15 Cost Accounting and Production Capacity

In the previous chapter, I explained that one advantage of activity based costing is that we can treat more variables as varying based on the activities of the organisation. In a working example, I allocated the cost of my salary as a lecturer to different units ^[1] and argued that we can use the cost allocation to decide whether it would be cost effective to have fewer assignments. Still, if the university policy is to reduce the number of assignments, that does not mean that the university will immediately save money. My salary is still being paid. The university will only save costs if they also assign me different activities that allow the university to grow without increasing staff numbers ^[2]. This reasoning implies that at any point in time I might have some free capacity to take on new activities or do more of my existing activities. In this chapter, I show how activity based costing systems  deal with this unused production capacity.

In the cost calculations so far, the capacity of the activity has been given. In the example in the previous chapter, I assumed that I could spend 100% of my time productively. This is not a realistic assumption. The useful productive capacity is typically lower than 100%. The typical choices are the capacity in normal circumstances, the maximum possible production in normal circumstances, or the theoretical possible production capacity. These different possibilities are respectively called the normal capacity, practical capacity, and theoretical capacity. In most cases, the practical capacity should be used for cost accounting calculations because we want to allocate costs to the unused capacity, i.e. machine time that was available but not used for production. The cost of unused capacity should give us an idea whether it is worthwhile to either scale down the production capacity or whether we should keep the current capacity. If we use the normal capacity in our calculations, under normal circumstances there will be no cost of unused capacity. In other words, normal capacity assumes that the firm in normal circumstances is working in full capacity. Theoretical capacity on the other hand overestimates how much the organisation realistically can produce.

Lehigh Steel Example

The example in this chapter is based on the Harvard Business Case on Lehigh Steel, an American steel manufacturer. In the case study, the costs for five sample products is calculated where a large part of the costs come from five activities in the production process. Each activity has its own associated costs because of the cost of the machines that are necessary in the production step, the maintenance of the machines, and the cost of power for the machines. One of the production activities, steel rolling, is run at its maximum capacity but the other four activities all have spare capacity. Lehigh Steel’s machines are capable of doing more of the four other activities but there is no point in running these machines for longer because there is one step in the production process that is constrained by its current capacity. An important strategic question for Lehigh Steel is how to adjust their investment in machines and whether they provide a competitive advantage. Cost calculations of spare capacity can clarify the cost-benefit trade-off of investing or divesting these large investments. In the calculations, I will use the case of the finishing machine for which the costs of the machines is $1.28 million, the cost of maintenance is $0.78 million, and the power cost is $0.87 million.

The case study ^[3] gives the key numbers for the calculations and I will reproduce them here. The finishing machine is used for 4.06 million minutes which is also the value for the normal capacity. I assume that the used capacity for the critically important rolling machine, 8.26 million minutes, is the theoretical capacity for all the machines. In reality, the organisation would have to use its understanding of the production process to calculate the  the theoretical capacity. With this assumption, the maximum capacity of the finishing machine is 8.26 million minutes. Lehigh Steel is probably using additional resources to make sure that the rolling machine’s operations are never interrupted because the rolling activity is critical to its operations. The finishing machine however may have some interruptions or may need to wait for the intermediate products coming from the rolling machine. One typical estimate for the practical capacity in a normal year is 85% of the theoretical capacity (= 7.02 million minutes) ^[4]. The practical capacity represents the maximum number of machine minutes accounting for a reasonable expected maintenance time.

Table 15.1 shows the calculation of the activity driver rates with normal capacity and practical capacity. The normal capacity activity driver is the one that is used in the case study. In most realistic scenarios, the practical capacity is often a better indicator of capacity in activity based costing calculations because it allows to calculate the cost of unused capacity. Normal capacity assumes that the firm is using all machines and employees at full capacity in the current circumstances, and that the machine could not be used more.

Table 15.2 shows the cost per minute of finishing for the sample products (condition round, roller wire, chipper knife, round bar, and machine coil) under the two different capacity regimes. For instance, to make one condition round it takes 0.06 minutes on the finishing machines which amounts to a cost of 4.32 cent under the normal capacity assumption and 2.52 cent under the practical capacity constraint. One key advantage of the practical capacity is that the costs of one product are not affected by production changes for the other products. If Lehigh Steel decides to change its product mix so that it needs less actual finishing minutes, the finishing driver rate and the cost of finishing for the existing products will increase under normal capacity. This is a strange conclusion because the production process of the existing process has not changed at all.

The other advantage of the practical capacity approach is that it is possible to calculate the cost of the unused capacity. In the example of the finishing machine there are [latex]2.96 = 7.02 - 4.06[/latex] million minutes of unused finishing capacity. The excess capacity costs Lehigh Steel [latex]2.96 \times 0.42 = 1.24[/latex] million dollar.

Unused Capacity and Strategy

We can interpret this cost in different ways depending on the strategy of the firm. The unused capacity might be superfluous and represent an avoidable cost. In that case, the organisation will want to reduce the capacity and its associated costs. Machines can be sold, or, less drastically, not replaced when they are no longer functioning. Employees can be fired or reassigned to activities that are value-adding. However, not all excess capacity is an indication of inefficiency. Firms might have good reasons to have more capacity than they are currently using. Overcapacity may give a firm more flexibility in ramping up production when demand increases or in changing its product mix when customer preferences change. Excess capacity in seasonal downturns also helps a firm to cope with periods of high seasonal demand. Another reason to build up excess capacity is to threaten potential entrants to markets where the organisation has a high profit margin. Manufacturing firms can build overcapacity so that they can increase production quickly when competitors would enter the market. The excess capacity credibly signals to potential competitors that the incumbent organisation is capable of unleashing a price war. Possible entrants will think twice about competing with this organisation. They know that the firm can easily flood the market and drive the price down. The overcapacity helps firms to set a price higher than the competitive price.

The advantage of the practical capacity approach to costing is that it allows the accountant to quantify the cost of not using the capacity. This cost can be compared to the benefit of meeting demand and preventing customers from entering the market which allows the firm to make a cost-benefit analysis of the excess capacity. In contrast, an important consideration for a small business is to limit fixed costs (=capacity). If customer demand is disappointing, the firm will still have to pay the fixed costs. Recent research shows the opposite is true in more mature firms (Banker et al. 2014). For those firms the bigger risk is not to have capacity that needs to be paid for but to disappoint customers when demand is surging. Mature firms can find credit to bridge periods of disappointing demand but they cannot recover sales once they had to turn away customers.

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