1) For the taking management decision, the Variable costing is used which helps the management to decide about the financial leverage.

2) The variable costing allows the management to decide whether a product line is contributing towards the fixed costs and the profits of the company.

3) The absorption costing helps the company to reduce the cost per unit and increase the profits, through production of maximum units and deferring the manufacturing fixed costs to the next period through transfer of the closing stock.

4) The absorption costing do not differentiate between the fixed and variable cost. According to absorption costing all costs are to be considered to calculate the profits of the period.

5) The absorption costing is based on Accrual based accounting where the sales are always accompanied with their concerned costs. So, all period and variable costs related to units sold considered to calculate the profits of the period.

===================