Too Many Problems

US automakers used a common accounting practice to justify rising inventories, but the negative effects hold lessons for all manufacturers.

It is no secret that in the years leading up to the Great Recession, the Big Three automakers were producing far more vehicles than the market demanded, leading to huge inventories at dealerships across the country. Now some researchers say they know why the automakers acted that way, and they are warning other manufacturers to avoid falling into the same temptation.

By combining overproduction with absorption costing, managers at GM, Ford and Chrysler were able to boost profits and hit short-term targets, according to professors at Michigan State University and Maastritch University in the Netherlands. (Their study on the subject was recognized in January for its contribution to management accounting by the American Institute of Certified Public Accountants and other groups.) Ultimately, the practice hurts the automakers, in part because increased advertising and inventories drive up costs and possibly cause a decline in brand image, the researchers say.

From 2005 to 2006, well before GM and Chrysler went bankrupt and requested federal aid, the automakers had excess capacity. At that time, as now, they had enormous fixed costs, from plants and machinery to employees, whose contracts protected them from layoffs when demand was low, says Karen Sedatole, associate professor of accounting at Michigan State University and co-author of the study.

To “absorb” these massive costs, the automakers produced more cars while using absorption costing, a widely used system that calculates the cost of manufacturing a product by dividing total manufacturing costs, fixed and variable, by the number of products made. The more vehicles they made, the lower the cost per vehicle and the higher the profits. As a result, 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 may use absorption costing for “normal capacity,” but must treat “abnormal” excess capacity as a period cost, according to Sedatole. But the standard does not clearly define what is normal, leaving room for companies to overproduce in order to lower their cost per unit. Companies that do this “are, in a way, managing earnings upward and parking the costs on the balance sheet as inventory so that they don’t hurt the income statement,” she said.

Eroding Brand Image

But business leaders should think twice before adopting this tactic, Sedatole warns. Even though they may make their companies look more profitable in the short term by hiding the cost of excess capacity on the balance sheet, holding so much excess inventory can exact a high price.

“When [dealers] can’t sell cars, they sit on the inventory,” Sedatole says. “They would 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, usually at discounted prices. And by making their cars cheaper and more readily available, they may have alienated potential customers, she adds.

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

Some might argue that this is a good strategy for a company that is already obligated to pay wages, to manufacture products beyond its capacity. “An economist would say that as long as I can sell the car for more than its variable cost, I’m better off selling it,” Sedatole said. But, she adds, “that is a very, very short-term way of thinking,” because it neglects the costs that come with carrying a lot of excess inventory.

Lessons Learned

Using absorption costing to monitor efficiency can lead companies to make poor production decisions, said Ranjani Krishnan, professor of accounting at Michigan State University and co-author of the study (along with Alexander Brüggen, associate professor at Maastricht University). A company that does this could appear to be becoming less efficient when demand falls. If a plant produces fewer cars this year than last year, for example, its cost per car will look higher, and the company may then start producing more than necessary to appear more favorable to investors, customers and analysts.

Instead, Krishnan suggests, companies should report the cost of excess capacity as an expense on their internal income statement, a practice that can help give them new perspectives.

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

“A lot of this behavior was driven by greed,” says Krishnan. “If you look at the kind of managerial incentives the automakers had during the time of our study, the executive committee deliberations, it was all about hitting short-term numbers or forecasts to satisfy analysts so they could earn their bonuses.”

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

In fact, companies should not use financial reporting methods to make internal decisions, says Krishnan. “The purpose of financial accounting is to provide information to investors who are external to the company,” he says. “But it is not adequate from the perspective of internal decision-making. Management accounting needs to focus on the best ways of providing information that will lead to strategic economic decisions.”

Portuguese translation by Tamiris Masetto Manzano.