As the CFO, how would you respond to this comment from the Controller of the Manufacturing Division, "The problem with variable costing is that it ignores the problem of excess capacity at certain times of the year. We have a cyclical business, and it simply costs us much more per unit in the off-season than it does in peak-season. We should allocate all fixed manufacturing overhead to total production each month. This also enables us to improve net income by producing for inventory, producing more than we can sell, if sales lag. The stockholders seemed to like this technique last year because it kept earnings up and prevented a decline in stock price."
This is an issue of absorption costing and variable costing
In product/service costing, an absorption costing system apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. Thus under absorption costing, all normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit (sales minus cost of goods sold) is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead.
Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the ...
This compares the absorption costing and variable costing