“Using absorption costing to monitor efficiency can lead companies to make poor production decisions,” says Ranjani Krishnan, professor of accounting at Michigan State. “A company that does this could seem to be growing less efficient when demand decreases. If a factory makes fewer cars this year than last year, for instance, its cost per car will look higher, and it may then overproduce in order to present itself more favorably to shareholders, consumers, and analysts.”
Not only can absorption costing lead to poor decisions, that is exactly what happened at Chrysler and General Motors in the months leading up to the recession in 2008. Professor Krishnan and his co-author Alexander Brüggen recently published their research paper on the causes of the demise of these two car companies. Their paper* shows that all the “big three” US automakers consistently overproduced their cars and created massive excess inventories in dealers lots across the country. The primary reason for this excess production was the need to absorb overhead costs delineated in their standard costing system. Everyone knew the demand for their automobiles was drifting down but they continued to push production through the factories owing to the pressure to absorb overheads. If you absorb overheads – even by making cars no one wants to buy – your company can show increased profits that are not really there. This is not fraudulent practice; it is a pernicious side-effect of standard costing.
I work with a lot companies in the area of accounting, measurement, and decision making processes within manufacturing, distribution, and the supply chain. All these companies are involved in a “lean journey or transformation” and have recognized the need for new approaches to accounting, control, and measurement. There is often some push-back when we suggest the elimination of standard costing and I cite (among other things) these over-production issues caused by overhead absorption. The operations people state firmly that they would never over-produce just to keep monthly profits high!! They are a sophisticated company. And yet, I see evidence of this in most companies we work with.
It is common to see production and output increase towards month-end. You often see the planners building up extra inventory and sales people offering generous incentives for customers to take more deliveries by month-end or quarter end. This is specially true when the inventory is (poorly) controlled by two-bin or max-min replenishment instead of pull systems or kanban.
IMHO overhead absorption is a very dangerous habit within manufacturing companies. It creates huge amounts of waste. The waste of over-production. The waste of inventory. This leads to large batches and long lead times.
But there is an underlying and more serious problem. This practice leads to the attention of the managers being focused on short-term profit and stock-price rather than value for the customer. According to Krishnan and Bruggen, in the case of Chrysler and GM, this was exacerbated by a bonus system that rewarded executives for achieving padded profits on the income statements. This contributed to both companies bankruptcy and “bail-out” by the hardworking US tax-payer.
Absorption costing viciously violates all five of the principles of lean thinking & practice. Art Byrne, in his new book “The Lean Turnaround”, asserts that “absorption accounting … twists behavior by making shop-floor managers more interested in hitting absorption goals than [in] making what the customers want.”
* Ranjani Krishnan and Alexander Brüggen and Karen Sedatole
Drivers and Consequences of Short-Term Production Decisions: Evidence from the Auto Industry
Contemporary Accounting Research
Volume 28, Issue 1, pages 83–123, Spring 2011