Final answer:
Absorption costing can lead to overproduction as it allocates fixed costs to each unit produced, allowing companies to defer recognizing these costs, which can inflate profits. Variable costing avoids this by expensing fixed costs in the period they're incurred, better aligning production with sales and accurately reflecting income.
Step-by-step explanation:
The use of absorption costing in determining income can lead to overproduction because this costing method includes both variable and fixed costs in the cost of each unit produced. When a company produces more units than it sells, the unsold inventory carries over these fixed costs, which does not affect the income statement until the products are sold. This can result in managers overproducing to allocate more fixed costs to inventory, thereby reducing the cost of goods sold and inflating profits in the short term.
On the other hand, variable costing only includes variable production costs in the cost of each unit. Fixed costs are treated as period costs and are expensed in full during the period they are incurred. This means that producing additional units will not defer the recognition of fixed costs, thereby avoiding the incentive to overproduce and accumulate inventory. Instead, income reported under variable costing reflects the current period's production and sales activities more accurately.
By focusing on variable costs, companies can make more informed decisions that reflect the firm's ability to cut costs in the present and the extent to which costs will increase if production rises, as variable costs provide a clearer picture of the incremental costs associated with producing one more unit.