Criticism of absorption cost systems have lead to improvements but has not always lead to the replacement of these systems by either a variable or activity based system. These criticisms address the fact that accounting systems have to balance the contradictory goals of decision-making /control with external reporting. Unintended consequences of using accounting control systems for performance evaluations can lead to decisions that result in individual reward, but not optimal reward for the firm. By adopting specific controls, management defines job responsibilities because these controls are used to evaluation job performance through out the organization. But the fact that most companies haven’t adopted variable costing systems indicates that the costs of such systems are viewed as outweighing their benefits. All control systems rely on successful incorporation into performance evaluations matrix for effective execution.
Absorption accounting systems can have the unintended consequence of creating an incentive to overproduce because they allocate overhead expenses to inventory. product-evaluation Operational performance as measured by accounting systems uses historical data, and can be manipulated so current production levels exceed demand. By spreading overhead over a larger inventory base average costs are lower in the current period because the overhead is moved from the current period to a future period when the inventory is consumed. If managers are evaluated on current period net income, and if absorption accounting system is used, then managers have an incentive to increase production to lower average costs in the current period. But doing this would lead to a buildup in inventory, which can be addressed directly by modifying managers’ performance evaluation.
A variable costing system would minimize the effect of overproduction lowering production costs because variable costing treats fixed costs as period costs and are deducted from net income in the period incurred. Criticisms of variable costing systems include; managers have the discretion to determine which costs are fixed and which are variable, and variable systems don’t fully remove the incentive to overproduce because they can still defer current period overhead expenses into future periods in the form of ending inventory. Managers’ performance evaluations can be modified to directly address this issue by having senior management set inventory levels, or by adopting Just-In-Time production that ties inventory to customer orders. This would take the decision control on inventory levels away from managers. Variable costing systems are not required for external reporting so there’s an additional expense to reconcile back to absorption costing. This usually leads business to conclude that the costs of adopting a variable system outweigh the benefits.
Another criticism of absorption accounting is that they don’t accurately reflect product costs. They don’t represent opportunity costs, and they don’t always reflect cost driver behavior, especially when there are fewer input factors, and when production runs include small special orders. Activity based costing (ABC) systems address these concerns because they better identify cause and effect cost drivers. These cost drivers can be different based on the business activity being monitored. They can be custom tailored to each business unit. This can improve decision making by providing more accurate estimations of opportunity costs, and can focus managements’ attention on activities that drive costs. ABC systems do require self reporting by managers which takes time away from other management activities. ABC systems give managers the decision rights to identify cost driver activities. It has the same issue as absorption and variable costing systems in terms of manager’s incentive to adopt cost drivers that maximize their own reward over the total reward for the firm.
These criticisms of absorption costing systems have not lead to full scale adoption of alternative costing systems such as variable costing or activities based costing. This doesn’t mean that the criticism is unwarranted. The criticism has lead to other less costly methods of control, such as modifications to managers’ performance evaluation, or removal of manager’s decisions rights over inventory levels. Absorption costing is required for external reporting, which means there could be additional reconciliation costs when using alternative costing systems. This leads to a lower cost/benefit ratio. The combination of additional costs and reduced benefits means alternative costing systems that provide more accurate data for decision making are not passing internal cost benefit analysis at many firms. These same firms recognize the limitations of absorption costing systems and mitigate those with less costly alternatives to full adoption of an alternative costing system.