Question

Topic 2: Which method do you think allows for the greatest manipulation of net income: variable or absorption costing and why? Discuss any ethical concerns associated with your answer. Do not forget APA format on your sources, in-text citations.

Answer 1

Reference : Drury C. (1992) Absorption costing and variable costing. In: Management and Cost Accounting. Springer, Boston, MA

First of all, we need to understand product costing under Variable or Absorption costing method. Absorption costing included all costs including fixed costs incurred in production while Variable costing includes only the variable costs incurred in production. Companies that keep variable costing method keeps fixed cost separate from the production cost. Some of the direct costs include direct materials, direct labor & overhead. The fixed cost that differentiate variable costing and absorption costing are mainly overheads like salaries, building leases, which do not change with the change in production quantity. A company has to pay its fixed expenses regardless of whether it produces many products or no products. Whichever method company chooses for accounting, there are advantages & disadvantages.

Absorption Costing, also known as full costing, allocate all fixed overhead costs to the units produced, thereby determining per unit cost, whereas in Variable costing, fixed overhead costs are shown as a single expense in balance sheet deducted from the net income. Variable costing may make it difficult to determine ideal pricing as it does not consider all the costs of production.

Absorption costing allows for the greatest manipulation of net income due to change in method of inventory valuation. It assumes all the costs incurred to production costs. It does not show full expenses of the period. Absorption costing gives room to production managers to increase net profit by showing goods produced without selling them. This happens due to the capitalization of fixed costs in inventory balances. Higher inventory costs dilute the indirect costs and fixed costs in the income statement, thereby increasing the inventory balance in balance sheet.

Ethical concerns

Absorption costing is a form of accounting which includes all variable and fixed costs into the manufacturing of a product, including direct materials, labor and overheads. When this form of accounting is used, it leads to unethical practices by manipulating costs, assets and inventory values and showing a better financial position of the company than it actually is.

Misrepresentation - One of the most obvious unethical practice in the income statement by absorption costing method is misrepresentation of true costs. Even if the value of expense is under the budget and guidelines, the amount shown as expense in marketing is misrepresented to the shareholders or directors.

Uneven Expenses - Some items that need to be paid annually are accounted as monthly expense at a fixed amount per month. The amount can be skipped and added to different month, if the shareholders have seen the previous month income statement, they will be unaware of the adjustment.

Manipulation of assets - Asset represent future income and under absorption costing, the company can shows assets at a higher value than it actually is. The unsold inventory can be accelerated to the next accounting period and shown as an asset in the balance sheet with the full value whereas the variable cost of the inventory is lower.

Hiding bad months - Adjustment of total costs of a particular month can temporarily hide the fact that the company is losing money. The costs can be added back to the correct months and no one will know this adjustment unless the company is overall performing good.