Question

In the years leading up to the 2008 recession, General Motors, Ford, and Chrysler (the big three) were producing new vehicles in excess of market demand. This led to large inventories on car dealer’s lots across the United States. At the same time, under the absorption costing method, profits were rising and executives at these three companies were achieving their short-term incentive targets. Explain how firms can increase net operating income simply by producing more units under the absorption costing method. Identify and discuss the ethical issues involved in the decision top executives in the big three auto companies made about the level of production.

Answer 1

Absorption costing increases th profits -

Absorption costing will result in increase in profits with increase in production even if the sale are not increased..

In absorption costing cost per unit is calculated by taking direct material , direct labour , direct overheads , and all fixed cost divided by total units produced hence in this method total fixed cost are distributed amoung total production hence fixed cost are deffered thus lowering cost and increasing profits .Thus total fixed overhead will be lowered by producing more units and it will increase in profits of the companies.

Ethical issues -

1. Ethical issues in using absorption costing is it misrepresentation in cost of inventory..

2.Deffering the fixed expenses , although expenses are incurred in current year are deffered to future years .

3. Overproduction so as to lower the cost to increase the profits , this practice is fatal for survival of company.