Producing To Profits - Pitfalls of Absorption Cost Systems

By Justin Baird

When goods are manufactured there are typically two types of costs that comprise the "total cost" of manufacturing the product. Fixed costs are the costs associated doing business, such as lease of the land that the production facility is built on, the building itself, marketing, administrative, and other overhead are all combined into a "Fixed Cost". A Variable Cost is the incremental cost to produce one more unit of output, for example the amount of electricity needed to produce another unit, the additional materials required, and the additional labor hours required to assemble it. These variable costs are directly tied to the production of the good, while the fixed costs are shared among all units produced.

In an absorption cost system the variable cost of the manufactured good is added to 1 share of the fixed costs for that unit.

For example in a factory that produces 1000 cars their costs could be broken down like this:

Fixed Cost: $100,000
Time& Materials: $100,000
Units Produced:1,000
Variable Cost Per Unit: $100
Fixed Cost Share Per Unit: $100
Total Cost Per Unit: $200
Sale Price $1,000
Profit Per Unit $800
Total Profit: $800,000

If that same factory doubled production but could only sell 1,000 cars the costs would look like:

Fixed Cost: $100,000
Time& Materials: $100,000
Units Produced:2,000
Variable Cost Per Unit: $100
Fixed Cost Share Per Unit: $50
Total Cost Per Unit: $150
Sale Price $1,000
Profit Per Unit $850
Total Profit: $550,000

So despite producing more cars and effectively losing more total profit, they were able to maximize the profit per unit sold which could lead businesses to make poor pricing decisions.

There is an underlying problem here that may contribute to a company incentivizing its managers to make more short term decisions instead of long term decisions. By doing a traditional compensation incentive programs manufacturers could actually be rewarding employees for losing the company money. If a manufacturing manager was provided a bonus for driving the cost of producing a unit under 175$ per unit the executives of the organization would hope that the bonus would incentivize the manager to create greater efficiencies in the supply chain, or find a more cost effective supplier, or drive labor costs down but the manager could leave everything exactly how it currently runs and just produce more cars.

In the books it would look like the manager did a great job in driving the cost per unit to $150 and exceeding his or her goal, but the managers decision actually hurt the company in the long run because now they have excess inventory to manage, lower total profits, and workers that may have to sit idle while the excess inventory is sold off. This is an example of how absorption cost systems and improper incentives can combine to cause a company to be very short sighted in its decisions.

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