Does an inventory related accounting standard encourage overproduction?

2. SFAS No. 151 encourages overproduction

The authors of the article determined that SFAS No. 151 in fact encourages overproduction.† The three major reasons noted are as follows:

  • Managerial reputation: if a company reports fixed overhead expenses (i.e., the company has unused capacity), managersí decision making about investments equipment, etc. may be questioned.
  • Market focus on short-term results: this is referred to as market short-termism and implies that managers will be under market pressure and would prefer to eliminate any apparent impact on the bottom line from idle capacity.
  • Managerial compensation: bonuses and other forms of incentive compensation may depend on achieving established budget goals for financials results and reporting fixed overhead as a period expense (and reducing net income) may influence managersí decisions about production levels.

The authors of the article also found that overproduction due to SFAS No. 151 will be more relevant to companies that:

  • Have lower accruals management flexibility.
  • Are under pressure to meet or beat earnings benchmarks.
  • Are in their stagnant stage of their life cycle.
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