Summary by Maria Du
Master of Accountancy Program
University of South Florida, Summer 2002
In this article, McNair discusses the concepts of capacity and hidden waste resource assumptions. Then she redefined capacity concepts and introduced the philosophy of continuous improvement. The purpose of the article is to focus management’s attention on wasted resources rather than on the output of the plant.
Capacity means different things to different people
Capacity is the resources available to do work – represents a company’s profit potential. McNair provides five definitions of capacity.
Various Definitions of Capacity
Theoretical Capacity - Maximum output of a plant with no downtime, waste or idle time.
Practical Capacity - Maximum output of plant with normal downtime and waste.
Normal Capacity - The output that a plant ordinary produces in a specific period.
Budgeted Capacity - Estimated output as a result of sales forecasts, inventory levels and politics.
Actual Capacity - Total number of actual labor hours "earned".
As you can see above, definitions of capacity except theoretical capacity, are based on the output that embeds waste, downtime and idle capacity into the plant’s ordinary operations. Managers who are driven to maximize the earned hours in a plant lost sight of the ultimate goal, which is to produce better, faster and cheaper goods.
Hidden waste resource assumptions
McNair mainly discussed five types of resource waste in capacity management in most companies summarized as follows.
Definitional waste: The definitions of capacity, except theoretical capacity, creates an acceptable level of waste. Managers perpetuate waste, downtime, and idle capacity and build them into the company’s normal operations.
Management-based waste: The author gave an example of a company where the Paint booth operation (bottle neck operation) was running at full capacity at two shifts and five days a week. Managers never questioned traditional plant practices by asking why two out of a potential seven days were left idle. These two days of waste are actually built into the company’s cost structure. Maximizing the number of hours the machine is up and running doesn’t guarantee that products gets out the door as fast as possible.
Technical waste: Fixed costs are increasing as technology replaces labor in the growth of international competition. The relationship between the inputs and the outputs is less known, as a result, managers try to balance the production process by using rules of thumb, trial and error. A company usually rewards overproduction by emphasizing efficiency (i.e. keeping the machines busy) over effectiveness (i.e. the right goods are produced at the right time and in the right way).
Accounting-based waste: "It is going to happen, so we might as well factor in into our estimates". Standard cost systems often build in expected levels of scrap and downtime that is attainable most of the time by an average worker. Full cost systems absorb all production costs into the inventory accounts and unintentionally encourage wasted capacity.
Structural waste: This type of waste is the hardest type to avoid, e.g., rent paid. Only long term changes in how a product is made, or in how a service is provided can affect structural waste and increase competitiveness in the global market.
To begin unraveling the myths about capacity management, "capacity" itself has to be redefined. Capacity is the output capability of a company when it fully utilizes its bottleneck resources to create the maximum value for customers while generating the minimum waste. Understanding the waste represented by unused resources or resources used in ways that do not increase the value delivered to the customers is essential to minimize wasted capacity. Managers should utilize the resources of the plant and minimize the waste to strive for theoretical maximum capacity.
Solution: the philosophy of continuous improvement
Remember overhead? Overhead is a pool of many different kinds of cost that can’t be directly tied to an output and is the place where idle capacity waste is hidden. Overhead has been dramatically increased due to high technology changes. Differences between planned output and actual output result in volume variances that build waste into the very fiber of the organization by focusing budged capacity.
The chart below is based on Ishikawa's fishbone diagram that identifies the root cause of quality-based waste and provides a viable option for refocusing capacity management efforts to minimize waste.
Redefining capacity and identifying idle capacity is the first step toward achieving effective capacity management. A second step is continuous improvements that strives for the theoretical optimum, questions all assumptions, continues to eliminate waste and focuses on the creation of value to the customers. A company searches for ways to provide product variety to meet customers’ needs and constantly seeks improvements to increase flexibility in utilizing limited resources at a lower cost. Historical data is the best baseline to use in evaluating the effectiveness of continuous improvements. Trending actual performance over time provides active, ongoing measurements of the effectiveness of the production process and also sends a clear picture about the challenges that are occurring.
Capacity is a long term concept – the future of the company. This article provides a renewed focus on idle capacity as the key to continuous improvement and eliminating waste in organizations.
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. (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).
Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
Frank, W. G. 1990. Back to the future: A retrospective view of J. Maurice Clark's Studies In The Economics of Overhead Costs. Journal of Management Accounting Research (2): 155-166. (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).
Greer, H. C. 1966. Anyone for widgets? The Journal of Accountancy (April): 41-49. (Summary).
Martin, J. R. Not dated. Goldratt's dice game or match bowl experiment. Management And Accounting Web. http://maaw.info/MatchBowlExperiment.htm
Yu-Lee, R. T. 2002. Target costing: What you see is not what you get. Journal of Cost Management (July/August): 23-28. (Summary).
Yu-Lee, R. T. 2003. Don't miss the bottom line with productivity increases. Industrial Management (January/February): 8-13. (Summary).