Summary by Adebola Shokunbi
Master of Accountancy Program
University of South Florida, Fall 2004
The authors’ purpose in this article is to set forth the argument that fixed overhead rates should be determined based on practical capacity measures, which ought to represent the maximum levels at which each plant, shift, cell, or work island can operate efficiently. The argument is supported by an example that compares the traditional approach to the approach based on practical capacity, and indicates that the practical capacity approach provides superior cost information and in turn produces improved management decision making.
Traditional Approach to Fixed Overhead Rate Determination
Fixed overhead costs, which represent all overhead costs that are not variable, includes costs that are fixed for the entire plant, costs that are step-fixed, and costs that vary with non-volume-related cost drivers. The definitions of capacity levels include: Theoretical, Practical, Normal, and Master Budget Capacity, which is the most popular capacity used for setting fixed overhead rates.
Pacing Work Center - The constraining work center that established the pace of production for manufacturing operations.
Theoretical Capacity - The production of output 100 percent of the time.
Practical Capacity - The maximum level at which the plant or department can operate efficiently. Practical capacity often allows for unavoidable operating interruptions, such as repair time or waiting time.
Normal Capacity - The level of capacity utilization (which is less than 100 percent of practical capacity) that will satisfy average customer demand over a span of time (often five years) that includes seasonal, cyclical, and trend factors.
Master Budget Capacity - The anticipated level of capacity utilization for the coming year or other planning period (such as six months).
The employment of the master budget capacity results in a product cost that is neither consistent nor accurate when production activity differs between periods. This occurs because the master budget disregards any consideration of the underutilized capacity of a plant.
Practical Capacity Approach to Fixed Overhead Rate Determination
To promote simplicity, the authors separate fixed overhead costs into two categories: fixed plant costs and fixed shift costs.
Fixed Plant Costs are sustained simply by maintaining a manufacturing facility. They do not vary with production or number of shifts worked, e.g., Property taxes.
Fixed Shift Costs include all fixed costs that do not fall under the fixed plant costs category. Most fixed shift costs are assumed to behave in a step-fixed manner - even though they vary with volume-driven activities, their variation is in “chunks.”
The relevant capacity level is Practical Capacity because it uncovers the cost of unused resources. It differentiates the cost of resources available from the cost of resources actually used for a particular purpose.
Fixed Overhead Rates should be based on the practical capacity of each resource. In turn, product costs will be consistent because they will not include the cost of unused resources.
In determining the Fixed Plant Cost Rate, fixed plant costs should be divided by the practical capacity available in the plant (usually the maximum or three-shift practical capacity). The result is that each identical item of production will be assigned the same cost because the unused resources are disregarded. The use of practical capacity is advantageous because consistent cost information is extremely vital for management decision making. In addition, it highlights inefficiencies such as idle capacity in the system.
The Fixed Shift Cost Rate should be determined by dividing the fixed shift costs by the practical capacity used in the plant. This will result in the cost of the underutilized shifts being represented as underapplied overhead and written off as a waste of available resources.
The example reveals that the traditional approach computation focuses on the master budget capacity, which will vary annually. Consequently, the fixed cost per machine hour is overstated, resulting in flawed managerial decisions. For example, the information provided by the traditional approach, would promote erroneous decisions involving product introductions, product discontinuations, and outsourcing.
On the other hand, the practical capacity approach produces fixed overhead rates that do not vary with volume or the budgeted machine use. These consistent fixed overhead rates produce production costs changes that result solely because of changes in the production requirements of specific products. Significantly, product costs will not vary because of changes in the production requirements of other products.
The practical capacity approach also provides accurate fixed overhead rates for each work center, because it excludes the cost of unused resources from product costs. Although managers may be well aware of the fact that their manufacturing facilities are being underutilized, they may not be aware of the extent of the overstatement of product costs that will result.
In essence, the employment of practical capacity enhances the traditional approach because it produces more consistent and accurate product costs and reduces dysfunctional management decisions.
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Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).
Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).
Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).
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