Question

Describe how use of absorption costing in determining income can lead to overproduction and a buildup of inventory. Explain how variable costing can avoid this same problem.

Short answer

The fixed costs is considered in absorption costing so as the unit of production increases the unit cost per unit reduces, so this encourages the managers to produce more units as it will give incentive.

Reported income under variable costing is not impacted by production level changes because all fixed production costs are charged when incurred.

Step-by-step solution

Absorption costing in determining income can lead to overproduction

Under absorption costing while determining the cost per unit the fixed costs are likewise considered, hence to bring the cost per unit at a lower side managers tends to overproduce the products, as they do so to demonstrate their performance. Since the fixed costs is considered, so as the unit of production expands the unit cost per unit comes to low, so this encourages the department to produce more units, as it will give incentive to them, by bringing the cost per unit at a lower side.This incentive problem empowers inventory buildup, which leads to inflated costs in financing, storage, and obsolescence.

Variable costing can avoid the problem

When income is measured using variable costing the manager incentive problem is avoided. This shows that managers cannot inflate income under variable costing by simply expanding production without expanding sales. Under variable costing, companies raise income by selling more units and not by overproduction of inventory.