Cost of Capacity: A Study

Further, this cost of capacity also includes the cost of ideal capacity or unused capacity meaning thereby the cost of contribution margin lost due to non-utilization or improper utilization of capacity. This is a theoretical concept and is rarely used in practical business as practical business is expose to disruptions like employees vacations, lock downs, machine break down or its scheduled maintenance, etc (AccountingCoach.com, 2018).

Solution-1
The solutions to the given questions are as below:
a) Cost of capacity means the cost incurred to increase the capacity. In the other words, fixed
expenses incurred on increasing the production facility or establishing the new plants for
expanding the operations/capacity so that the sales can be increased. This fixed costs include
the land purchase cost, machine costs, employing and hiring the skilled labor and compliances
or government costs. Further, this cost of capacity also includes the cost of ideal capacity or
unused capacity meaning thereby the cost of contribution margin lost due to non-utilization or
improper utilization of capacity.
b) The flawed data due to changes in measurement base mislead the company into investing a new
plant. As a result of flawed data, the management decided to invest in capacity and extend its
capacity without analyzing the available unused capacity. As a result of this, the company faced
the negative consequences, which were sales increased by 30%, fixed costs tripled, profits
turned into losses and stock prices fell over 75%.
c) Effective management of capacity requires identifying and measuring the full potential of
available and unused capacity and resources. This can be done with the help of available plans,
reports and various systems and softwares. The effective management of capacity is required so
that the company can take proper and accurate decisions regarding extending of company’s
capacity or not and its effective utilization. Due to wrong decisions of capacity availability, the
company can have adverse effect in the form of increased fixed costs due to capacity expansion
with no or minimal increase in sales.
d) The capacity of producing the products at full efficiency is termed as theoretical capacity. In
other words, the full capacity assuming that all the equipment’s and conditions of
manufacturing would be perfect and would not have any disruptions. This is also termed as ideal
capacity and refer to the optimum utilization of resources. It is the maximum capacity and
assumes that no employee vacations or breakdowns of machines will occur. This is a theoretical
concept and is rarely used in practical business as practical business is expose to disruptions like
employees vacations, lock downs, machine break down or its scheduled maintenance, etc
(AccountingCoach.com, 2018).
On the other hand, the practical capacity is capacity actually available with the company to use.
In other words, the theoretical capacity less the unavoidable operating interruptions is termed
as practical capacity. These unavoidable operating interruptions includes, scheduled
maintenance time, shutdowns and lock downs, etc. These interruptions occurs because
theoretical capacity does not considers the impact of human behavioral. This capacity refers to
the product produced at manufacturer’s level of output that means the actual available capacity
that can be used to produce the products. The practical capacity is realistic and hence used in
the businesses or companies (AccountingCoach.com, 2018).

e) The concept of capacity involves two types of capacities, one is theoretical capacity and another
is practical capacity. The practical capacity is mainly used in the business and has some flaws,
these flaws are:
(a) Use and related cost of individual capacity components is buried in the aggregated data
(b) Ignorance of relevant cost drivers while allocating fixed overhead costs
(c) Failure to use the potential productivity as the actual measure of capacity.
The above flaws apply to practical capacity as there is no unfavorable volume variance in
theoretical capacity as it is always the ideal capacity.
f) Bottleneck is that level of activity for which resources are not sufficiently available or it is that
point in production process which is unable to handle the production process when the
workload is quite high. This is because that production process has limited capacity which
impacts the whole production process or chain. Due to limitation of capacity of one process the
further process of production gets blocked and hampered. Thus, it is mandatory for the
companies to manage this bottleneck effectively, so that maximum utilization of resources can
be made.
The following are the solutions for bottlenecks as mentioned in the article that do not require a
permanent increase in capacity (Staff, 2018):
(i) Short term solutions, like overtime and extra shifts of machines and labor
(ii) Outsourcing the process to a third party
(iii) Temporary help in the form of renting in of machine or contractual labor
Permanent increase in capacity is a decision with long term commitments and involve huge
costs. This is because for permanent increase of capacity companies need to look out for the
appropriate machines and skilled labor to run those machines, further space is also required to
install those machines. Apart from all these, compliances with countries laws to install further
machines is also mandated, this includes arranging permissions, getting them documented and
registered etc. All these arrangements involve huge costs and efforts. Thar’s why the permanent
increase in capacity is costly.
Among 9 out of 12 companies are experiencing the bottlenecks, hence bottlenecks are quite
common. This is so because, the production process involves various levels and activities, out of
which some activities have limited capacity and some have excess capacity. The activities with
limited capacity results in bottlenecks. And the management is required to manage the excess
capacity and limited capacity for optimum utilization of its resources.
g) Schedule of Contribution Margin not Realized
XZY Ltd
Schedule of Contribution Margin not Realized

Product X Product Y Product Z
Average selling price $ 8.00 $ 6.00 $ 40.00
Average variable overheads $ 1.60 $ 1.20 $ 8.00
Prime costs (direct materials & labour) $ 5.00 $ 3.00 $ 26.00
Contribution per unit $ 1.40 $ 1.80 $ 6.00
Total capacity at sales product mix 8,000,000 5,000,000 600,000
Aactual production 7,900,000 4,800,000 560,000
Lost production (B) 100,000 200,000 40,000
Capacity not utilized (%) 1.3% 4.0% 6.7%
Contribution margin not realized (AxB) $ 0.02 $ 0.07 $ 0.40
The above table shows the selling price and its variable costs of the products, its resultant
contribution margin, the total capacity available, the capacity used and the lost capacity,
further, the capacity not utilized which is the difference of available capacity and used capacity
and the lost contribution margin or the contribution margin not realized which is lost capacity
multiplied by contribution margin.
This report should be used in the business to analyze the unused capacity and its related costs.
This report highlights the used capacity, the unused capacity and the lost contributions due to
unused capacity. It directly relates to sales, costs, resources and its utilization. This report helps
the management not to misinterpret the capacity measurement base and its outcomes and
helps the management in correct decision making. With the help of this report, the company
can easily identify and demonstrate the capacity utilization, and related costs of used capacity
and ideal capacity. By analyzing this information, the company can become more competitive
amongst its competitors as the company will be able to manage its costs more effectively and
can have the competitive advantages.
As per the study, only 3 companies out of 63 companies are having measures to review their
unused capacity and related costs.
h) The two advantages of measuring the cost of capacity are:
a. It helps in company becoming more competitive and have competitive advantages over
other companies. This can be done by reviewing the costs of unutilized capacity and
managing the costs associated with it.
b. It helps in companies identifying the idle capacity and hence helps in identifying the
areas of waste so that these wastes can be managed significantly and costs can be
eliminated or controlled.

References:
AccountingCoach.com. (2018). What is theoretical capacity? | AccountingCoach. [online]
Available at: https://www.accountingcoach.com/blog/what-is-theoretical-capacity [Accessed 5
May 2018].
AccountingCoach.com. (2018). What is practical capacity? | AccountingCoach. [online] Available
at: https://www.accountingcoach.com/blog/what-is-practical-capacity [Accessed 5 May 2018].
Staff, I. (2018). Bottleneck. [online] Investopedia. Available at:
https://www.investopedia.com/terms/b/bottleneck.asp [Accessed 5 May 2018].