Cost Accounting (14th Edition)

314 CHAPTER 9 INVENTORY COSTING AND CAPACITY ANALYSIS
purposes if (and only if) it is treated as inventoriable for the purposes of financial reporting.
Accordingly, costs must often be allocated between those portions related to manufacturing
activities and those not related to manufacturing. 3
Learning
Objective 5
Describe the various
capacity concepts that
can be used in
absorption costing
. . . supply-side:
theoretical and
practical capacity;
demand-side: normal
and master-budget
capacity utilization
Denominator-Level Capacity Concepts and
Fixed-Cost Capacity Analysis
We have seen that the difference between variable and absorption costing methods arises
solely from the treatment of fixed manufacturing costs. Spending on fixed manufacturing
costs enables firms to obtain the scale or capacity needed to satisfy the expected
demand from customers. Determining the “right” amount of spending, or the appropriate
level of capacity, is one of the most strategic and most difficult decisions managers
face. Having too much capacity to produce relative to that needed to meet market
demand means incurring some costs of unused capacity. Having too little capacity to
produce means that demand from some customers may be unfilled. These customers may
go to other sources of supply and never return. Therefore, both managers and accountants
should have a clear understanding of the issues that arise with capacity costs.
We start by analyzing a key question in absorption costing: Given a level of spending
on fixed manufacturing costs, what capacity level should be used to compute the fixed
manufacturing cost per unit produced? We then study the broader question of how a firm
should decide on its level of capacity investment.
Absorption Costing and Alternative Denominator-Level
Capacity Concepts
Earlier chapters, especially Chapters 4, 5, and 8, have highlighted how normal costing
and standard costing report costs in an ongoing timely manner throughout a fiscal year.
The choice of the capacity level used to allocate budgeted fixed manufacturing costs to
products can greatly affect the operating income reported under normal costing or standard
costing and the product-cost information available to managers.
Consider the Stassen Company example again. Recall that the annual fixed manufacturing
costs of the production facility are $1,080,000. Stassen currently uses absorption
costing with standard costs for external reporting purposes, and it calculates its budgeted
fixed manufacturing rate on a per unit basis. We will now examine four different capacity
levels used as the denominator to compute the budgeted fixed manufacturing cost rate:
theoretical capacity, practical capacity, normal capacity utilization, and master-budget
capacity utilization.
Theoretical Capacity and Practical Capacity
In business and accounting, capacity ordinarily means a “constraint,” an “upper limit.”
Theoretical capacity is the level of capacity based on producing at full efficiency all the
time. Stassen can produce 25 units per shift when the production lines are operating at
maximum speed. If we assume 360 days per year, the theoretical annual capacity for
2 shifts per day is as follows:
25 units per shift * 2 shifts per day * 360 days = 18,000 units
Theoretical capacity is theoretical in the sense that it does not allow for any plant maintenance,
shutdown periods, interruptions because of downtime on the assembly lines, or
any other factors. Theoretical capacity represents an ideal goal of capacity utilization.
Theoretical capacity levels are unattainable in the real world but they provide a target to
which a company can aspire.
3 Details regarding tax rules can be found in Section 1.471-11 of the U.S. Internal Revenue Code: Inventories of Manufacturers
(see http://ecfr.gpoaccess.gov). Recall from Chapter 2 that costs not related to production, such as marketing, distribution, or
research expenses, are treated as period expenses for financial reporting. Under U.S. tax rules, a firm can still consider these
costs as inventoriable for tax purposes provided that it does so consistently.