Criticism of Absorption Cost System - Math Problem Example

As common sense would have it, fixed cost remains fixed no matter what the level of production is. Hence, in such a case managers often tend to over produce thinking it’s better to allocate the fix overhead over a wider range of output and reducing the cost per unit (since spreading fixed cost over greater units tends to drive down fixed cost per unit and when fixed costs per unit go down then so does the overall costa per unit), thus seeking an increase in profit per unit of output. The lower fixed cost per unit does of course increase the level of profitability.

But a couple of factors need to be considered while making the overproduction decision. While over producing tends to allocate fixed cost over a greater units of output, we need to see whether we really need to over produce. Many factors would need to be considered including the demand for the excess produce, storage and handling costs, cash flow situation etc. There would be no point going for over production if there is no sales market for additional units or the storage costs are high as such a step might actually cost more than the saving done by allocating the fixed overheads on excessive production.

It also needs to be considered that what would happen to the excess inventory that would be produced. If the company has not taken care of the market conditions and consequently it produces in excess of its projected sales, then such an exercise would result in excessive stock piling. Clearly the company wouldn’t be profitable in such a scenario. Another key question that needs to be answered is whether the incentive to overproduce allows over producing stock irrespective of stock piling or storage conditions.

The excessive inventory that would be produced would be visible to everyone, reflected on managerial accounts as well as in the company’s audited financial statements. It is no doubt important for managers and decision makers to consider here whether the allocation of fixed overheads provides an incentive to overproduce or not. However the danger reflected by the incentive to over produce should not be made the basis of decision making about the allocation of the fixed overheads. I agree with your view that over production results in excess inventory.

Yes, sometimes it does happen that excessive production is done at the year-end so that the production costs can be driven down and financial statements are efficiently window dressed to show a good position of the company. However you need to know that there are some products that take a lot of time to be produced and their fixed costs are extremely high. In such a case, I personally think that over production is justified provided there are adequate storage facilities and there is an active sales market.

Student’s Response: “In my experience allocations which are confined to fix overhead is the catalyst to overproduce a less than desirable product. There are two things that definitely go wrong. 1. When management have an incentive to decrease the cost of product, usually this is a force step toward decrease quality of all resource used to make a final product with less capital and in less time.