Question

A recent issue of Business Week reported the following: During the recent auto sales slump, GM, Ford, and Chrysler decided it was cheaper to sell cars to rental companies at a loss than to lay off workers. That's because closing and reopening plants is expensive, partly because the auto makers' current union contracts obligate them to pay many workers even if they're not working. When the article discusses selling cars "at a loss," is it referring to accounting profit or economic profit? How will the two differ in this case? Explain briefly.

Short answer

The 'loss' that GM, Ford, and Chrysler are experiencing due to selling cars at a price below production costs refers to an accounting loss. While it may seem like they are operating at a deficit, the companies are actually trying to minimize their total costs when one considers the economic aspects. The costs of laying off workers and shutting down/reopening plants, which include both explicit and implicit costs, might outstrip the loss from selling their cars to rental companies below cost.

Step-by-step solution

Analyze the context

Begin by analyzing the situation. GM, Ford and Chrysler are selling cars to rental companies at a loss to avoid laying off workers. It's stated that shutting down and restarting production plants is costly due to union contracts obligating the payment of many workers, regardless of employment status.

Identify the type of 'loss'

Considering the context, the 'loss' they are referring to would be an accounting loss. This is because the auto manufacturers are selling the vehicles for less than the explicit costs associated with producing them, such as materials, labor, and overhead.

Consider the alternative (economic profit)

If we consider economic profit, which includes opportunity costs, the loss might look different. For instance, the opportunity cost of laying off workers and shutting down plants includes the cost of unemployment payments, possible damaging publicity, and the potential loss of skilled labor. Therefore, the decision may not represent an economic loss, as the alternative option could be more costly than selling at an accounting loss.

Key concepts

Accounting Profit

Accounting profit is the straightforward calculation of a business's financial performance. It is determined by subtracting the total explicit costs, such as material costs, salaries, and other overheads, from the total revenue. Accounting profit focuses solely on actual monetary transactions. In the auto industry context, when GM, Ford, and Chrysler mentioned selling cars to rental companies "at a loss," they referred to an accounting loss. This means the revenue from selling the cars was less than the direct costs involved in producing them. These costs are easily identifiable and measurable from the company's financial statements.

For instance, if the cost of producing a car is $20,000 but the car is sold for $18,000, it reflects a $2,000 accounting loss per car. The clear advantage of tracking accounting profit is its ability to provide a clear snapshot of the company's financial status without complication.

• Does not consider intangible factors.
• Represents explicit costs only.
• Useful for preparing financial statements.

While accounting profit is crucial for understanding basic operational viability, it does not account for broader implications like opportunity costs.

Opportunity Cost

Opportunity cost is an essential economic principle that considers the value of the next best alternative foregone. It recognizes costs beyond just monetary transactions, including benefits lost when choosing one option over another. In our auto industry example, GM, Ford, and Chrysler's decision to continue producing cars rather than close plants included substantial opportunity costs.

If they had chosen to close plants, the opportunity cost would involve several factors: paying unemployment benefits, potential legal challenges due to breaching union contracts, reputational damage, and the potential loss of trained personnel, complicating future production restarts. Essentially, opportunity costs provide a deeper understanding of the economic landscape by weighing choices against potential alternatives.

• Includes implicit and explicit costs.
• Aims to maximize overall economic benefits.
• Provides a more comprehensive picture of economic decision-making.

By assessing opportunity costs, companies can make well-informed decisions even when facing apparent losses in traditional accounting measures.

Auto Industry Economics

The auto industry economics landscape is shaped by a variety of unique factors that influence business decisions, from labor agreements to macroeconomic trends. Companies like GM, Ford, and Chrysler must consider complex economics when deciding operational strategies. In this instance, maintaining production operations at a traditional accounting loss was deemed more beneficial than the costs associated with plant closures.

Several constraints are peculiar to the auto industry: stringent labor contracts which sometimes require continued salary payments to workers not actively engaged in production, high fixed costs of operating and reactivating manufacturing plants, and competitive market pressures. Moreover, companies strive to balance their immediate financial outcomes against long-term strategic goals.

• Involves significant fixed and variable costs.
• Impacted by union contracts and employment laws.
• Influenced by market competition and consumer demand.

Understanding auto industry economics requires a balanced approach considering not just direct financial metrics but also the broader competitive and regulatory environment that impacts business decisions.