Ridgeline Manufacturing: Absorption-Costing Inventory Build and the Plant Bonus
Ridgeline Manufacturing began the year with zero finished-goods inventory. It produced 50,000 units and sold 45,000 at $70 each. Variable manufacturing cost is $28 per unit, fixed manufacturing overhead is $600,000, variable selling cost is $4 per unit sold, and fixed selling and administrative expense is $250,000. The plant manager's annual bonus is 2% of reported operating income under absorption costing. In November, the manager proposes raising production to 60,000 units while sales remain at 45,000, arguing that the plant has idle capacity and that spreading fixed overhead over more units will improve margins. The controller notes that the extra 10,000 units would require $280,000 of variable cash cost and would be stored in a rented warehouse costing $45,000 per year. The CFO wants to know whether the proposal creates economic value or merely changes the accounting report.
1. Compute operating income under absorption costing and variable costing at the current 50,000-unit production level. Reconcile the difference.
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Absorption costing. Fixed overhead per unit is $600,000 / 50,000 = $12. Product cost is $28 + $12 = $40. Sales are 45,000 × $70 = $3,150,000. Cost of goods sold is 45,000 × $40 = $1,800,000. Gross margin is $1,350,000. Subtract variable selling of 45,000 × $4 = $180,000 and fixed selling and administrative expense of $250,000. Operating income is $1,350,000 − $180,000 − $250,000 = $920,000.
Variable costing. Revenue is $3,150,000. Variable manufacturing cost is 45,000 × $28 = $1,260,000. Variable selling is $180,000. Contribution margin is $3,150,000 − $1,260,000 − $180,000 = $1,710,000. Subtract fixed manufacturing overhead of $600,000 and fixed selling and administrative expense of $250,000. Operating income is $860,000.
The $60,000 difference equals the fixed overhead deferred in ending inventory: 5,000 units × $12 = $60,000. Absorption income is higher because 5,000 units produced were not sold.
2. Compute operating income at 60,000 units produced and 45,000 sold. Does the production increase create economic value or mainly improve the reported bonus?
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At 60,000 units, fixed overhead per unit is $600,000 / 60,000 = $10. Product cost is $28 + $10 = $38. Cost of goods sold is 45,000 × $38 = $1,710,000. Sales remain $3,150,000, so gross margin is $1,440,000. Subtract variable selling of $180,000 and fixed selling and administrative expense of $250,000. Absorption operating income is $1,010,000.
That is $90,000 higher than the $920,000 reported at 50,000 units, so the manager's 2% bonus rises by $1,800. But the increase is an accounting timing effect, not value creation. Variable costing operating income stays at $860,000 because sales did not change. The $90,000 increase equals the additional fixed overhead deferred in ending inventory: 15,000 units × $10 = $150,000, less the $60,000 already deferred at 50,000 units.
Economically, the extra 10,000 units consume $280,000 of variable cash cost and incur $45,000 of warehouse cost. Inventory rises by 15,000 × $38 = $570,000, but no customer has bought the output. Unless future sales are expected at full price and the storage cost is recoverable, the proposal destroys cash value while inflating reported income and the bonus.
3. Redesign the incentive and reporting approach so the plant manager's bonus rewards economic value rather than inventory build. What two controls would you add?
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Base the bonus on variable-costing operating income or contribution margin after a charge for inventory carrying cost, not absorption operating income. That removes the incentive to produce for inventory. If absorption costing is needed for external reporting, reconcile it to variable costing in the management pack and show the fixed-overhead-in-inventory adjustment explicitly.
Control one: require a production plan tied to forecast sales and a maximum finished-goods inventory limit, with any build above the limit requiring CFO approval. Control two: charge the plant a carrying cost, for example 15% to 25% of average inventory value per year, including warehouse rent, obsolescence risk, and working capital. If the plant builds 10,000 extra units at $28 variable cost, the carrying charge should appear in its monthly scorecard.
Also separate the bonus formula: 60% contribution margin, 20% inventory turns or cash conversion, and 20% quality and delivery. That way the manager is rewarded for selling and operating efficiently, not for moving fixed costs into a warehouse.