In this article we will discuss about the measures to obviate idle capacity in a factory.
Actions taken to Obviate the Idle Capacity:
The action to be taken by the management to obviate the idle capacity depends on the causes leading to it. Some causes such as lack of materials, tools or equipment’s, breakdown of machines in the absence of preventive maintenance etc. can be controlled by the suitable management action.
If the idle capacity is due to surplus or excessive capacity arising due to recession or out of sales due to slack periods, then the concern can either introduce new products or explore new markets to push up sales or can take vigorous advertisement, appoint more efficient salesmen, introduce after sales services or gift product to push up sales.
If these measures do not produce any result and surplus capacity appears to be a permanent feature, then it should be disposed of.
Sometimes the capacities of the various departments in a factory are not properly matched. Excess capacity arises due to such imbalances which create bottlenecks in certain departments and can be eliminated by working overtime, working additional shift, temporary off loading, purchase of additional equipment or sub-contracting the excess work etc.
If this bottleneck is likely to be a permanent feature, the overhead rate should be based on normal capacity related to the capacity of the bottleneck department. If excess capacity cannot be balanced, then it is better to dispose of the machinery and equipment which causes the excess capacity.
Overhead based on Normal Capacity:
Predetermined overhead costs are charged to cost units at normal capacity. The normal rate is calculated as under:
Because of shortages of labour and materials, a department in a factory is working at 55 per cent of its normal capacity. In its cost records, it charges manufacturing overhead to work-in-progress as a percentage of direct labour. For the current year, budgeted direct labour cost is Rs.2,50,000 and budgeted manufacturing overhead is Rs.2,25,000 (Fixed Rs.1,00,000 and variable Rs.1,25,000).
A dispute has arisen as to the percentage of direct labour which should be charged to work-in-progress. One officer claims that it should be 90 per cent, another claims that it should be much less than this. Give your opinion and a brief reason for it.
A department, in this case, is working at 55% of its normal capacity. In other words, 45% of its established normal capacity is to be treated as idle capacity. Fixed cost is obviously incurred for the normal capacity work.
Therefore, 45% of fixed cost, being the cost of idle facility, should be excluded from the calculation of overhead recovery rate. Thus the appropriate recovery rate is to be found by dividing the 55% of fixed cost plus 100% variable manufacturing overhead by the budgeted direct labour cost.
or Overhead Rate = 55 % of Fixed Manufacturing Overhead + 100% Variable Manufacturing Overhead ÷ Budgeted Direct Labour Cost x 100
= (55% of Rs.1,000 + Rs.1,25,000)/Rs.2,50,000 x 100
From the following figures calculate overhead rate:
(i) When normal capacity is related to practical capacity,
(ii) When normal capacity is related to sale expectancy, and
(iii) When normal capacity is related to maximum capacity.
From the above it can be observed that the variable overhead rate is constant in all the three cases while fixed overhead rate varies according to the level adopted at the normal capacity. If the actual capacity utilized in a period is assumed to be 7,000 hours, the effect of calculating overhead rates on the basis of each of three categories discussed in illustration will be as follows:
The under-absorption indicates the cost of capacity unutilized due to lack of sales provided no other cause as change in level of spending or difference is predetermined and actual overhead rate is attributable to this under-absorption. It reflects the loss to be shown against the sales department due to its inability to sell or to the production department because of excessive or surplus capacity.
Under-absorption represents the cost of unutilized capacity due to not achieving the target of expected sales. If the actual capacity is more than the capacity based on sales expectancy, there would have been over-absorption.
Under-absorption represents the cost of idle capacity inclusive of the unavoidable interruptions.
Determination of overheads rates using practical capacity base is better as production is charged with the amount of variable overhead, cost of idle capacity is indicated in the form of unabsorbed fixed cost, variations in volumes can be reasonably explained, it provides a stable basis because of its assessment with a fair degree of accuracy and costs are not affected by variation in sales volumes, stocks are correctly valued and profits accurately calculated.
Determination of overhead rates on the basis of capacity at sales expectancy if:
(i) The amount of fixed overheads charged to cost of production bears the same ratio to total fixed overheads as actual activity bears to the capacity based on sales expected,
(ii) Full recovery of overhead costs is made from production, and
(iii) Cost per unit is to be worked out for making decisions on price fixation and for integration in the budgetary plan.
M/s SISTAS & Co. manufacture product A at the rate of 80 pieces per hour. The company has been producing and selling 1,60,000 units annually during the period 2005 to 2009. However, during the year 2010 the company was able to produce 1,46,000 units only.
The company’s annual fixed overhead for 2010 amounted to Rs.5,84,000. The company works on single shift only at 8 hours per day and 6 days a week. The company had declared 13 holidays during the year 2010. The quarterly preventive maintenance and repairs work involved 77 hours. You are required to
(а) Calculate the maximum, practical, normal and actual capacities in 2010 in terms of hours;
(b) Compute the idle capacity and hourly rate for recovery of overhead rates for each of the capacities computed at (a) above; and
(c) Prepare a statement showing the idle capacity cost assuming that the overhead rates of recovery are based on the various capacities arrived at (a) above.
Capacity utilisation refers to the extent to which the capacity of a factory or plant is worked. It can be expressed in terms of the percentage of the total capacity (i.e. maximum or operating or normal). We know that variable overheads vary with the changes in the level of output but fixed costs are not affected by the extent of capacity utilisation.
Change in capacity utilisation affects the cost per unit. The cost per unit comes down with higher capacity utilisation and vice versa is true when capacity utilisation is low. The cost data at low levels of capacity utilisation is given as follows to make it more clear:
The capacity usage ratio and the capacity utilisation ratio in respect of a machine for a particular month is 90 and 80 per cent respectively. The total available working hours in the month are 200 hours.
The idle-time card reveals as follows:
Waiting for material 10 hours
Waiting for tools 6 hours
Breakdown 10 hours
Report the idle time cost to the management if hourly fixed costs of the machine amount to Rs.4.25 and operator is paid Rs.0.75 per hour.