Scenario: An auditor is testing the allocation of overhead to inventory. The client uses a standard costing system. The auditor notes that production volume dropped significantly this year, but the overhead absorption rate remained the same as the prior year. <br/><br/>What is the likely impact on the financial statements?

When production drops significantly (idle capacity), fixed overhead costs per unit effectively rise. However, GAAP requires that overhead be allocated based on *normal* capacity. The unallocated fixed overhead (variance) due to idle capacity must be expensed as a period cost (COGS). If the client simply capitalizes all overhead or misallocates the variance to inventory, Inventory will be overstated and COGS understated.