Absorption Costing and Performance Measurement

Learning Objective 3 Understand how absorption costing can provide undesirable incentives for managers to build up inventory

• producing more units for inventory absorbs fixed manufacturing costs and increases operating income

Absorption costing is the required inventory costing method for external financial reporting in most countries (we provide potential reasons for this rule later in the chapter). Many companies use absorption costing for internal accounting as well for several reasons:

• It is cost-effective and less confusing for managers to use one common method of inventory costing for both external and internal reporting and performance evaluation.
• It can help prevent managers from taking actions that make their performance measure look good, but that hurt the income the company reports to shareholders.
• It measures the cost of all manufacturing resources, whether variable or fixed, necessary to produce inventory. Many companies use inventory-costing information for long-run decisions, such as pricing and choosing a product mix. For these long-run decisions, inventory costs should include both variable and fixed costs.

An important attribute of absorption costing is that it enables a manager to increase margins and operating income by producing more ending inventory. Producing for inventory is justified when a firm’s managers anticipate rapid growth in demand and want to produce and store additional units to deal with possible production shortages in the next year. For example, with expectations that global solar power capacity will triple over the next 5 years, manufacturers of solar panels are stepping up production in order to take advantage of an anticipated high demand. But, under absorption costing, managers may be tempted to produce inventory even when they do not anticipate customer demand to grow. The reason is that this production leads to higher operating income, which can benefit managers in two ways: directly, because higher incomes typically result in a higher bonus for the manager, and indirectly, because greater income levels have a positive effect on stock price, which increases managers’ stock-based compensation. But higher income results in the company paying higher taxes. Shareholders and supporters of good corporate governance would also argue that it is unethical for managers to take actions that are intended solely to increase their compensation rather than to improve the company. Producing for inventory is a risky strategy, especially in industries with volatile demand or high risk of product obsolescence because of the pace at which innovation is occurring. For example, tablet sales have been sliding since 2014 and even newer models such as the iPad Pro are being sold at deeply discounted prices in an attempt to spur sales and reduce inventories.

To mitigate the undesirable incentives to build up inventories that absorption costing provides, a number of companies use variable costing for internal reporting. Variable costing focuses attention on distinguishing variable manufacturing costs from fixed manufacturing costs. This distinction is important for short-run decision making (as in cost–volume–profit analysis in Chapter 3 and in planning and control in Chapters 6, 7, and 8).

Companies that use both methods for internal reporting—variable costing for short-run decisions and performance evaluation and absorption costing for long-run decisions—benefit from the relative advantages of each. Surveys sponsored by Chartered Institute of Management Accountants (United Kingdom), the world’s largest professional body of management accountants, have shown that while most organizations employ absorption-costing systems, more than 75% indicate the use of variable-costing information as either the most important or second most important measure for decision-making purposes.

In the next section, we explore in more detail the challenges that arise from absorption costing.

Undesirable Buildup of Inventories

A manager whose bonus is based on reported absorption-costing income may be motivated to build up an undesirable level of inventory. Assume that Stassen’s managers have such a bonus plan. Exhibit 9-4 shows how Stassen’s absorption-costing operating income for 2021 changes as the production level changes. This exhibit assumes that the production-volume variance is written off to cost of goods sold at the end of each year. Beginning inventory of 2,000 units and sales of 6,500 units for 2021 are unchanged from the case shown in Exhibit 9-2. As you review Exhibit 9-4, keep in mind that the computations are basically the same as those in Exhibit 9-2.

Exhibit 9-4 shows that production of 4,500 units meets the 2021 sales budget of 6,500 units (2,000 units from beginning $\text{inventory}+\text{4,500}\hspace{0.17em}\text{units}$ produced). Operating income at this production level is $1,267,500. By producing more than 4,500 units, commonly referred to as producing for inventory, Stassen increases absorption-costing operating income. Each additional unit in 2021 ending inventory will increase operating income by $135. For example, if 9,000 units are produced (column H in Exhibit 9-4), ending inventory will be 4,500 units and operating income increases to $1,875,000. This amount is $607,500 more than the operating income with zero ending inventory $(\$\text{1,875,000}-\$\text{1,267,500},\hspace{0.17em}\text{or}\hspace{0.17em}\text{4,500}\hspace{0.17em}\text{units}\times \$135\hspace{0.17em}\text{per unit}=\$\text{607,500}).$ By producing 4,500 units for inventory, the company using absorption costing includes $607,500 of fixed manufacturing costs in finished-goods inventory, so those costs are not expensed in 2021.

The scenarios outlined in Exhibit 9-4 raise three other important points. First, column D is the base-case setting and just restates the 2021 absorption costing results from Panel B of Exhibit 9-2. Second, column F highlights that when inventory levels are unchanged, that is, production equals sales, absorption-costing income equals the income under variable costing (see Panel A of Exhibit 9-2 for comparison). Third, the example in Exhibit 9-4 focuses on 1 year, 2021. A Stassen manager who built up an inventory of 4,500 telescopes at the end of 2021 would have to further increase ending inventories in 2022 to increase that year’s operating income by producing for inventory. There are limits to how much inventory levels can be increased over time because of physical constraints on storage space and management controls. Such limits reduce the likelihood of incurring some of absorption costing’s undesirable effects. Nevertheless, managers do have the ability and incentive to move costs in and out of inventory in order to manage operating income under absorption costing.

Top management can implement checks and balances that limit managers from producing for inventory under absorption costing. However, the practice cannot be completely prevented. There are many subtle ways a manager can produce for inventory that may not be easy to detect. For example, consider the following scenarios:

• A plant manager may switch to manufacturing products that absorb the highest amount of fixed manufacturing costs, regardless of the customer demand for these products (called “cherry-picking” the production line). Delaying the production of items that absorb the least or lower amount of fixed manufacturing costs could lead to failure to meet promised customer delivery dates (which, over time, can result in a loss of customers).
• A plant manager may accept a particular order to increase production, even though another plant in the same company is better suited to handle that order.
• To increase production, a manager may defer maintenance of equipment beyond the current period. Although operating income in this period may increase as a result, future operating income could decrease by a larger amount if repair costs increase and equipment becomes less efficient.