Question

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: ANSWER THIS

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

Variable costing product cost includes direct material, direct labor and variable manufacturing overheads only. Fixed manufacturing overheads is treated as period cost and charged to the period in which it is incurred. Absorption costing product cost includes direct material, direct labor, and variable manufacturing overhead and fixed manufacturing overheads. The difference in product cost between 2 methods is fixed manufacturing overheads. The profit under absorption costing and variable costing needs to be reconciled in certain cases.

· When production and sales are equal the profit or loss as per variable costing and absorption costing is same since there is no closing stock

· When production is higher than sales profit reported in absorption costing is higher than variable costing due to fixed manufacturing overhead deferred in closing inventory

· When Opening stock is higher than closing stock profit reported in absorption costing is lower since the deferred fixed manufacturing overhead is charged to cost of goods sold

Ethical issues:

Absorption costing leads to ethical issues among employees when higher production is done to meet the profit target through inventory build up. This situation does not arise under variable costing since fixed manufacturing overheads are charged to income statement.

Risks involved in over-producing to meet short term profit targets

· It will lead inventory obsolescence if sales are reduced

· It will lead to non moving and slow moving stock if new launches are failures

· It needs more working capital to produce inventory

· It will lead to higher operating cycle through increase in inventory days on hand

· It affects the profit of subsequent period when inventory is sold