When companies use direct costing, managers have more of an incentive to overproduce inventory than if the company used absorption costing.

Question

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When companies use direct costing, only variable manufacturing costs are included in the cost of goods sold, which means that any unsold inventory carries no fixed overhead costs. This gives managers less of an incentive to overproduce since any unsold inventory would not contribute to fixed overhead costs. In contrast, under absorption costing, fixed overhead costs are included in the cost of goods sold, so managers may feel pressure to increase production levels to absorb these costs.

When Companies Use Direct Costing, Managers Have More of an Incentive