Test bank accounting management 11e chapter 09 INVENTORY COSTING AND CAPACITY ANALYSIS

CHAPTER 9
INVENTORY COSTING AND CAPACITY ANALYSIS
LEARNING OBJECTIVES
1. Identify what distinguishes variable costing from absorption costing
2. Prepare income statements under absorption costing and variable costing
3. Explain differences in operating income under absorption costing and variable costing
4. Understand how absorption costing can provide undesirable incentives for managers to build up finished
goods inventory

5. Differentiate throughput costing from variable costing and absorption costing
6. Describe the various capacity concepts that can be used in absorption costing
7. Understand the major factors management considers in choosing a capacity level to compute the budgeted
fixed overhead cost rate

8. Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
9. Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the
production-volume variance

CHAPTER OVERVIEW
Chapter 9 is about fixed manufacturing costs. As a manufacturing cost, the issue of inventory costing and its
effect on operating income under different costing systems exists. As a fixed cost, the issue of rate
calculations and choice of a denominator exists. These issues can be studied separately through the structure
of the chapter though both have the common characteristic of how best to determine the cost of manufacturing
a product when that cost changes upon being applied as a cost per unit of product.
For external reporting all usual and reasonable manufacturing costs are considered as costs of the product
using absorption costing. Managers, however, often find the behavior aspect of costs, rather than the function
of those costs, to be most helpful in making decisions about volume and profit and use variable costing for
internal reports. These two costing approaches yield different operating income amounts when production and
sales differ.
The investment base for a manufacturing-sector company is usually the source for most of the fixed
manufacturing costs and with the emphasis on technology, many companies have more fixed manufacturing

costs than variable manufacturing costs. Managers must wrestle with how much capacity as well as how to
cost their products so as to recover those costs with a competitive selling price. Assigning responsibility for
fixed or capacity costs presents interesting challenges also. The guideline of different costs for different


purposes is highlighted throughout the chapter.
The calculation of breakeven point using absorption costing is illustrated in the appendix to the chapter.

CHAPTER OUTLINE
I. Fixed manufacturing costs – the difference in inventory costing systems
Learning Objective 1:
Identify what distinguishes variable costing from absorption costing

A. Classification issue
1. Methods of inventory costing
a. Variable costing of inventory
i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs excluded from inventoriable costs because charged to
income as incurred—expenses

b. Absorption costing of inventory: required method under GAAP for external reporting and tax
reporting in most countries

i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs included as inventoriable costs—assets initially
All nonmanufacturing costs in the value chain, whether variable or fixed, charged to income as
incurred within the accounting period
Do multiple choice 1.

Assignments start with L. O. 3.

Learning Objective 2:
Prepare income statements under absorption costing and variable costing
B.

Income statement presentation [Exhibit 9-1]

1. Highlighted by format indicating cost classification

a.

Variable costing – contribution-margin format
Costs categorized by variable or fixed—only variable manufacturing costs
inventoriable

Fixed costs expensed in total
Absorption costing – gross-margin format
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Costs categorized by manufacturing or nonmanufacturing—all manufacturing
costs inventoriable
Fixed manufacturing costs expensed per unit in cost of goods sold
2. Direct costing: not accurate term to describe variable costing
Variable costing does not include all direct costs as inventoriable (only direct variable
manufacturing costs—direct fixed manufacturing and direct nonmanufacturing
excluded)
Variable costing includes direct and some indirect variable manufacturing costs as

inventoriable
Not all variable costs are inventoriable costs—must be manufacturing variable costs
Do multiple choice 2 and 3. Assignments start with L.O. 3.
Operating income differences [Exhibit 9-2]
Learning Objective 3:
Explain differences in operating income under absorption costing and variable costing
Goods sold versus goods produced [Exhibit 9-3]
Variable costing: quantity sold drives cost and income
Absorption costing: quantity sold and produced drives cost and income
Inventory increase from beginning to end: less fixed costs expensed
Inventory decrease from beginning to end: more fixed costs expensed
c.
Do multiple choice 4.

Low levels of inventory have less effect (less “material” in amount)
Assign Exercises 9-16, 9-18, 9-20, and 9-21.

Income manipulation—undesirable buildup of inventories [Exhibit 9-4]
Using reported income based on absorption costing to increase operating income by
increasing production (even if no increase in customer demand)
Learning Objective 4:
Understand how absorption costing can provide undesirable incentives for managers to build up
finished goods inventory

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Switch to manufacturing products that absorb highest amounts of fixed

manufacturing costs and delaying those that absorb the least or lower fixed
manufacturing costs
ii Accept orders to increase production at one plant rather than produce at a
better suited plant
Defer maintenance beyond current accounting period
Increase amount of inventory units each year
b.
Revising performance evaluation—reducing undesirable effects of absorption
costing
Careful budgeting and inventory planning to reduce management freedom to build
up excess inventory
Change the accounting system from absorption costing to variable costing for
internal reporting
Incorporate a carrying charge for inventory in the internal accounting system
Change to a longer time period to evaluate performance
Include nonfinancial as well as financial variable in measures for performance
evaluation [Concepts in Action]
Do multiple choice 5.

Assign Exercise 9-23, Problems 9-30 and 9-33.

Learning Objective 5:
Differentiate throughput costing from variable costing and absorption costing
Another costing method – throughput costing (also called super-variable costing)
Method of inventory costing in which only direct material costs are inventoriable costs; all other
costs are costs of the period in which incurred
Reporting includes throughput contribution: revenues minus all direct material costs of goods sold
[Exhibit 9-5]
Advocates say it provides less incentive to produce for inventory than other methods
E.

Comparison of inventory costing methods [Exhibit 9-6] [Surveys of Company
Practice]
Do multiple choice 6.

Assign Exercises 9-17 and 9-19.

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Fixed manufacturing cost capacity analysis and denominator-level capacity concepts
Learning Objective 6:
Describe the various capacity concepts that can be used in absorption costing
Choices for denominator-level capacity (absorption costing issue)
Supply–based choices (available from the plant—upper limit or constraint)
Theoretical capacity: producing at full efficiency all the time: largest
denominator/smallest rate
Practical capacity: reduces theoretical capacity by unavoidable operating
interruptions: somewhat smaller than theoretical denominator/larger rate
Demand-based choices (demand for product is constraint)
Normal capacity utilization: satisfies average customer demand over several
periods: typically lesser than practical denominator/larger rate
Master-budget capacity utilization: expected level of capacity utilization for the
next budget period: usually smallest denominator/largest rate
Do multiple choice 7.

Assign Exercise 9-24 and Problem 9-34.

Choices for capacity level to compute budgeted fixed overhead cost rate

Different costs for different purposes
Learning Objective 7:
Understand the major factors management considers in choosing a capacity level to compute the
budgeted fixed overhead cost rate
Effect on product costing and capacity management

Highlighting the cost of capacity acquired but not used by use of practical capacity
level
b.
Managing unused capacity (practical capacity level) by designing new
products, leasing to others, eliminating excess capacity
Do multiple choice 8.

Assign Exercise 9-25.

Learning Objective 8:
Describe how attempts to recover fixed costs of capacity may lead to price increases and lower
demand

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Effect on pricing decisions
Customers willing to pay price that covers cost of capacity actually used but not
willing to bear cost of unused capacity—use of practical capacity
Using smaller denominator of supply-based capacity levels with unused capacity
means larger cost per unit
Continuing reduction in demand for product when not meeting competitors’ prices

may result in downward demand spiral resulting in higher and higher units costs
and more reluctance to meet competitors’ prices
Using practical capacity level avoids recalculation of rate—use of capacity available
rather than capacity used to meet demand
Do multiple choice 9.

Assign Problems 9-36, 9-39, and 9-40.

Effect on performance evaluation
Use of appropriate capacity level for time-span of performance period: if current year
is evaluation period, use short-term measure such as master-budget capacity
utilization (the principal short-run planning and control tool)
Use of responsibility accounting to classify part of difference between practical
capacity level and master-budget capacity utilization as planned unused capacity
Learning Objective 9:
Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects
the production-volume variance.
Effect on financial statements
Magnitude of favorable/unfavorable production-volume variance affected by choice
of denominator used to calculate the rate (absorption costing)
Method of handling end-of-period variances results in different effect on financial
statements [Refer to Chapter 4]
Adjusted allocation-rate approach—effectively changes to actual costing so
denominator choice has no effect on end-of-period financial statements
Proration approach—denominator choice has no effect on end-of-period financial
statements as underallocated or overallocated is spread among ending balances of
work-in-process inventory, finished goods inventory, and cost of goods sold
c. Immediate write-off to cost of goods sold approach—denominator choice has
an effect on end-of-period financial statements [Exhibit 9-7]
Regulatory requirements: IRS requires use of practical capacity level to calculate the rate and

proration for tax reporting
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Difficulties in forecasting chosen denominator-level capacity
Practical capacity (supply concept) provides more reliable estimate
b.
Normal capacity utilization (demand concept) more difficult to estimate but
shorter time span for master-budget capacity utilization more reliably estimated
Other issues
Managers use range of activity due to uncertainty about the future: denominator-level
concept (normal or standard costing) use a single amount of activity—unused
capacity allows gain from meeting sudden demand surges
Events affect amount of fixed costs used in numerator of rate calculation
c. Capacity as a total concept for an organization with parts of value chain having individual
capacity concerns

Do multiple choice 10.
35, 37, 38.
III.

Assign any of Exercises 9-22, 27, 28 or 29 and Problems 9-

Breakeven point with absorption costing

Do multiple choice 11 and 12.

Chapter Quiz Solutions: 1.c

Assign Exercise 9-26, Problems 9-31 and 9-32.

2.d 3.c 4.b 5.a 6.d 7.c 8.a 9.b 10.d 11.c 12.a

CHAPTER QUIZ
1. The main difference between variable costing and absorption costing is
a. the treatment of nonmanufacturing costs.
a. the accounting for variable manufacturing costs.
b. the accounting for fixed manufacturing costs.
c. their value for decision makers.
The following data apply to questions 2 and 3.
Alvin Inc. planned and actually manufactured 200,000 units of its single product in 2001, its first year of
operations. Variable manufacturing costs were $30 per unit of product. Planned and actual fixed
manufacturing costs were $600,000, and marketing and administrative costs totaled $400,000 in 2001. Alvin
sold 120,000 units of product in 2001 at a selling price of $40 per unit.

2. [CMA Adapted] Alvin’s 2001 operating income using variable costing is
a. $800,000.

b. $600,000.

c. $440,000.

d. $200,000.

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3. [CMA Adapted] Alvin’s 2001 operating income using absorption costing is
a. $840,000.

b. $800,000.

c. $440,000.

d. $200,000.

4. [CPA Adapted] Operating income using variable costing as compared to absorption costing
would be higher
a.
b.
c.
d.

when the quantity of beginning inventory equals the quantity of ending inventory.
when the quantity of beginning inventory is more than the quantity of ending inventory.
when the quantity of beginning inventory is less than the quantity of ending inventory.
under no circumstances.

5. Absorption costing enables managers to increase operating income in the short run by changing
production schedules. Which statement is true regarding such action?
a. The reason for increased operating income is the deferral of fixed manufacturing overhead
contained in unsold inventory.
b. A desirable effect of these changes in production is “cherry picking” the production line.
c. This is done through decreases in the production schedule as customer demand for product
falls.
d. None of the above statements are true regarding manager’s action to increase operating

income through changes in the production schedule.
6. The proponents of throughput costing
a. maintain that variable costing undervalues inventories.
b. maintain that it provides more incentive to produce for inventory than do either variable or
absorption costing.
c. argue that only direct materials and direct labor are “truly variable” and all indirect
manufacturing costs be written off in the period in which they are incurred.
d. treat all costs except those related to variable direct materials as costs of the period in which
they are incurred.
7.

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The absolute minimum absorption-inventory cost that would be reported under the best conceivable
operating conditions is a description of which type of denominator-level concept cost?
a.
b.
c.
d.

Master-budget utilization
Practical capacity
Theoretical capacity
Normal utilization

8. Use of capacity levels based on demand
a.

b.
c.
d.

hides the amount of unused capacity.
highlights the cost of capacity acquired but not used.
yields a cost rate that does not include a charge for unused capacity.
results in a price that covers the cost of capacity customers expect to pay.

9. A company may experience the downward demand spiral when
a. the use of theoretical capacity as a denominator-level has contributed to budgets that project
sales to be higher than actually attainable.
b. spreading capacity costs over a small number of units and setting selling prices even higher
to recover those costs.
c. engaged in a cyclical business and after experiencing an upturn.
d. the production-volume variance is unfavorable each time period during a year.
10. The manner in which a company deals with end-of-period variances will determine the effect
production-volume variances have on the company’s end-of-period operating income. When the
chosen capacity level exceeds the actual production level, which approach to end-of-period
variances results in an unfavorable production-volume variance affect on that period’s operating
income?
a.
b.
c.
d.

Proration approach
Adjusted allocation-rate approach
Theoretical approach
Write-off variances to cost of goods sold approach

11. Under a variable costing system, the breakeven point is a function of
a.
b.
c.
d.

Sales Volume
Yes
No
No
Yes

Production Volume
Yes
Yes
No
No

12. Under an absorption costing system, the breakeven point is a function of
a.

Sales Volume
Yes

Production Volume
Yes

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b.
c.
d.

No
Yes
No

Yes
No
No

WRITING/DISCUSSION EXERCISES
1. Identify what distinguishes variable costing from absorption costing
What is the background of the concept of variable costing? H. Thomas Johnson and Robert
Kaplan describe the origins of cost accounting practices in their book, Relevance Lost: The Rise and Fall of
Management Accounting, (Harvard Business School Press, 1987). According to them, J. Maurice Clark,
economist at the University of Chicago, was influential in giving prominence to the concept of fixed and
variable costs in cost accounting for use in decision making during the 1920s.

2. Prepare income statements under absorption costing and variable costing
Compare the assumptions made for the text example of Stassen Company (year 2003) for
preparation of absorption and variable costing income statements and the assumptions
made for the cost-volume-profit model in Chapter 3. Which of the assumptions is not stated
about CVP because it is not critical to the calculation of income on a variable costing basis
but is a critical assumption when comparing variable to absorption costing? Assumptions
from Stassen model that match to the cost-volume-profit model assumptions:

1. One cost driver of output units (driven by units produced or sold)[linear relation]
2. Costs are divided into variable or fixed classification
3. Unit selling price, unit variable costs, and fixed costs are known (budgeted)
4. Single product or constant sales mix
One assumption from Stassen model needed for comparison of variable costing to absorption costing: Units
produced are different than units sold.
The CVP model does not explicitly state an assumption about a change in inventory level because
such a change would have no effect on operating income. Absorption costing, however, has
manufacturing fixed costs as part of the unit cost of the product. If inventories increase (more units
produced than units sold) manufacturing fixed costs are “parked” on the balance sheet rather than
expensed through cost of goods sold. If inventories decrease, manufacturing fixed costs are pulled
from the balance sheet to the income statement and expensed in a greater amount than the amount of
that year’s fixed costs in total.

3. Explain differences in operating income under absorption costing and variable
costing
The authors of the text note that by keeping inventory levels low, the differences between
absorption costing and variable costing become less in amount. What other factors could
minimize the differences between these two types of costing inventory? Companies that have a
steady flow of production and sales would tend to have less fluctuation in the levels of inventory, and
therefore less variation in comparing absorption costing and variable costing. If a company has a pattern of

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peaks and valleys for building up inventory in anticipation of heavier times of sales followed by periods of
low sales, the accountant would want to make the users of the statements aware of such seasonal or cyclical

behavior. In the Standards of Ethical Conduct for Management Accountants under the standard of
“competence,” accountants have the responsibility to “prepare complete and clear reports and
recommendations after appropriate analysis of relevant and reliable information.” Under the standard of
“objectivity” is the responsibility to “disclose fully all relevant information that could reasonably be expected
to influence an intended user’s understanding of the reports, comments, and recommendations presented.”
The management accountant does have an ethical responsibility to be aware of the environment and make
known situations or circumstances that could impact reported numbers.

4. Understand how absorption costing can provide undesirable incentives for
managers
Discuss the importance of setting appropriate performance criteria for managers.
As illustrated in the text, the criterion of operating income for evaluating managers can lead to the
undesirable buildup of inventory when the absorption costing method is used to measure operating
income. The phenomenon of “unintended consequences” can be used to describe the intention of
increasing operating income by setting that as a performance measure but having the consequence of
inventory buildup because that is a method of increasing operating income – though that method was
not the one meant to be used. Another example is as follows:
The old Soviet Union provides many cases where overstress on one or two aspects of the
measurement system may lead to uneconomical behavior that focuses on a subgoal without
considering overall organizational goals. To illustrate, taxi drivers were put on a bonus system based
on mileage. Soon the Moscow suburbs were full of empty taxis barreling down the boulevards to
fatten their bonuses. In response to bonuses based on tonnage norms, a Moscow chandelier factory
produced heavier and heavier chandeliers until they started pulling ceilings down.
5. Differentiate throughput costing from variable costing and absorption costing
Throughput costing would seem best suited to what time frame? Throughput costing
considers all manufacturing costs but direct materials to be expenses of the time period. In the shortrun perspective most costs are fixed and this would fit with variable costing—fixed costs expensed
when incurred. Over the long-run time frame, most costs are variable. Throughput costing then
would seem to be especially useful for short-run concepts as costs which cannot be changed quickly
are deemed to be “fixed” and expensed as incurred.
6. Describe the various capacity concepts that can be used in absorption costing

The authors note that “engineering and human resource factors are both important
when estimating theoretical or practical capacity.” How can managers discern human
resource factors in estimating supply-based capacity? The authors note the increased
injury risk when the line operates at faster speeds as a human-safety factor. Management-byobservation during times of different levels of production could inform the manager of potential
problems. Manufacturers of equipment used and materials processed provide labels and/or warnings
about the use of their products. Regulatory agencies of various oversight groups and governments
issue occupational guidelines. The company’s medical team and/or medical insurance provider
would also be sources of information. The cost of human injury could far exceed the benefit of
extracting a bit more capacity in most cases.
7. Understand the major factors management considers in choosing a capacity level to compute the
budgeted fixed overhead cost rate

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Do companies have varying levels of capacity at any one time? How flexible is
capacity that is defined in the text as a “constraint” or “upper limit”? In today’s market,
most companies must be able to adapt readily to changes in customer demands and in technology. A
company can develop various options for its “capacity.” One method might be to have relationships
with other companies that could be used when demand exceeded “in-house capacity” through
outsourcing. Companies to momentarily increase their capacity to meet sudden surges in demand
could use short-term rentals or leases. Changes in design could also be used in some situations to
change a process allowing more product to flow through. If “excess capacity” is the problem, the
company could rent out space or processing facilities until such time as needed in-house. A company
would not want to be handicapped by only enough capacity to meet regular demand, balancing
capacity with demand. Most companies need “wiggle room” in calculating capacity.
8. Describe how attempts to recover fixed costs of capacity may lead to price increases and lower
demand

Discuss the value of creating “capacity” in smaller increments as opposed to one
super-sized unit. Sometimes a company has the choice of investing in many smaller sized pieces
of equipment or one expensive “efficient” super-sized piece of equipment. The large piece of
equipment may seem most economical for capacity demands but could prove inflexible if demand
decreases – and may not be suitable for other production processes if demand switches to a different
type of product.
The choice of how to develop capacity is tied to a company’s strategy. If a company is pursuing a
cost leadership strategy, the equipment that can produce large quantities for the lowest price is a
better choice. Equipment that could be adapted for changing product features would be better for a
company pursuing a product differentiation strategy.
9. Explain how the choice of the denominator level affects the production-volume variance
Apply the saying that “inside the solution to one problem are other problems just
waiting to get out” to the choice of a denominator-level capacity concept. Selecting a
denominator-level capacity is necessary in using absorption costing under a normal or standard
costing basis. Several good purposes are served by choosing a specific denominator-level amount.
The ability to prepare external reports and to provide information on a timely basis through the use of
a predetermined rate are two benefits of using specific denominator levels. The choice of one number
as the denominator, however, creates the problems described in the text as to pricing, dealing with
uncertainty, and performance evaluation, for example.

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Demonstration Problem for Use with Text Problem 9-33
Comparison of Variable and Absorption Costing
(From earlier edition of textbook)
The data below pertain to the B. E. Company for the year 2002:

Selling price per unit
Total fixed costs—production
Total fixed costs—marketing, distribution, customer service
Variable cost per unit—marketing, distribution, customer service
Sales in units
Production in units
Normal activity in units (based on 3 – 5 year demand)
Operating loss
No opening or closing inventories

$2.00
$8,400,000
$ 600,000
$0.50
17,000,000
17,000,000
30,000,000
$ 500,000

The board of directors has approached a competent outside executive to take over the company. He is an
optimistic soul and he agrees to become president at a token salary, but his contract provides for a year-end
bonus amounting to 10 percent of net operating profit (before considering the bonus or income taxes). The
annual profit was to be “certified” by a huge public accounting firm.
The new president, filled with rosy expectations, promptly raised the advertising budget by $3,500,000, and
stepped up production to an annual rate of 30,000,000 units (“to fill the pipelines,” the president said). As soon
as all outlets had sufficient stock, the advertising campaign was launched, and sales for 2003 increased—but
only to a level of 25,000,000 units.
The “certified” income statement for 2003 contained the following data:
Sales, 25,000,000 x $2.00
Production costs:

Variable, 30,000,000 x $1.00
$30,000,000
Fixed
8,400,000
Total
$38,400,000
Ending inventory, 5,000,000 units (1/6)
6,400,000
Cost of goods sold
Gross margin
Marketing, distribution, customer service costs:
Variable
$12,500,000
Fixed
4,100,000
Operating income

$50,000,000

32,000,000
$18,000,000
16,600,000
$ 1,400,000

The day after the statement was “certified,” the president resigned to take a job with another corporation having
difficulties similar to those that B. E. Company had a year ago. The president remarked, “I enjoy challenges.
Now that B. E. Company is in the black, I’d prefer tackling another knotty difficulty.” His contract with his
new employer is similar to the one he had with B. E. Company.
REQUIRED:

1. As a member of the board, what comments would you make at the next meeting regarding the most recent income
statement? Maximum production capacity is 40,000,000 units per year.

2. Would you change your remarks in (1) if (consider each part independently):
a. Sales outlook for the coming three years is 20,000,000 units per year?
b. Sales outlook for the coming three years is 30,000,000 units per year?
c. Sales outlook for the coming three years is 40,000,000 units per year?
d. The company is to be liquidated immediately, so that the only sales in 2004 will be the 5,000,000 units still in
inventory?

e. The sales outlook for 2004 is 45,000,000 units?
3. Assuming that the $140,000 bonus is paid, would you favor a similar arrangement for the next president? If not, and
you were outvoted, what changes in a bonus contract would you try to have adopted?

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Notes for Demonstration Problem—B. E. Company
(From earlier edition of textbook)

1. Depending on the business outlook, I would object strenuously because the $1,400,000 profit is
represented by $1,400,000 share of fixed production costs (5/30 x $8,400,000). The $1,400,000
which was plowed into inventory is an asset only if it represents a future cost saving in the form of
the lost profits on added sales that would otherwise be lost of increases in future production costs.
Income statement recast using variable costing:
Sales, 25,000,000 x $2.00
Variable costs:
Variable production,

25,000,000 x $1.00
$25,000,000
Variable nonproduction, 25,000,000 x $0.50
12,500,000
Total variable costs
Contribution margin
Fixed costs:
Fixed production
$ 8,400,000
Fixed nonproduction
4,100,000
Operating income

$50,000,000

37,500,000
$12,500,000
12,500,000
$
0

The conventional statement as shown in the problem generally is not a proper basis for declaring
bonuses. It does not seem right that we should be making profits by producing for inventory. Not
only have we really made zero profits; we also must fork out a $140,000 bonus and pay income taxes.
So this arrangement has resulted in a real loss instead of a profit.
2. a. No. As long as the company can meet its sales needs out of current production the fixed costs do not
represent assets because no future savings are forthcoming. The loss situation will continue.
b. No, for the same reason as (a).
c. No, unless the present inventory really represents future cost savings which may offset the danger of
increases in variable costs through time or of a permanent loss of sales.

d. If the fixed costs continue and selling prices remain the same, the answer would be “no.” If the fixed
costs do not continue and the regular selling price can be attained, the answer would be “yes.”
d. Yes. If the 5,000,000 units were not held in stock, the future sales would be only 40,000,000 units.
Therefore, the case for recognizing fixed costs as an asset is strong.
3.
No. Tie bonus in with more factors, not conventional income alone. If I could not get the
other board members to accept direct costing, I would try to hinge the bonus on board-approved
budgeted figures.
If the board decided to continue with the same basic bonus arrangement, I would insist on having a
maximum inventory level determinant so that fixed overhead related to production in excess of the
maximum would be deducted from conventional net operating profit in bonus computations.
A discussion of incentive and risk considerations may also be desirable. The present bonus scheme
encourages the executive to take heavy risks by building up inventories because the bonus is a direct
function of reported income.
In contrast, an incentive (bonus) system tied directly to budgeted income would dampen the
executive’s tendency to not abide by the directors’ wishes.
If absorption income for a one-year contract is used, the bonus formula could include an adjustment
factor for inventory effects.

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SUGGGESTED READINGS
Balachandran, B., Baladrishnan, R. and Sivaramakrishnan, K., “On the Efficiency of Cost-Based Decision
Rules for Capacity Planning,” The Accounting Review (October 1997) p.599 [21p].
Balakrishnan R. and Sivaramakrishnan, K., “Is Assigning Capacity Costs to Products Really Necessary for
Capacity Planning?” Accounting Horizons (September 1996) p.1 [11p].
Brausch, J. and Taylor, T., “Who is Accounting for the Cost of Capacity?” Management Accounting

(February 1997) p.44 [7p].
Buttross, T., Buddenbohm, H. and Swenson, D., “Understanding Capacity Utilization at Rocketdyne,”
Management Accounting Quarterly (Winter 2000) p.42 [6p].

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