Question

Which of the following is an example that critics of absorption costing may use to show its potential for leading to undesirable incentives for managers?

1) Overproduction
2) Underproduction
3) Variable costing
4) Fixed costing

Answer 1

Critics of absorption costing argue it can lead to overproduction as managers produce excess to lower per-unit cost allocation of fixed costs. Overproduction can result in excess inventory and misrepresents the timing of cost recognition. Variable costing is suggested as a more informative alternative as it only includes variable costs, making it clearer for decision-making.

Step-by-step explanation:

Critics of absorption costing often point to overproduction as an undesirable incentive that it creates for managers. Absorption costing allows for all fixed costs to be absorbed by the units produced, which can sometimes lead to situations where managers are incentivized to produce more than what is immediately needed, just to reduce the per-unit fixed cost allocation. This is problematic because it can lead to excess inventory and the deferment of fixed cost recognition in the profit and loss statement.

Fixed costs are sunk costs, which should not influence future production decisions because they cannot be altered and must be incurred before any production occurs. Critics argue that variable costing, which includes only variable costs that increase with production in the cost of goods sold, provides clearer information for decision-making, as it reflects the additional costs of producing more goods without the murky allocations of fixed costs.