THE ABSORPTION COSTING

The Absorption Costing/Inventory Management Conundrum

The Absorption Costing/Inventory Management Conundrum

The article studies the conflicting Influence of Inventories on net Income and effective operations of a company and introduces a simple Theory of Constraint-based conflict resolution tool as a means of understanding, and possibly resolving, the Inventory-related conflicts experienced by managers. The article discusses that even if we understand that reducing inventory has significant long-term benefits. Profits are initially reduced as inventory is reduced. so managers have a powerful disincentive to reduce inventory. This disincentive is a function of the fact that generally accepted accounting principles require inventory value to include the cost of raw materials direct labor, as well as factory overhead that is required for their production. The article illustrate the impact of increasing or decreasing inventory on net profit, introduce a simple conflict resolution tool referred to as an evaporating cloud; and discuss a more serious inventory-related conflict that management is caught in-that of using inventory to smooth net income.

The level 1 conflict which the managers face is that the reduction of inventory reduces the profit. The Inventory Accounting Debate Absorption costing of inventories has long been an element of Generally Accepted Accounting Principles (GAAP), however, that has not always been the case. Under current GAAP, finished goods inventories are valued based on the direct materials, direct labor, variable factory overhead, and fixed factory overhead that are used in manufacturing those finished goods. Because the direct materials costs, direct labor costs, and variable overhead costs are considered variable costs, those costs are incurred in direct proportion to the quantity of finished goods units produced during an accounting period.

The direct costing supporters want to include only the direct material, direct labor, and variable overhead costs among the product costs upon which the inventories were valued. They want the ...