Learning Objective 5 Describe the different capacity concepts that can be used in absorption costing
We have seen that the difference between variable and absorption costing arises solely from the treatment of fixed manufacturing costs. Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most difficult decisions managers face. Having more capacity than is needed to meet market demand means firms will have unused capacity and will incur costs associated with the unused capacity. Having less capacity than is needed to meet market demand means that demand from some customers will be unfilled. These customers may go to other sources of supply and never return. Both managers and accountants must understand these issues related to capacity costs.
We start this section by analyzing a key question in absorption costing: Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit produced? We then study the broader question of how a firm should decide on its level of capacity investment.
Earlier chapters, especially Chapters 4, 5, and 8, highlighted how normal and standard costing report costs in an ongoing timely manner throughout a fiscal year. The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect the product-cost information available to managers and the operating income reported under normal or standard costing.
Consider the Stassen Company example again. Recall that the annual fixed manufacturing costs of the production facility are $1,080,000. Stassen currently uses absorption costing with standard costs for external reporting purposes, and calculates its budgeted fixed manufacturing rate on a per unit basis. We will now examine four different capacity levels that could be used as the denominator to compute the budgeted fixed manufacturing cost rate: theoretical capacity, practical capacity, normal capacity utilization, and master-budget capacity utilization.
In business and accounting, capacity ordinarily means a “constraint,” or an “upper limit.” Theoretical capacity is the level of capacity based on producing at full efficiency all the time. Stassen can produce 25 units per shift when the production lines are operating at maximum speed. If we assume 360 days per year, the theoretical annual capacity for 2 shifts per day is as follows:
Theoretical capacity is theoretical in the sense that it does not allow for any slowdowns or downtimes due to plant maintenance, shutdown periods, or interruptions on the assembly lines. Theoretical capacity levels are unattainable in the real world, but they represent an idealized aspiration for capacity utilization.
Practical capacity is the level of capacity that is achieved when theoretical capacity is reduced by considering unavoidable production interruptions such as scheduled maintenance time and shutdowns for holidays. Assume that practical capacity is the practical production rate of 20 units per shift (as opposed to 25 units per shift under theoretical capacity) for 2 shifts per day for 300 days a year (as opposed to 360 days a year under theoretical capacity). The practical annual capacity is as follows:
Engineering and human resource factors are both important when estimating theoretical or practical capacity. Engineers at the Stassen facility can provide input on the technical capabilities of machines for cutting and polishing lenses. Human resources can evaluate employee safety factors such as increased injury risk when the line operates at faster speeds.
Both theoretical capacity and practical capacity measure capacity levels in terms of what a plant can supply—available capacity. In contrast, normal capacity utilization and master-budget capacity utilization measure capacity levels in terms of demand for the output of the plant, that is, the amount of capacity the plant expects to use based on the demand for its products. In many cases, budgeted demand is well below production capacity available.
Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period (say, 2 to 3 years) that includes seasonal, cyclical, and trend factors. Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period, which is typically 1 year. These two capacity utilization levels can differ quite significantly in industries that face cyclical demand patterns. For example:
Consider Stassen’s master budget for 2020, based on production of 8,000 telescopes per year. Despite using this master-budget capacity utilization level of 8,000 telescopes for 2020, top management believes that over the next 3 years the normal (average) annual production level will be 10,000 telescopes per year. It views 2020’s budgeted production level of 8,000 telescopes to be “abnormally” low because a major competitor has been sharply reducing its selling price and spending a lot of money on advertising. Stassen expects that the competitor’s lower price and advertising blitz will not be a long-run phenomenon and that, by 2021 and beyond, Stassen’s production and sales will increase.