Question

Effects of differing production levels on absorption costing income. Metrics to minimize inventory buildups. Effects of differing production levels on absorption costing income: Metrics to minimize inventory buildups. University Press produces textbooks for college courses. They recently hired a new editor, Leslie White, to handle production and sales of books for an introduction to accounting course. Leslie’s compensation depends on the gross margin associated with sales of this book. Leslie needs to decide how many copies of the book to produce. The following information is available for the fall semester 2010:

The fixed cost allocation rate is based on expected sales and is therefore equal to

 $120,000/10,000 books = $12 per book

Leslie has decided to produce either 10,000, 12,000, or 16,000 books.

1. Calculate expected gross margin if Leslie produces 10,000, 12,000, or 16,000 hooks. (Make sure you include the production-volume variance as part of cost of goods sold)

2. Calculate ending inventory in units and in dollars for each production level.

3. Managers who are paid a bonus that is a function of gross margin may be inspired to produce product in excess of demand to maximize their own bonus. The chapter suggested metrics to discourage managers from producing products in excess of demand. Do you think the following metrics will accomplish this objective? Show your work.

a. Incorporate a charge of 10% of the cost of the ending inventory
 as an expense for evaluating the manager.

b. Include non-financial measures when evaluating management and rewarding performance.

 

Answer 1

Effects of differing production levels on absorption costing income Metrics to minimize inventory buildups.

1.

2.

3a.

 

While adjusting for ending inventory does to some degree mitigate the increase in inventory associated with excess production, it may be difficult to mechanically compensate for all of the increased income. In addition, it does nothing to hold the manager responsible for the poor decisions from the organization’s standpoint.

 

3b.

 

• A ratio of ending inventory to beginning inventory, as suggested in the book, is not possible since beginning inventory was 0, so we substituted change in inventory level.
• For these non-financial measures to be useful they must be incorporated into the reward function of the manager

• A ratio of ending inventory to beginning inventory, as suggested in the book, is not possible since beginning inventory was 0, so we substituted change in inventory level.
• For these non-financial measures to be useful they must be incorporated into the reward function of the manager