-How, under absorption costing, reported earnings can be "managed" by choice of the denominator volume used to establish the fixed overhead application rate.
Any given cost-information system is a function of a number of design choices. For product-costing purposes, one such choice relates to how overhead, particularly fixed manufacturing overhead, application rates are determined.
Your team will play the role of controller for your company. You have been asked to prepare a written presentation for an upcoming meeting of the board of directors. In preparing this assignment, assume that board members are reasonably knowledgeable about financial-reporting issues, but not necessarily about the intricacies of cost accounting systems. As you construct your document, feel free to consult outside references in addition to the material in your text. You can assume that this document is meant as a formal presentation to members of the board. Thus, your writing should be concise, clear, and reflective of proper grammar and construction.
Following is a note from the instructor about what he is expecting for the answer to this question:
-Just a note on this one. First of all how is the fixed overhead rate built?
Two examples of fixed overhead would be manufacturing overhead salaries and manufacturing building depreciation expense. Both these cost should be constant over the period. So lets build an example, lets say the yearly depreciation expense for the manufacturing is 100,000 per year.(this should not change year to year or period to period). So the question becomes how do you apply this cost to your books in a standard or normal cost system. As we have studied in a standard or normal cost system you "apply" cost with rates and then periodically you adjust those "applied" to cost to actual. So this rate could look like this:
100,000 depreciation expense/ 50,000 machine hours = 2.00 dep exp/machine hour
or you could use the following
100,000 depreciation expense/ 20,000 square feet (size of building used for manufacturing). = 5.00 dep exp/sq ft
So in my two examples above i used tow different denominators to spread the same fixed cost. One was the building square footage (which like the cost will not change) and the other was machine hours (which is variable based on sales and the related required production).
Can the class see how the applied cost could be manipulated by the choice of the allocation base (denominator)? Why would a company want to manipulate the product cost? After all, at some point the cost will be adjusted to actual. Would not the adjustment to actual clear up any transparency issues?