Reflection Paper 2: Chrysler
While preparing for the Chrysler article I became interested in the idea of absorption costing and how it influenced operations management, so I spent some time reading about this issue. Chrysler was facing excess capacity (more cars than consumers) and high fixed costs including factory leases and labor.
Absorption costing allows companies to calculate the cost of making a product by dividing the total costs by the total number of products made (including the cost of paying for leases or rent on unused factories.) All of the fixed costs are considered part of the cost of goods sold so it can give companies an incentive to spread that cost among more products to make the cost-per-product look lower. So if Chrysler has excess capacity, produces all the products it can, and sells up to demand-its cost of goods sold will be lower than it would if the company had only produced up to demand. According to accounting standards, companies can use absorption costing for “normal capacity” but must treat “abnormal” excess capacity as a period cost. However, it does not explicitly define what is normal.
Absorption costing can artificially make your profit margins look higher because you do not have to deduct all of your fixed overhead if you have not sold all of your manufactured products. Your statements do not accurately show the full expenses you had for the period. The lower cost of goods sold in turn improves profits on the income statement. Therefore, instead of writing off the cost of these idle plants as an expense, companies can shift the cost to the balance sheet as inventory. In the short run then the company looks more profitable by ‘hiding’ excess capacity costs on the balance sheet. However, we have learned that keeping excess inventory is costly in the longer term. In Chrysler’s case the cars were gas-guzzlers and quickly