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

Net Income under Absorption costing can be increased by building more closing stock. The production needs to be more than sales during the period so that inventory builds up and closing stock is valued at higher cost. Product cost in Absorption costing consists of Variable manufacturing cost and fixed manufacturing overheads. Variable manufacturing costs consists of direct material, direct labor and Variable manufacturing overheads. Hence when units produced are more than sales Absorption costing will have higher closing inventory level which will increase the net operating income reported during the period. A portion of fixed manufacturing overhead is carried over to next period in the closing stock shown in the books.

Ethical issues:

Earning more incentives by just building up inventory is not a sustainable business practice. The reason being actual sales is lower than production and the firm has risk of inventory obsolescence due to non moving inventories in case of recession in economy or changes in the consumer spending pattern.

Also there is no performance by the management team in increasing sales hence the actual net operating income generated is lower than what management expects. The net operating income is higher than target only due to inventory build up which is not profitable and sustainable from the organisation point of view. Hence it is compromise by top management on their ethical behaviour to get their incentive income from the organisation for non-performance and non-delivery of business key performance indicators.