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Dear John
Below is a question and answer from June 2018 paper.
Could you pls help me understand how a manager can manipulate the return for his division using the method described in statement 2.The explanation give in the report is “Statement 2: when a manufacturing division uses absorption costing, building high inventory levels will result in a large proportion of production overheads being carried from one period to the next in inventory. This increases the return figure benefiting the divisional managers if these are linked to bonuses but would only benefit the company if those units of inventory can be sold in the following period.”
Example 2
Which of the following could lead to an increase in management bonus, without benefitting
the organisation?(1) A manager holds on to heavily depreciated assets in order to avoid heavy investment in the period
(2) A manager in a manufacturing division uses absorption costing and builds up high levels of inventory
(3) A sales manager changes their fixed target to a relative target based on market shareA 1 and 2 only
B 1, 2 and 3
C 1 only
D 2 and 3 onlyWhat does this test?
? The behavioural aspects of performance management.
What is the correct answer?
? The correct answer is AWith absorption costing the fixed costs are absorbed into the unit cost and so the more units that are produced then the lower the fixed cost will be per unit. If the fixed cost per unit is lower then the full cost per unit will be lower, and therefore the profit per unit will be higher.
So, by producing a lot more units than they actually need to produce (and therefore having high inventory at the end of the period), the profit on those units sold during the period will be higher. That is OK provided that they can sell the inventory in the next period, but the risk is that they will end up with lots of inventory that becomes out of date and is never sold.
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