Question 1 Of 2050 Points When Absorption Costing Is Used

Question 1 of 2050 Pointswhen Absorption Costing Is Used And Manageme

When absorption costing is used and management bonuses are related to operating income, managers are more likely to:

  • A. decrease inventory levels.
  • B. increase inventory levels.
  • C. keep inventory levels consistent.
  • D. steal from the company.

Paper For Above instruction

Absorption costing, also known as full costing, allocates all manufacturing costs — including direct materials, direct labor, and both variable and fixed manufacturing overheads — to each unit of product. This method impacts managerial decision-making, especially when bonuses or incentives are tied to reported operating income. Under absorption costing, managers may be influenced to manipulate inventory levels to maximize reported income due to income statement effects. As inventory increases, fixed manufacturing overheads are spread over a larger number of units, reducing per-unit costs and inflating gross profit and operating income. This incentive creates a managerial bias towards increasing inventory levels.

Empirical studies and managerial accounting principles suggest that managers, motivated by the desire to meet financial targets, tend to increase inventory levels when bonuses hinge on operating income. This occurs because unsold inventory on the balance sheet allows for spreading fixed costs over higher units, thereby elevating gross profits and operating income on the income statement. Conversely, decreasing inventory reduces the number of units over which fixed costs are spread, potentially reducing reported income. This strategic behavior can distort true profitability, impacting managerial decisions and external perceptions of the company's financial health. Therefore, the more likely answer is (B): increase inventory levels.

Furthermore, this incentive aligns with managerial accounting theory, which indicates that managers might deliberately smooth earnings or inflate profits by increasing inventory when bonuses are tied to operating income under absorption costing. Such practices, while legally permissible, can lead to false impressions of performance. To mitigate these distortions, companies often implement additional performance measures or adopt variable costing for internal decision-making, which does not allow fixed costs to be deferred in inventory.

In conclusion, managers are more likely to increase inventory levels when absorption costing is used and bonuses are based on operating income. This behavior stems from the accounting mechanics that make inventory levels influence reported earnings, thus motivating managers to manipulate inventory to meet financial targets.

References

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