Stellar Packaging Products uses absorption costing to compute additional compensation eligibility for managers. In December, Stellar Packaging Products’ controller, Robin Simmons, noted that a considerable production overrun was experienced, resulting in increased ending inventories for its major customer, Estrella Coffee Company. Simmons approached Frank Moses, the production manager, regarding these facts. Moses indicated that indeed, the production overrun was deliberate and completed in order that more overhead application would occur in December, and “everyone would make their year-end bonus.”
Would the situation have changed if the company used variable costing as a basis of additional compensation? Why or why not?
Answer:
Yes, this situation would be different if variable costing is used as a basis of additional compensation.
Variable Costing is a managerial costing accounting concept. The system of cost allocation is basically divided into two headings namely, variable costing and absorption costing. Variable Costing includes those costs that change in total with changes in production level. Under variable costing, fixed manufacturing overheads are not included in the product cost. Under variable costing all the variable costs are deducted from the sales revenue and then the resultant figure is termed as contribution margin and all the fixed costs are then deducted from the contribution margin to arrive at net profit. Variable Costing is also called as marginal costing or direct costing.
Under variable costing, costs are considered as product cost which are directly related with the output. Traditional costing approach, absorption costing, or full costing, absorb all costs incurred to produce goods which can result in misleading product cost information for discussionmaking. In absorption costing or full costing, the fixed overheads are considered as product cost. These are added in the cost of inventory and not shown as separate item (period cost) in the income statement. The full cost includes cost of direct materials, direct labor, variable manufacturing overheads and fixed overheads.
Thus when company will use variable costing as a basis for additional compensation, the additional compensation would be less as compared to the amount computed using absorption costing.