Learning Objective 6 Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate
At the start of each fiscal year, managers must determine the budgeted fixed manufacturing cost rates to be used for different purposes, including (1) product costing and capacity management, (2) pricing decisions, (3) performance evaluation, (4) financial reporting, and (5) tax requirements. We now discuss how to choose among the different denominator levels related to the various capacity concepts.
As the Stassen example illustrates, use of theoretical capacity results in an unrealistically small fixed manufacturing cost per unit because it is based on an idealistic and unattainable level of capacity utilization. Theoretical capacity is rarely used to calculate budgeted fixed manufacturing cost per unit because it departs significantly from the capacity that is effectively available to a company.
Instead, many companies favor practical capacity as the denominator to calculate the budgeted fixed manufacturing cost per unit. Practical capacity in the Stassen example represents the maximum number of units (12,000) that Stassen can reasonably expect to produce per year for the $1,080,000 it will spend annually on capacity. If Stassen had consistently planned to produce fewer units, say 6,000 telescopes each year, it would have built a smaller plant and incurred lower fixed manufacturing costs.
Stassen budgets $90 in fixed manufacturing cost per unit based on the $1,080,000 it costs to acquire the capacity to produce 12,000 units. This level of plant capacity is an important strategic decision that managers make well before Stassen uses the capacity and even before Stassen knows how much of the capacity it will actually use. That is, the budgeted fixed manufacturing cost of $90 per unit measures the cost per unit of supplying the capacity.
Demand for Stassen’s telescopes in 2020 is expected to be 8,000 units, which is 4,000 units lower than the practical capacity of 12,000 units. However, it costs Stassen $1,080,000 per year to acquire the capacity to make 12,000 units, so the cost of supplying the capacity needed to make 12,000 units is still $90 per unit. The capacity and its cost are fixed in the short run; unlike variable costs, the capacity supplied does not automatically reduce to match the capacity needed in 2020. As a result, not all of the capacity supplied at $90 per unit will be needed or used in 2020. Using practical capacity as the denominator level, managers can subdivide the cost of resources supplied into used and unused components. At the supply cost of $90 per unit, the manufacturing resources that Stassen will use equal Manufacturing resources that Stassen will not use are
Using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of the demand for the capacity. Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity, perhaps by designing new products to fill unused capacity, by leasing unused capacity to others, or by eliminating unused capacity. In contrast, using either of the capacity levels based on the demand for Stassen’s telescopes—master-budget capacity utilization or normal capacity utilization—hides the amount of unused capacity. For example, if Stassen had used master-budget capacity utilization as the capacity level, it would have calculated budgeted fixed manufacturing cost per unit as This calculation does not use data about practical capacity, so it does not separately identify the cost of unused capacity. Note, however, that the cost of $135 per unit includes a charge for unused capacity: It is composed of the $90 fixed manufacturing resource that would be used to produce each unit at the practical capacity utilization level of 12,000 units plus the cost of unused capacity allocated to each unit,
From the perspective of long-run product costing, which cost of capacity should Stassen use for pricing purposes and for benchmarking its product cost structure against competitors: $90 per unit based on practical capacity or $135 per unit based on master-budget capacity utilization? Probably the $90 per unit based on practical capacity. Why? Because $90 per unit represents the budgeted cost per unit of only the capacity used to produce the product, and it explicitly excludes the cost of any unused capacity. Stassen’s customers will be willing to pay a price that covers the cost of the capacity actually used but will not want to pay for unused capacity that provides no benefits to them. Customers expect Stassen to manage its unused capacity or to bear the cost of unused capacity, not pass it along to them. Moreover, if Stassen’s competitors manage unused capacity more effectively, the cost of capacity in the competitors’ cost structures (which guides competitors’ pricing decisions) is likely to approach $90. In the next section, we illustrate how using normal capacity utilization or master-budget capacity utilization can result in managers setting selling prices that are not competitive.