Chapter 19: Production and Pricing

This section covers the application of absorption costing and variable costing in various business decisions: 1. 2. 3. 4. Planning Production Analyzing Special Orders Setting Target Prices Assessing Costs for Services 1. Planning Production Absorption costing can lead to overproduction because it allocates fixed overhead costs across all units produced. When production increases, the fixed cost per unit decreases, lowering the per-unit product cost. As a result, more fixed costs are capitalized into inventory, deferring expenses to future periods. This practice can increase reported income, which might incentivize managers to produce more units than needed to earn higher bonuses, especially if bonuses are linked to income under absorption costing. For example, IceAge’s production manager decides to produce 100,000 units instead of 60,000 in Year 1. Producing excess inventory reduces the unit cost from $25 to $21 because the fixed overhead is spread over more units. The income difference arises from $240,000 in fixed overhead costs being allocated to ending inventory rather than being expensed as part of the cost of goods sold. Ethical Implications: Overproduction to meet bonus targets can lead to excess storage costs, obsolescence, and ultimately harm the company’s financial health. Variable costing, which treats fixed manufacturing overhead as a period cost, avoids this problem since managers can’t manipulate income by overproducing without increasing sales. 2. Analyzing Special Orders In short-run decisions, fixed costs are sunk costs that don’t change with production levels. When considering a special order, managers should assess only variable costs to determine profitability. Using IceAge as an example: • • • IceAge’s variable cost per unit is $17 ($15 for goods + $2 for selling expenses). The company receives a special order at $22 per unit. Even though the absorption cost is $25, the special order covers variable costs and contributes an additional $5,000 to the contribution margin. Thus, the special order should be accepted because it contributes positively to income. This approach highlights the importance of using variable costing for special-order analysis rather than absorption costing, which might incorrectly suggest rejecting orders below full absorption cost. 3. Setting Target Prices To ensure profitability, a product's selling price should cover all costs and provide a return to owners. For this purpose, absorption costing is useful because it includes both variable and fixed production costs, representing the full cost that a selling price must exceed. To set a target price: 1. Determine Product Cost per Unit: Using absorption costing, IceAge’s product cost is $25 per unit. 2. Determine Target Markup: IceAge decides on a 60% markup. 3. Compute Selling Price: $25 + (60% of $25) = $40 target price. This price ensures IceAge covers its costs and meets its return objectives. 4. Assessing Costs for Services In service industries, variable costing aids decision-making by focusing on variable costs, which change with the level of service provided. Fixed costs do not fluctuate with service volume, so short-term pricing for special services should exceed variable costs to contribute positively to income. For example: • • BlueSky Charter Services has a variable cost of $30,000 per flight. If a special group offers $35,000 per flight (below the usual $50,000 price), BlueSky can still cover variable costs and gain a $5,000 contribution margin by accepting the special rate. This approach enables the company to utilize excess capacity profitably while maintaining flexibility in pricing for special offers. Summary Using absorption and variable costing effectively in decision-making can: • • • • Optimize production planning (avoiding overproduction). Ensure profitable special order acceptance. Set competitive yet profitable target prices. Maximize contribution in service industries by understanding variable costs. Variable costing tends to be more appropriate for internal decision-making as it offers insights into short-term contributions and eliminates incentives for overproduction.