Summary by Renauri Castro
Master of Accountancy Program
University of South Florida, Fall 2004
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The idea of tracking both variable and fixed costs in production in order to attribute the fixed costs to the products manufactured is not a new concept. The author states that the cost of producing a good needs to be tracked in order to be able to price it accurately and to be able to determine its profitability. Unfortunately the system in place for tracking the overhead costs back to the output produced is flawed according to Gantt. Especially when such systems are needed the most, for example when the economy is in a recession and production levels drop requiring more accurate cost structures.
According to Gantt the allocation to outputs should be based on maximum production levels, which he calls normal levels 1 . The error in calculating cost of production takes place when production drops below the normal or maximum level. Traditional theories on cost allocation continue to allocate all of the production overhead costs to the output regardless of volume. This method of thinking creates inflated costs, provides managers with incorrect information, and subsequently creates incorrect decisions.
For example assume that a factory has a variable cost of 1 dollar per output produced and a fixed cost of 100 dollars. At a maximum production level of 100 items the total cost of producing the 100 units would be 200 or 2 dollars per unit. If however there were a drop in the economy and demand and therefore the factory cut production down to 50 units the total cost would be 150 dollars or 3 dollars per unit. The reduction in production forces the remaining units to carry the burden of the 50 less units being produced. If a manager were to look at this information they would price their items at an amount higher than 3 dollars because he believes that is the cost of producing 50 units. When in reality the extra dollar per unit is a cost of inefficiency or the cost of not producing at capacity.
As Gantt said, the traditional method of allocating cost was for the benefit of financiers who would rather not see a line item in the financial statements called loss due to underproduction. As a result the loss is attributed to cost of goods sold therefore creating an inaccurate picture to investors, managers and shareholders. If the factory manager relies on the inaccurate cost per unit for a particular item he may erroneously conclude that the item is not profitable and should therefore be purchased from or outsourced to a third party. Gantt tells of a story where a manufacturer told him he had done just that, after calculating cost he found a third party who could provide it for much less. Little did the manufacturer know that his units were actually cheaper to produce.
Another example Gantt uses to show the flaw in the traditional method involves looking at three factories of the same company located in different cities. Suppose then that the economy goes through a recession and production needs to be reduced to a third. If the company chooses to shut down production in two cities and keep one running at full production, the cost of that one factory will remain the same, however the overall bottom line would be reduced dramatically by the fixed cost of the other two factories. Now pretend that the factories were adjacent to each other as opposed to being in separate cities and there were no walls between them, the same rules should apply in that one third of the units being produced should not carry the burden of the other two thirds not being produced.
In conclusion Gantt’s main purpose in writing the article is to point out that the actual relationship between production and cost is not what people always assumed it to be. Instead of recalculating costs for goods being produced every time production levels change, the difference in cost should be separated and shown as a deficiency of production. Gantt’s suggestion is that by using this method manufacturers should try to maximize whatever resources they have before considering expanding. When a manufacturer does decide to expand it should only be because they can produce at or near the new maximum levels. This would not only encourage better efficiency but more accurate cost and pricing.
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1 Although Gantt used the terms "normal capacity" and "full capacity" interchangeably, many authors currently use the term normal capacity to mean the average output level expected over the next several years. This level could be considerably less than full capacity. (See denominator activity levels for more on the capacity issue).
Related summaries:
Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50. (Summary).
Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Summary).
Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).
Clark, J. M. 1981. Studies in Economics of Overhead Costs. The University of Chicago Press. Reprint of Clark's 1923 publication. For reviews of this book, see Davidson, S. 1963. Old wine into new bottles. The Accounting Review (April): 278-284. (JSTOR link); Paton, W. A. 1924. Studies in the Economics of overhead Costs. by J. Maurice Clark. Journal of The American Statistical Association (June): 257-259. (JSTOR Link); and Jackson, J. H. 1925. The Economics of Overhead Costs. The American Economic Review (March): 82-84.
Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
Greer, H. C. 1966. Anyone for widgets? The Journal of Accountancy April): 41-49. (Summary).
Martin, J. R. Not dated. 200 years of accounting history dates and events. Management And Accounting Web. AccountingHistoryDatesAndEvents.htm
McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).