One problem with absorption costing (GAAP) is that it enables a manager to increase operating income in a specific period by simply increasing production - even if there is no customer demand for the additional production. Managers in companies with high fixed costs must manage capacity levels and make decisions about the use of available capacity which includes decisions on production and inventory policy. Performance incentives that are not well thought out could inadvertently incentivize actions by others that lead to higher short-term bonuses but leave detrimental long-term consequences for the company. A CEO whose bonus is tied to meeting certain financial metrics could direct a production manager to simply just produce more product and leave it sitting in the warehouse unsold to positively influence operating income. By producing more ending inventory, the firm's margins and operating income can be made higher. To align the interests of managers and shareholders, high level decision makers are frequently evaluated and rewarded on the basis of reported operating income. Producing inventory makes the manager's performance look better. 

1. How does just producing more finished goods inventory while still only selling the same number of units increase reported operating income in the current period?

 

2. Why would reclassifying period costs as product costs increase this period's reported earnings?

3. How could a company adjust their bonus program to better incentivize what is best for the company long-term instead of facilitating actions for the sole purpose of increasing compensation?

Answer rating: 100% (QA)

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