Proposals for Revising Performance Evaluation

Top management, with help from the controller and management accountants, can take several steps to reduce the undesirable incentives of absorption costing:

• Focus on careful budgeting and inventory planning to reduce management’s freedom to build up excess inventory. For example, include in the budgeted monthly balance sheets estimates of the dollar amount of inventories. If actual inventories exceed these dollar amounts, top management can investigate the inventory buildups.
• Incorporate a carrying charge for inventory in the internal accounting system. For example, the company could assess an inventory carrying charge of 1% per month on the investment tied up in inventory and for spoilage and obsolescence when it evaluates a manager’s performance. An increasing number of companies are beginning to adopt this practice.
• Change the period used to evaluate performance. Critics of absorption costing give examples in which managers take actions that maximize quarterly or annual income at the potential expense of long-run income. When their performance is evaluated over a 3- to 5-year period, managers will be less tempted to produce for inventory.
• Include nonfinancial as well as financial variables in performance evaluation schemes. Examples of nonfinancial measures that can be used to monitor the performance of Stassen’s managers in 2021 (see column H of Exhibit 9-4) are as follows:

Top management would want to see production equal to sales and relatively stable levels of inventory. Companies that manufacture or sell several products could report these two measures for each of the products they manufacture and sell.

Besides the formal performance measurement systems, companies develop codes of conduct to discourage behavior that benefits managers but not the company and to build values and cultures that focus on behaving ethically. We discuss these topics in Chapter 24.