58. Managing Capacity

Question 1

What are some of the challenges that arise from fixed costs that represent costs of capacity?

Answer 1

• Because organizations rarely use their entire capacity, the main issue that an organization faces with fixed capacity costs is determining how to handle the costs associated with idle capacity when planning, controlling, and evaluating costs in the organization.
• When unused capacity costs are not clearly identified and managed, product costs are unintentionally inflated, which can lead to detrimental pricing decisions.
• Without an adequate accounting system, it is difficult to effectively plan, control, and evaluate excess capacity.

Question 2

Some organizations use the budgeted volume of output to compute the predetermined rate for allocating budgeted costs. Describe the problem that an organization faces if they use the resulting product costs to establish or evaluate prices in the market

Answer 2

• If the cost for a product is high compared to the market price, the organization may look to raise the price or reduce promotion for that product in the marketplace.
• The likely result of either decision (raising the price or reducing promotion) is that future budgeted volumes will decrease. This decrease in budgeted volumes will increase predetermined cost allocation rates, further increasing future cost allocations of fixed capacity costs to the product. The ultimate result is a pricing death spiral.

Question 3

Describe the difference between a practical (normal) production capacity and a theoretical (ideal) level of capacity.

Answer 3

• Practical production capacity represents the level of output that can realistically be achieved based on the current management policies, as well as machine and labor scheduling expectations. This capacity also allows for unavoidable productivity losses from machine breakdowns, production errors, employee vacations, and so on.
• Theoretical capacity assumes that all policy constraints and scheduling limitations are removed, and no productivity is lost from breakdowns, errors, etc. This is an ideal capacity that is never actually achieved.

Question 4

What are the advantages and disadvantages of using the practical (normal) capacity level to set the predetermined allocation rate?

Answer 4

Advantages:
•Costs assigned during the year are unaffected by expected increases or decreases in the denominator used to set the allocation rate.
•Using practical capacity helps prevent death spiral effects in management pricing decisions when the expected production and sales volume declines.

Disadvantages:
•The practical capacity is a moving target.
•Organizations using the practical capacity as the denominator do not have a clear focus on the potential capacity of their capital investment.

Question 5

What are the advantages and disadvantages of using the theoretical capacity level to set the predetermined allocation rate?

Answer 5

Advantages:
•The theoretical capacity never needs to be adjusted.
•It can highlight what is possible in terms of achieving a higher level of practical capacity.

Disadvantages:
•The capacity costs will be significantly under-applied at the end of the year because a large amount of capacity costs will not be allocated to products during the year.
•If pricing decisions are based on product costs, the organization might allow the prices to slip too low to cover the under-applied costs.