Proposals for revising performance evaluation

Critics of absorption costing have made a variety of proposals for revising how managers are

evaluated. Their proposals include the following:

1 Changing the accounting system. As discussed previously in this chapter, variable costing

reduces the incentives of managers to stockbuild. An alternative approach is to incorporate

into the accounting system a charge for managers who tie up funds in stock. The higher the

amount of stock held, the higher the stock holding charge.

2 Changing the time period used to evaluate performance. Critics of absorption costing give

examples where managers take actions that maximise quarterly or annual income at the

potential expense of long-run income. By evaluating performance over a three- to five-year

period, the incentive to take short-run actions that reduce long-term income is lessened.

3 Careful budgeting and stock planning to reduce management’s freedom to build excess stock.

For instance, the budgeted monthly balance sheets have estimates of the value of stock. If the

actual stock values exceed these estimated amounts, top management is alerted to investigate

the stock build-ups.

4 Including non-financial as well as financial variables in the measures used to evaluate

performance. Companies are currently using non-financial variables, such as the following, to

monitor managers’ performance in key areas:

Closing stock in units this period

Closing stock in units last period

Sales in units this period

Closing stock in units this period

Any build-up of stock at the end of the year would be signalled by tracking the month-to-

month behaviour of these two non-financial stock measures (where a company manufactures or

sells several products, the two measures could be reported on a product-by-product basis).