ABSORPTION COSTING IS THE ENEMY OF LEAN. CHRYSLER AND GM PROVED IT IN 2008.

“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

This entry was posted in Lean Accounting, Lean Management System, Management Accounting, Performance Measures and tagged , , , , , , , , . Bookmark the permalink.

10 Responses to ABSORPTION COSTING IS THE ENEMY OF LEAN. CHRYSLER AND GM PROVED IT IN 2008.

  1. Alexander Kudasov says:

    Interesting article, but please take into account that vast number of companies also have such KPI as working capital which includes inventory so it’s not so straightforward with negative side of overheads absorption as a method itself.

    • BMaskell says:

      Alexander:
      You have raised the right issue. This post is an extreme example that if we use traditional measurements like overhead absorption or working capital, our lean strategy will fail.
      Brian

    • Marc Gilson says:

      Yes you are right, but experience has shown me that when contradictory managers favor short term profit instead of KPIs !

  2. Angelo Cusinato says:

    Another example of a tool that is used by people that
    > do not understand or
    > understand enough to use the flaw to maximize their short term bonus.

  3. Marc Gilson says:

    Excellent examples. As a Division Controller, I have seen many times bad behaviours linked to these silly variance maximizations, and especially the absorption one.

  4. Rob Green says:

    Excellent article, do you see a difference on the standard costing bad habits between publicly held company and privately held companies? I would think that it “could” be better at privately held companies because there wouldn’t be the outside pressures of Wall Street. I am currently a part of a publically held company, but will be moving to a private company in the near future. Would appreciate anyone’s experiences..

    • BMaskell says:

      Rob:
      When it comes to Lean I think private companies do much better the public. I expect there is a lot of reasons fir this, and the ones you mentioned are important ones.
      But … I think it all comes back to the leadership. The most important issue is the active commitment and driving of lean across the company.
      Brian

  5. Bill Gilbert says:

    When I first began to practice Lean in the late 1980’s (we called it JIT at that time), I rearranged manufacturing into cells. Lead times immediately went from weeks to hours. When I approached the CEO about reducing finished goods inventories, the VP of Finance jumped in and said “we can’t afford to do that since the reduced production will kill our production variances”. This was a pharmaceutical company with 70% margins who never looked at the balance sheet. The inventories stayed.

    I later went to a medical device company and discovered a leased warehouse filled with aging sub-assemblies. When I inquired as to why this inventory existed, I was told that the existing VP of manufacturing had built this inventory during the 1991 economic slowdown to keep the manufacturing variances looking good. He had been hailed as a hero at the time. Needless to say the inventory and the leased warehouse continued to gather dust.

    • BMaskell says:

      Bill:
      For me it was the early ’90s and working with companies doing “just-in-time” manufacturing. There we three companies that cancelled their (what we now call) lean improvements because the operational numbers and financial reports we showing bad results when good lean things were happening.

      With a background in both engineering and accounting, I recognized that traditional accounting is an enemy of lean transformation. This does not mean that traditional accounting is bad and wrong. But it does mean that it is UNSUITABLE for lean organizations. These days we have Lean Accounting that solves these problems, and replaces the old stuff.

      But as is shown by GM and Chrysler – both companies are purported to be working with lean – there are still many companies that continue to slavishly use these damaging methods. It’s like buying one of their cars and hitching up with dray horses.

      Brian

  6. Robert Baird says:

    This is really another example of leadership providing self serving decisions. As you point out they are not customer driven decisions and it always hurts the organization in the end. The cost in loss of revenue from the continuous month, quarter, and year end discounts are extreme but never added up?

Leave a Reply

Your email address will not be published. Required fields are marked *