Question

Motivational considerations in denominator-level capacity selection

1. If the plant manager of the Austin Brewery gets a bonus based on operating income, which denominator- level capacity concept would he prefer to use? Explain.

2. What denominator-level capacity concept would Lucky Lager prefer to use for U.S. income-tax reporting? Explain.

3. How might the IRS limit the flexibility of an absorption-costing company like Lucky Lager attempting to minimize its taxable income?

Answer 1

Motivational considerations in denominator-level capacity selection 

 

1.         If the plant manager gets a bonus based on operating income, he/she will prefer the denominator-level capacity to be based on normal capacity utilization (or master-budget utilization). In times of rising inventories, as in 2009, this denominator level will maximize the fixed overhead trapped in ending inventories and will minimize COGS and maximize operating income. Of course, the plant manager cannot always hope to increase inventories every period, but on the whole, he/she would still prefer to use normal capacity utilization because the smaller the denominator, the higher the amount of overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be able to “adjust” plant operating income by building inventory, normal capacity utilization (or master-budget capacity utilization) would be preferred.

 

2.         Given the data in this question, the theoretical capacity concept reports the lowest operating income and thus (other things being equal) the lowest tax bill for 2009. Lucky Lager benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximizes the deductions for manufacturing costs.

 

3.         The IRS may restrict the flexibility of a company in several ways:

a.   Restrict the denominator-level concept choice (to say, practical capacity).

b.   Restrict the cost line items that can be expensed rather than inventoried.

c.   Restrict the ability of a company to use shorter write-off periods or more accelerated write-off periods for inventoriable costs.

d.   Require proration or allocation of variances to represent actual costs and actual capacity used.

Require proration or allocation of variances to represent actual costs and actual capacity used.