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Excess Capacity: Accounting, Pricing and Production Issues

The severe economic conditions experienced by multiple industries during the recent worldwide recession have several accounting, pricing and production implications. In many instances, companies have been forced to dramatically change their cost structure by reducing the size of their workforce, reducing the number of shifts in a day or workdays within a week, reorganizing operations, restructuring their existing debt and accessing not only more debt, but typically more expensive debt. These efforts have been required due to a significant downturn in production.  All of the above factors contribute to an increased inherent risk in the valuation of inventory populations of many companies along with difficult production level and pricing decisions.

Variable vs. Fixed Costs

Companies have aggressively reduced operating costs during the past year. Those cost reductions have primarily been reductions in variable costs such as direct labor related costs. Reducing overhead costs can be more challenging since many of those costs are fixed. Determining how much overhead cost to capitalize to inventory can also be a challenge. The allocation of variable production overhead to inventory is based on actual use, while fixed overhead is capitalized based on the normal capacity of the production facilities.

The allocation of overhead’s variable component is fairly straightforward: allocate based on actual costs. Variable costs tend to rise and fall relatively consistent with production levels. Thus, these costs have little risk of being over- or under-allocated based on significant changes in production.

Fixed overhead costs are not as simple to allocate, as their allocation involves determining the normal capacity of the factory.

Normal Capacity

Businesses incur fixed manufacturing costs to obtain a certain throughput capacity. The acquisition of plant, machinery and personnel enables a company to produce a certain range of output. Normal capacity could be characterized as the practical output capacity of a factory. The definition of practical capacity is typically the maximum efficient output, approximately 85% of the absolute output level, which considers planned maintenance and other nonproductive time. However, if a company used practical capacity as normal capacity, then any time it produced at levels below full production, it would incur unallocated overhead expenses as a period expense.

U.S. Generally Accepted Accounting Standards (USGAAP)  considers normal capacity as a range, not as a single point. Some variation from period to period is expected and actual costs can be allocated when production is within the normal range. Normal capacity is determined by using judgment tempered with knowledge of the business and the industry in which it operates. Companies should attempt to anticipate shortages of labor and material, unplanned machine or facility downtime or declines in demand, as these can result in production levels outside of normal capacity.

Producing Below Normal Capacity: What’s Next?

The amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or an idle plant.

Example: If normal capacity is 4 – 6 million units of production, with 5 million units actually produced and actual fixed overhead of $5 million, the company could allocate the actual fixed overhead costs incurred, as production was within the range of normal capacity. This would ascribe $1 to each unit of production for fixed overhead.

Assuming the same normal capacity as above, but production was only 2.5 million units and actual fixed overhead remained at $5 million, the company should not increase the allocation of fixed overhead to each unit produced to $2 per unit. Instead, the allocation should be based on the range of normal capacity and would result in an allocation more in line with $1 to each unit. The difference, a production volume variance, is charged to expense.

A large concern with any capacity-based fixed overhead allocation measurement is that it creates an environment conducive to excess production driven by the production-level managers, as this absorbs the production volume variance. Excess inventory creates an entirely new set of problems.

What’s the Good News?

Management has the opportunity to begin diligently classifying and accounting for fixed and variable costs. The main benefit of this exercise will be to generate more meaningful cost allocations and better selling price decisions.

Understanding to a greater degree which costs are fixed versus variable will enable the company to utilize incremental pricing. This is a method of pricing a product in which the price of a unit produced (after all fixed costs of production have been met) is based on variable costs and not on the total cost incurred in its production. This will help in maximizing profits and avoiding sales at below cost.

Better Pricing

Pricing is limited by what the market will bear, and must be developed according to the available productive capacity of your company in the current economic environment. A rigid structure of setting prices by a mark-up percentage of projected job costs can steal your potential profit in two ways:

1. Price is higher than market – new business and old customers are lost.
2. Price is lower than market – you blow the opportunity to get a “well earned” rate of return.

So, take this opportunity to improve your understanding of your cost accounting and production issues and fine tune your ability to make well-informed pricing decisions to secure current and future profitable business.

Questions about excess capacity and costing? Please contact Brian Wiedenhoeft, Partner, at 312-980-3322 or bwiedenhoeft@BlackmanKallick.com.


 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.