Carpet authority's management is considering implementing a bonus for the supervisors based on gross margin under absorption costing. What incentives will this bonus plan create for the supervisors? What modifications could Carpet Authority management make to improve such a plan? Explain briefly.

To understand what incentives this bonus plan will create for the supervisors, we need to first recall to mind that Absorption Costing  and Gross Margin are.

Absorption costing is a methodology under Generally Accepted Accounting Principles which allows for companies to treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs.

Recall that total variable costs change proportionately with variations in total activity, while fixed costs do not change with activity levels.

Variable manufacturing costs usually consist of

Therefore all direct materials, direct labor, and overhead are captured collectively as product costs (or cost of goods sold).

Gross Margin is also called Gross Profit.

It is computed by removing the Cost of Goods sold from Sales.

An explanation for Question 1

Now that we understand the terms, how will the bonus tied to a higher Gross Margin affect the behavior of the supervisors?

It is clear that the Carpet Authority has a Business Strategy that will only succeed if they manage to lower costs significantly.

One of the ways they can do that is to lower the cost of the variable manufacturing costs.

Therefore to achieve this, they have tied a bonus or an incentive to the performance of the supervisors to ensure that they achieve a higher Gross Margin. Higher gross margins mean lower costs of goods sold.

The supervisors win. The management wins.

An explanation for Question 2

To improve their plan above, Management can decide to tie the supervisors' bonuses instead to each department's Net Income. By doing this, they would achieve a level of efficiency that reduces

Recall that the only costs reduced here are the Cost of Goods sold.

To arrive at Net Income, Operating Cost must be removed from Gross Margin.

Note:

Income statement reports as follows:

To arrive at Net Income, Operating Cost must be removed from Gross Margin.

Note:

and Net Income is based on the number of units sold.

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