Inventory Management and Benchmarking

Inventory Management and Benchmarking - The author...

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The author recommends that Hampshire Corporation uses absorption costing as the preferred method of inventory costing instead of variable (or, direct) costing. According to Horngren, Datar and Rajan (2015), under absorption costing, all variable and fixed manufacturing costs are included as inventoriable costs. This means that all manufacturing costs are allocated per piece and expensed in the period that they are incurred. Through variable costing, fixed manufacturing costs are treated as an expense in the period they are paid. Managers should use caution when observing the operating income with absorption inventory costing. Operating income can be easily manipulated with this method, to appear better than it actually is. If management's performance is tied to operating income, one might be tempted to manipulate the amount of inventory to their advantage. Horngren et al. (2015), wrote that the number of inventory affects the operating income differently in both cases - as inventory increases, so does operating income in the case of absorption costing, and the converse in the case of variable costing. Essentially, under absorption costing, managers can increase operating income by producing more inventory in the absence of anticipated demand. In an effort to reduce incentives to build inventories, Horngren et al. (2015), reported that many companies use variable costing for internal reporting. However, as the number of ending inventory approaches zero, so does the difference in the operating income between variable and absorption costing methods (Horngren, et al. 2015, p. 336). Absorption costing is the preferred international method of external financial reporting and also for internal accounting for several reasons, as identified by Horngren et al., (2015); 1. Its cost-effectiveness in terms of not having to prepare different financial documents, 2. It prevents managers from taking dishonest actions to increase the level of their perceived performance, 3. It measures and monitors costs of all resources necessary to produce inventory.
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Also, according to Horngren et al., (2015), subclassifications between variable and fixed costs can easily be modified to obtain subclassifications for variable and fixed costs. As long as
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Christopher Reinemann
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