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Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50.

Summary by Ben Miele
Master of Accountancy Program
University of South Florida, Summer 2002

Capacity Related Main Page | ABC Main Page

A profitable company starts a new plant to provide additional manufacturing capacity in order to make and sell more products. The new plant is designed to do the same thing as the existing plant. What is the outcome? Sales increased 30%, fixed costs tripled, profits turned into losses, stock prices fell over 75%. What happened? The Company already had available capacity in the old plant, that was known, but this information was "hidden" due to changes in the measurement base. Operation departments with actual operating capacities of 55% to 60% were reported at or near full capacity. In this case the measurement base was changed in order to make operations look better. The flawed data only aided management in the Company’s decision to build a new plant. To avoid this bad decision, the Company needed to understand: its true capacity, the cost of its existing unused capacity, and the costly effects of adding additional capacity to existing unused capacity.

The focus of the authors is to address the failure of companies to use the full capacity of committed resources, and to explore the costing and managing problems of unused production capacity. The authors draw from their findings and conclusions of a study of 12 companies (circa 1996/97) and cite similar findings from a study of 51 companies presented at a conference on capacity costs (circa 1996/1997). The authors found that mostly manufacturing (or operations) personnel (with informal communication with production, marketing, and other areas) are responsible for managing capacity, while in some cases a CEO, or a joint effort by manufacturing, marketing, and finance individuals, exists. Effective management of capacity and its cost requires a measure of the full potential output of available resources, or potential productivity. Various plans, reports, and systems exist that could provide accurate information about capacity utilization. However, the companies lacked a proactive view of production potential other than meeting the expectations of sales or marketing. For instance utilization rate reports can measure (true) unused capacity, if the measurement base used is (full) output potential, but this is seldom if ever the case.

Conditions of unused or excess capacity are and have been reported by cost accounting as unfavorable volume variances. The volumes used range from theoretical to no concept of capacity. The concepts of theoretical and practical capacity produce the largest measure of productive capacity, and result in larger unfavorable volume variances. All methods used, except possibly theoretical capacity, result in volume variances that reflect the failure to reach production levels built into the overhead rate formula, not unused capacity.

For instance, the use of practical capacity is flawed for three reasons (the first two also apply to expected and normal capacity),

1. Aggregation problems – use and related cost of individual capacity components is buried in the aggregated data,

2. Relevant cost drivers are ignored in the application of fixed overhead costs (as application is based on non-causal, volume-driven factors such as labor or machine hours),

3. Failure to use the potential productivity naturally present in the available resources as the actual measure of capacity.

Capacity is most always defined at levels of less than maximum production.

In order to determine the cost of unused capacity it is necessary to first define, and then measure a set of components in terms of potential output and associated costs. Then based on output realized, determine the level of usage and nonusage of the components. Some applications include using an opportunity cost approach where lost profit margins are traced to underutilized capacity, and reviewing resources for continued need, or for excessiveness. By determining the full cost of unused capacity, including "sunk costs" like depreciation, a basis for establishing accountability for the cost of all resources committed in establishing capacity can be achieved. Capacity cost analysis may provide a means to monitor long-term financial success.

Many companies subsequently evaluate capacity additions through post-implementation audits. The audits provide a realistic financial impact of capital additions and a way of learning from past mistakes (including making decisions based on inadequate/incorrect capacity data). Some companies use the review to evaluate management performance. The main benefit of the reviews is to minimize faulty capital decisions and the losses associated with excess capacity.

Maximum capacity is limited by bottlenecks in the production process. Bottlenecks limit increased production or throughput. They occur for varying reasons, mostly when products are not standardized, have varying features, and when production processes are less continuous and unbalanced. There are short-term solutions, such as use of overtime, extra shifts, outsourcing, and temporary help, etc. that avoid permanent (unneeded in long-run) additions to capacity; while decisions to actually expand capacity in the area of the bottleneck involve longer-term commitments. Another step used by some of the companies is training and employing multi-skilled employees that can be used in the bottleneck areas.

If there are areas of bottlenecks, then there are usually areas of nonbottlenecks, or unused/underutilized capacities. Strategies to cope with this excess capacity were found to be limited among the companies researched. Also, even if bottlenecks could be eliminated and a balanced production process achieved, most companies would still experience a good amount of unused capacity. It was noted that one company with a balanced production process had an estimated unused capacity of 40%. The main reason for this unused capacity was lack of sufficient business, which would only be improved by a significant increase in sales.

Capacity reporting, because it provides the amount of profit not realized due to unused capacity, requires separate reporting in order to increase its visibility. Capacity reporting places a dollar amount on the effective management of capacity. The authors recommend this type of reporting, specifically the measurement of Contribution Margin not Realized "for any firm wishing to highlight the opportunity cost of unused or underutilized capacity." (p. 49) A schedule of contribution margin not realized adapted from p. 49 follows:

Schedule of Contribution Margin not Realized
Product A Product B Product C
Average selling price $ 5.34 $ 4.23 $ 15.00
Average selling price discounted 15% $ 4.54 $ 3.60 $ 12.75
Less: prime costs $ 1.59 $ 1.53 $ 7.55
Contribution per unit (A) $ 2.95 $ 2.07 $ 5.20
Total capacity at sales product mix 10,000,000 8,000,000 600,000
Less: actual production 9,900,000 7,100,000 500,000
Lost production (B) 100,000 900,000 100,000
Capacity not utilized 1.0% 11.3% 16.7%
Contribution margin not realized (AxB) $ 295,000 $ 1,863,000 $ 520,000

This measurement highlights what the firm could be doing. It is relevant for decision making, as it directly relates to decisions involving sales/profit opportunities, downsizing, and re-deployment of resources. It is unlike volume variances, as it is based on meaningful data, it is easily calculated, and easily understood. The author cautions that this measurement should be presented to executive management to be used for strategic direction and not as a means to evaluate operational performance. This is to prevent operations from misinterpreting the measurement with the behavior of increasing capacity simply to increase capacity, along with the resulting possible harmful effects of increasing inventories.

The measurement should be used to identify and report unused capacity for what it is; waste. Management must re-focus their mindset and view production potential proactively, break out of their year-to-year plan way of thinking, and know what they should/could be achieving by adopting a longer range view, and mobilizing the full capacity of their company’s resources to get there. It may very well be in the best interest of a company to decide to maintain a permanent cost of excess capacity in order to periodically respond to surges in customer demand. This is entirely management’s decision. As management accountants we must make the decision-makers aware of the costs of unused capacity.

Measuring the cost of capacity resources, used and unused, can help companies become more competitive. Cost information about capacity, especially unused or idle capacity, point out areas of waste and also the associated cost of the waste. Once the waste has been identified, managers can then decide to eliminate it or redirect the resources to needed areas. Companies that measure capacity cost, and that pay attention to the cost of unused capacity, have a competitive advantage.

Following is a summary of certain key issues and problems concerning accounting for the cost of capacity based on the author’s independent findings from a study of 12 companies plus information for 51 other companies gathered by the author from a conference on capacity costs.

Accounting for the Cost of Capacity - Summary of Certain key Issues and Problems

Company Policy and Organizational Responsibility

No clear policy statements and lack of formal policies or guidelines (only implied or informal policies exist)

Vice president of manufacturing, plant manager, production control manager, or operations planning group responsible for managing capacity.

Measurement and Concept of Capacity

Focus of capacity measurement is on volume to be realized, not realizable output.

Planning capacity usage oriented for short-term sales goals versus long-term needs.

Most companies not running even close to optimum levels.

Unused or under-utilized capacity clearly exists in various areas of the organizations.

Little evidence of directing attention to these conditions.

General lack of concern for long-term capacity management.

Assigning Fixed Overhead Cost

Approximately 85% of the companies reviewed used an expected (budgeted), normal, or no concept of capacity concept.

Concept Used
Number of Companies using the concept from the 12 Companies Studied Number of Companies using the concept from the 51 Companies at the Conference Totals Percentage
Expected 5 29 34 54.0
Practical 2 5 7 11.1
Normal 2 6 8 12.7
Apply all fixed overhead 3 11 14 22.2
Totals 12 51 63 100.0

Actual usage of theoretical capacity is extremely rare.

Cost of unused capacity information provided by present cost accounting methods is very limited.

Capacity in most companies is defined at less than maximum production capacity.

The use of no capacity concept involves applying all actual fixed overhead costs to product, which is the result of full absorption costing.

Activity based costing can fall into this trap as well, if the process of cost assignment fully loads all costs on the cost objects without recognizing output achieved.

Determining the Cost of Unused Capacity

Volume variances reported presently by cost accounting systems serve little purpose in decision making, or in the management of capacity, or in determining the cost of unused capacity.

Only 3 out of 63 companies reviewed were using some measure of the cost of unused capacity in evaluations of manufacturing and factory activities.

Not all costly resources or activities are easily determined.

Significant resources and costs are present in service and support areas beyond the factory floor.

Only 3 out of 63 companies reviewed were using some measure of the cost of unused capacity in evaluations of support and nonfactory activities.

Subsequent Evaluation of Capacity Additions

Only 5 out of 12 companies studied were conducting post-implementation audits.

None of the 5 companies use the audit to evaluate management performance.

Addition of capacity that is not being utilized goes unnoticed in many companies, these costs are avoidable if proper evaluations of capacity additions are performed.

Bottlenecks and Nonbottlenecks

Bottlenecks were common among the companies studied, with 9 out of 12 companies experiencing them.

Optimal use of overall capacity require that bottlenecks be addressed and removed.

The mere existence of bottlenecks causes nonbottlenecks, unused or under-utilized capacities.

Alleviating bottlenecks may create a balanced production process, but unused capacity may still exist due to lack of sufficient business.


Related summaries:

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).

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. Activity based management models. Management And Accounting Web.

McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).