Capacity Management | Cost Accounting

The below mentioned article provides a note on capacity management.

Levels of Activity:

The following four major levels of activity used in capacity management:

1. Normal Activity:

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This can be defined as the rate of activity needed to meet average sales demand over a period that is sufficiently long to cover seasonal, cyclical and trend variations in the pattern of demand for company’s products.

Such a rate of activity will be influenced very largely by market factors in conjunction with the physical limits of plant capacity. If sales do not vary much from year to year, this will be equivalent to expected activity. A rule of thumb is to take normal activity to represent 75% to 90% of practical capacity.

2. Expected Activity:

The expected activity is the rate of activity that is expected to prevail over the next year. This method is considered to be more appropriate than normal activity when environ­mental conditions prevent reliable forecasts being made for periods in excess of one year.

3. Practical Capacity:

This measure represents the maximum level at which a company can realistically operate at full efficiency. This allows for unavoidable operating interruptions such as the need for maintenance work to be carried out and waiting time which means that practical capacity is less than ideal capacity. Nevertheless, the concept of practical capacity is an introspective engineering concept that pays no attention to current or expected demand conditions.

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The effectiveness of the measure depends on stability of demand giving stability of operations. In other words, given a ready market for its output and no distribution problems, practical capacity is that level of activity at which most managements would wish to operate.

4. Ideal Capacity:

This is the maximum number of operating hours that could be available ignoring the stoppages due to down time, repairs etc. No attention is paid to demand conditions which emphasizes the artificial nature of the measure. It represents a theoretical ideal that can be used as a bench mark. For example, practical capacity is usually taken to be 75% to 85% of ideal capacity.

The relationship amongst these concepts of capacity is shown in figure 7.1 in which normal activity is taken to include expected activity for simplicity.

Levels of Production CapacityBetween the 100% maximum of ideal capacity and the more realistic practical capacity there is a gap due to inevitable but acceptable interruptions, considered from the view point of the industrial engineer. A further gap exists between practical capacity and normal capacity which allows for the contingencies of uncertainty and environmental fluctuations.

Idle Capacity Costs:

Idle capacity is that part of capacity of a plant, machinery or equipment which cannot be effectively utilised in production, due to lack of demand, shortage of raw material, power, labour etc. Idle capacity is the difference between the practical capacity and capacity utilised.

The idle capacity may exist due to internal problems or problems beyond the control of organisation. The costs associated with the idle capacity are generally of fixed in nature like depreciation, repairs and maintenance, insurance premium, rent, management and supervisory costs. These costs cannot be absorbed fully due to under utilisation of capacity available with the organisation.

The idle capacity costs are treated in the cost accounts in the following ways:

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(a) Idle capacity costs due to unavoidable causes are absorbed into capacity utilised.

(b) Idle capacity costs due to avoidable causes are transferred to Costing profit and loss account.

(c) Idle capacity costs due to seasonal fluctuations are absorbed into the cost of production by using supplementary overhead rates.

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