Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
There are several alternative denominator activity levels that might be chosen as a basis for the overhead rate calculations. These include: 1) maximum capacity, 2) practical capacity, 3) the normal or long run average production level, and 4) planned production, i.e., master budget units to be produced.
Maximum capacity is defined as the annual output the firm could produce assuming perfect conditions, i.e., if there were no problems such as downtime caused by shortages of inputs or machinery breakdowns.
Practical capacity is defined as a somewhat lower level of output assuming efficient operations, but allowing for some unavoidable downtime or idle time. Using either maximum or practical capacity as the denominator will result in relatively large planned and actual production volume variances.
Normal capacity is an average output level expected over the next several years. Using normal capacity as the denominator would cause unfavorable production volume variances in some years and favorable variances in other years.
Planned capacity is represented by the number of units the firm plans to produce during the year as stated in the master budget. Using planned capacity eliminates planned production volume variances (in annual statements, but not monthly or quarterly statements), and tends to minimize the actual production volume variances.
A 1980 survey of Fortune 500 firms revealed that approximately 57% of the 247 firms that responded to the questionnaire used planned production as the basis for calculating overhead rates, while 21.1% used practical capacity, 18.2% used normal capacity and only 1.6% used maximum capacity1.
Although, it is not clear why certain firms choose a particular denominator, the choice of denominator activity can have a significant effect on product cost and absorption costing net income.
Although many firms may still use planned capacity as the basis for overhead rates, a number of authors have advocated using full, or practical capacity as the denominator for overhead rates to provide more accurate product costs and to avoid a "death spiral" effect that may occur when planned capacity is used. For some early arguments for using full capacity to provide more accurate product costs, see the Gantt, Church, and Frank summaries. Advocates of activity-based costing recommend using full capacity to provide more accurate activity costs, as well as product costs. For some more recent arguments see the ABKY Chapter 4, Cooper & Kaplan 1992, McNair 1994, and Brausch & Taylor 1997 summaries.
1 See Chiu, J. and Y. Lee. 1980. A survey of current practice in overhead accounting and analysis. Proceedings, Western Regional Meeting. American Accounting Association: 242.
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).
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).
McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary)