The Economy

Lots of Trouble

U.S. automakers used a common accounting practice to justify huge run-ups in inventories, but the downside risks offer lessons for all manufacturers.
Marielle SegarraMarch 1, 2012

It’s no secret that in the years leading up to the Great Recession, the Big Three automakers were producing vehicles in excess of market demand, leading to large inventories on dealers’ lots across the country. Now, some researchers say they know why the automakers acted as they did, and they are warning other manufacturers to avoid the same temptation.

By coupling excess production with absorption costing, managers at GM, Ford, and Chrysler were able to boost profits and meet short-term incentives, according to professors at Michigan State University and Maastricht University in the Netherlands. (Their study on the topic was recognized in January for its contribution to management accounting by the American Institute of Certified Public Accountants and other groups.) Ultimately, however, the practice hurt the automakers, in part by driving up advertising and inventory holding costs and possibly causing a decline in brand image, the researchers say.

From 2005 to 2006, long before GM and Chrysler filed for bankruptcy and appealed for federal aid, the automakers had abundant excess capacity. Then as now, they had enormous fixed costs, from factories and machinery to workers whose contracts protected them from layoffs when demand was low, says Karen Sedatole, associate professor of accounting at Michigan State and a co-author of the study.

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To “absorb” those massive costs, the automakers churned out more cars while using absorption costing, a widely used system that calculates the cost of making a product by dividing total manufacturing costs, fixed and variable, by the number of products produced. The more vehicles they made, the lower the cost per vehicle, and the higher the profits on the income statement. In effect, the automakers shifted costs from the income statement to the balance sheet, in the form of inventory.

Under Statement of Financial Accounting Standards No. 151, companies can use absorption costing for “normal capacity” but must treat “abnormal” excess capacity as a period cost, according to Sedatole. But the standard doesn’t clearly define what’s normal, leaving room for companies to overproduce in order to lower unit cost. Companies that do so “are, in a way, managing earnings upward by trapping costs on the balance sheet as inventory, so they won’t hit the income statement,” she says.

Eroding Brand Image
But business leaders should think twice before adopting this tactic, cautions Sedatole. Even though they can make their companies appear more profitable in the short term by concealing excess capacity costs on the balance sheet, holding so much excess inventory can exact a price.

“When [the dealers] couldn’t sell the cars, they would sit on the lot,” says Sedatole. “They’d have to go in and replace the tires, and there were costs associated with that.” The companies also had to pay to advertise their cars, often at discounted prices. And by making their cars cheaper and more readily available, they may have turned off potential customers, she adds.

“If you see a $12,000 car in a TV ad is being auctioned off for $6,000 at your local dealer, that affects your image of that vehicle,” says Sedatole. This effect on brand image is difficult to quantify, but the researchers correlated 1% of rebate with a 2% decline in appeal in the J.D. Power and Associates Automotive Performance Execution and Layout Index.

Some might argue that it’s good strategy for a company already obligated to pay salaries to make products up to its capacity. “An economist would say as long as I could sell the car for more than its variable cost, I’m better off selling it,” Sedatole says. But, she adds, “that’s a very, very short-term way of thinking” because it neglects the costs that come with having a lot of excess inventory.

Lessons Learned
Using absorption costing to monitor efficiency can lead companies to make poor production decisions, says Ranjani Krishnan, professor of accounting at Michigan State and a co-author of the study (along with Alexander Brüggen, an associate professor at Maastricht University). 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.

Instead, Krishnan suggests, companies should record the cost of excess capacity as an expense on their internal income statements, a practice that may help give them perspective.

Another way to avoid overproduction is to change the way executives are paid. Like many companies, the automakers put their managers under pressure to deliver in the short term by structuring compensation incentives around metrics like labor hours per vehicle, which the industry’s Harbour Report uses to compare automaker productivity. With fixed labor hours, the only way to look more efficient under this measure is to produce more cars.

“A lot of this behavior was frankly driven by greed,” says Krishnan. “If you look at the type of managerial incentives [the automakers] had during the time of our study, the executive-committee deliberations, it was all about meeting short-term quarterly traffic numbers or meeting analysts’ forecasts so that they could get their bonuses.”

Instead, companies “have to look at performance from a more holistic perspective, and not just look at financial numbers like net margin or profit, or return on investment, but also at things like customer satisfaction or brand image, things that may be a little bit more difficult to measure because they’re not as quantifiable.”

Indeed, companies shouldn’t use financial-reporting methods to make internal decisions, says Krishnan. “The objective of financial accounting is to provide information for stakeholders that are external to the company,” he says. “But that is not adequate from the perspective of internal decision makers. Managerial accounting needs to focus on the best way to provide information that will lead to strategic economic decisions.”

Marielle Segarra is staff writer at CFO.