Why is it that when you produce to inventory that financial results tend to look better? And when you shift to Lean and produce to customer demand, inventory falls and the financials look worse? Why does product cost tend to go down when production is high, and up when production is low? These are but some of the mysteries that financial accounting rules and standards bring to a discussion of capacity utilization, and they don’t help.
What is needed is an internal managerial view of capacity and its costs. Where to start? All organizations have a common strategic goal, which is to optimize their operations to achieve more with the same, or fewer, resources. This means that operations should be continuously seeking to create excess and idle capacity for sales and marketing to fill with orders. This is a logical, but somewhat radical concept; reward people for figuring out how to be less busy, at least in the short term.
Accounting for optimizing
Optimizing the use of capacity isn’t the type of cost issue that financial accounting and traditional standard costing can address. Let’s take a managerial accounting view of capacity and its costs.
The first category of costs is capacity provision costs. These are the costs required to acquire and keep a resource ready for use, even if it isn’t presently being used. Examples for a machine might be acquisition or lease costs, maintenance costs, costs to keep people trained to use it and the cost of floor space to house it. These capacity provision costs aren’t all fixed, but they all must be incurred as long as you maintain the option to use the machine.
The second category of costs is capacity usage costs. These costs are incurred when the machine produces product. Examples are electricity, lubricants, use-driven maintenance and people to operate and set up the machine. These capacity usage costs are both fixed and proportional; however, some will not be incurred when production ceases for a period of time.
Capacity provision and usage costs must be examined across the employment of the resource in three basic states: (1) productive, (2) nonproductive or (3) idle/excess. Productive time is when the resource is creating value, i.e. making product. Idle/excess time occurs when there is no market demand for the resource’s output, or when management doesn’t allow production work (statutory holidays). Nonproductive time is scheduled and unscheduled maintenance, wait time between jobs, repair time, set-up, rework or basically anything that isn’t idle or productive time.
When considering the cost of capacity, capacity provision costs should be applied to the entire time the resource is available. For an owned machine, that is 24x7x365, or theoretical capacity— the maximum amount of time the resource could be available for use. Capacity usage costs arising during productive and non-productive time should be applied using cause-and-effect relationships to the output of the machine.
Capacity needs to be analyzed with thoughtfulness to ensure that correct decisions are made. If you apply all capacity provision costs into an overhead pool for one shift, you will lose visibility of the costs and have a difficult time assessing the correct margins for work done on overtime or a second full shift. The cost information manager’s need for nearly all decisions is marginal or incremental, which requires understanding which costs can be avoided and which costs will increase as the result of a decision. This can only be determined with a thorough understanding of the nature of your resources, how they are employed and how cost flows in a cause-and-effect manner with the employment of the resources.
Larry White, CMA, CPA, CGFM, firstname.lastname@example.org,
is Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org), which seeks to advance management accountants’ ability to contribute to improving business performance.