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

2. 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

i. Costs categorized by variable or fixed—only variable manufacturing costs inventoriable

ii. Fixed costs expensed in total

b. Absorption costing – gross-margin format

i. Costs categorized by manufacturing or nonmanufacturing—all manufacturing costs

inventoriable

ii. Fixed manufacturing costs expensed per unit in cost of goods sold

2. Direct costing: not accurate term to describe variable costing

 a. Variable costing does not include all direct costs as inventoriable (only direct variable
manufacturing costs—direct fixed manufacturing and direct nonmanufacturing excluded)

b. Variable costing includes direct and some indirect variable manufacturing costs as
inventoriable

c. Not all variable costs are inventoriable costs—must be manufacturing variable costs

Do multiple choice 2 and 3. Assignments start with L.O. 3.

C. Operating income differences [Exhibit 9-2]

Learning Objective 3:
Explain differences in operating income under absorption costing and variable costing

1. Goods sold versus goods produced[Exhibit 9-3]

a. Variable costing: quantity sold drives cost and income

b. Absorption costing: quantity sold and produced drives cost and income

i. Inventory increase from beginning to end: less fixed costs expensed

ii. Inventory decrease from beginning to end: more fixed costs expensed

c. Low levels of inventory have less effect (less “material” in amount)

Do multiple choice 4. Assign Exercises 9-16, 9-18, 9-20, and 9-21.

2. Income manipulation—undesirable buildup of inventories [Exhibit 9-4]

a. 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

i. 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

iii. Defer maintenance beyond current accounting period

iv. Increase amount of inventory units each year

b. Revising performance evaluation—reducing undesirable effects of absorption costing

 i. Careful budgeting and inventory planning to reduce management freedom to build up
excess inventory

ii. Change the accounting system from absorption costing to variable costing for internal
reporting

iii. Incorporate a carrying charge for inventory in the internal accounting system

iv. Change to a longer time period to evaluate performance

v. 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

D. Another costing method – throughput costing (also called super-variable costing)

1. Method of inventory costing in which only direct material costs are inventoriable costs; all other
costs are costs of the period in which incurred

2. Reporting includes throughput contribution: revenues minus all direct material costs of goods sold
[Exhibit 9-5]

3. 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.

II. 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

A. Choices for denominator-level capacity (absorption costing issue)

1. Supply–based choices (available from the plant—upper limit or constraint)

a. Theoretical capacity: producing at full efficiency all the time: largest denominator/smallest
rate

b. Practical capacity: reduces theoretical capacity by unavoidable operating interruptions:

somewhat smaller than theoretical denominator/larger rate

2. Demand-based choices (demand for product is constraint)

a. Normal capacity utilization: satisfies average customer demand over several periods:
typically lesser than practical denominator/larger rate
 b. 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.

B. Choices for capacity level to compute budgeted fixed overhead cost rate

1. 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

2. Effect on product costing and capacity management

a. 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

3. Effect on pricing decisions

a. 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

b. Using smaller denominator of supply-based capacity levels with unused capacity means larger
cost per unit

c. 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

d. 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.

4. Effect on performance evaluation

a. 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)

b. 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.

5. Effect on financial statements

a. Magnitude of favorable/unfavorable production-volume variance affected by choice of
denominator used to calculate the rate (absorption costing)
b. Method of handling end-of-period variances results in different effect on financial statements
[Refer to Chapter 4]
a. Adjusted allocation-rate approach—effectively changes to actual costing so denominator
choice has no effect on end-of-period financial statements
b. 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]
6. Regulatory requirements: IRS requires use of practical capacity level to calculate the rate and
proration for tax reporting
7. Difficulties in forecasting chosen denominator-level capacity
a. 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
8. Other issues
a. 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
b. 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. Assign any of Exercises 9-22, 27, 28 or 29 and Problems 9-35, 37, 38.

III. Breakeven point with absorption costing

Do multiple choice 11 and 12. Assign Exercise 9-26, Problems 9-31 and 9-32.

Chapter Quiz Solutions: 1.c 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.

b. the accounting for variable manufacturing costs.
c. the accounting for fixed manufacturing costs.
d. 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.

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. when the quantity of beginning inventory equals the quantity of ending inventory.
b. when the quantity of beginning inventory is more than the quantity of ending inventory.
c. when the quantity of beginning inventory is less than the quantity of ending inventory.
d. 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. 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. Master-budget utilization
b. Practical capacity
c. Theoretical capacity
d. Normal utilization

8. Use of capacity levels based on demand

a. hides the amount of unused capacity.

b. highlights the cost of capacity acquired but not used.
c. yields a cost rate that does not include a charge for unused capacity.
d. 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. Proration approach
b. Adjusted allocation-rate approach
c. Theoretical approach
d. Write-off variances to cost of goods sold approach

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

Sales Volume Production Volume

a. Yes Yes
b. No Yes
c. No No
d. Yes No

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

Sales Volume Production Volume

a. Yes Yes
b. No Yes
c. Yes No
d. 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 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 short-run 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-by-observation 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

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.
 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 $2.00
Total fixed costs—production $8,400,000
Total fixed costs—marketing, distribution, customer service $ 600,000
Variable cost per unit—marketing, distribution, customer service $0.50
Sales in units 17,000,000
Production in units 17,000,000
Normal activity in units (based on 3 – 5 year demand) 30,000,000
Operating loss $ 500,000
No opening or closing inventories

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 $50,000,000
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 32,000,000
Gross margin $18,000,000
Marketing, distribution, customer service costs:
Variable $12,500,000
Fixed 4,100,000 16,600,000
Operating income $ 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?
 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 $50,000,000
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 37,500,000
Contribution margin $12,500,000
Fixed costs:
Fixed production $ 8,400,000
Fixed nonproduction 4,100,000 12,500,000
Operating income $ 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.”
e. 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.