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Results of allocating fixed overhead to product costs

Many accounting writers have emphasized the effect that the allocation of fixed overhead can have on managerial incentives to overproduce. When fixed overhead is allocated to product, the greater the production level, the lower the fixed cost per unit. The lower fixed cost per unit might increase perceived profitability, but is the company really more profitable? Explain

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The concept of spreading fixed costs (overhead) over more units makes perfect sense, and the system is designed to lower the cost per unit of items produced. That is the theory, and it works in a growing economy where sales are increasing.

What happens in an economy where sales are flat or decreasing? If production continues at high levels but the product isn't selling, then inventories begin to build. It may be true that cost per unit is less, but increasing inventory (because the additional products aren't selling in a tough economy) can have several negative effects.

First, profits may increase for the units sold, because the unit cost is less. ...

Solution Summary

The 431 word solution explains some of the negative outcomes that can result when more and more product is produced to lower the overhead cost per unit. There are 9 such reasons or situations presented.

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