It’s been said that the worst of all the types of waste is the waste of overproduction, because it generates all sorts of other waste. And in the lean world, it’s also been understood for quite a long time some of the dangers that traditional accounting can cause in creating these wastes.
CFO magazine seemed to have just stumbled upon this reality. In their recent profile of the automotive industry, titled Lots of Trouble, they explore absorption costing encourages overproduction. From CFO:
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 managmenet accounting by the American Institute of Certified Public Accountants and other groups.) Ultimately, however, the practice hurt the automakers, in part by diving 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.
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.
You don’t say? I have a hard time understanding how this is a groundbreaking study when we’ve seen it for decades and known it already to be true. But, it is nice to know that the accounting community is waking up to the affect.
But let me use this opportunity to paint a slightly different picture. Yes, some traditional accounting encourages the wrong behavior. I use the word encourage purposely. But this is fact – it doesn’t CAUSE it. It is still a human decision. The accounting is just an input, a contributor. It may make things harder to make the right decision, but it doesn’t cause the wrong decision.
Managers at all levels of the organization are tasked with making tough decisions with incomplete or even contradictory decisions. That’s just the reality of the role. Once you use accounting as an excuse to make a decision that you know to be wrong, I feel that you have forfeited the right to those decisions. Yes, we should improve our accounting methods to better reflect what we know to be good management decisions. But we also need the courage to make the right decision, regardless of the conflicting inputs.
Don’t let accounting be an excuse for doing the wrong thing.