Cost of Capacity: A Study
Added on 2021-06-14
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Solution-1The solutions to the given questions are as below:a)Cost of capacity means the cost incurred to increase the capacity. In the other words, fixedexpenses incurred on increasing the production facility or establishing the new plants forexpanding the operations/capacity so that the sales can be increased. This fixed costs includethe land purchase cost, machine costs, employing and hiring the skilled labor and compliancesor government costs. Further, this cost of capacity also includes the cost of ideal capacity orunused capacity meaning thereby the cost of contribution margin lost due to non-utilization orimproper utilization of capacity.b)The flawed data due to changes in measurement base mislead the company into investing a newplant. As a result of flawed data, the management decided to invest in capacity and extend itscapacity without analyzing the available unused capacity. As a result of this, the company facedthe negative consequences, which were sales increased by 30%, fixed costs tripled, profitsturned into losses and stock prices fell over 75%.c)Effective management of capacity requires identifying and measuring the full potential ofavailable 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 sothat the company can take proper and accurate decisions regarding extending of company’scapacity or not and its effective utilization. Due to wrong decisions of capacity availability, thecompany can have adverse effect in the form of increased fixed costs due to capacity expansionwith no or minimal increase in sales.d)The capacity of producing the products at full efficiency is termed as theoretical capacity. Inother words, the full capacity assuming that all the equipment’s and conditions ofmanufacturing would be perfect and would not have any disruptions. This is also termed as idealcapacity and refer to the optimum utilization of resources. It is the maximum capacity andassumes that no employee vacations or breakdowns of machines will occur. This is a theoreticalconcept and is rarely used in practical business as practical business is expose to disruptions likeemployees 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 termedas practical capacity. These unavoidable operating interruptions includes, scheduledmaintenance time, shutdowns and lock downs, etc. These interruptions occurs becausetheoretical capacity does not considers the impact of human behavioral. This capacity refers tothe product produced at manufacturer’s level of output that means the actual available capacitythat can be used to produce the products. The practical capacity is realistic and hence used inthe businesses or companies (AccountingCoach.com, 2018).
e)The concept of capacity involves two types of capacities, one is theoretical capacity and anotheris 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 intheoretical 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 thatpoint in production process which is unable to handle the production process when theworkload is quite high. This is because that production process has limited capacity whichimpacts the whole production process or chain. Due to limitation of capacity of one process thefurther process of production gets blocked and hampered. Thus, it is mandatory for thecompanies to manage this bottleneck effectively, so that maximum utilization of resources canbe made.The following are the solutions for bottlenecks as mentioned in the article that do not require apermanent 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 laborPermanent increase in capacity is a decision with long term commitments and involve hugecosts. This is because for permanent increase of capacity companies need to look out for theappropriate machines and skilled labor to run those machines, further space is also required toinstall those machines. Apart from all these, compliances with countries laws to install furthermachines is also mandated, this includes arranging permissions, getting them documented andregistered etc. All these arrangements involve huge costs and efforts. Thar’s why the permanentincrease in capacity is costly. Among 9 out of 12 companies are experiencing the bottlenecks, hence bottlenecks are quitecommon. This is so because, the production process involves various levels and activities, out ofwhich some activities have limited capacity and some have excess capacity. The activities withlimited capacity results in bottlenecks. And the management is required to manage the excesscapacity and limited capacity for optimum utilization of its resources.g)Schedule of Contribution Margin not RealizedXZY LtdSchedule of Contribution Margin not Realized
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