Instructor – Donald Frey
January 25, 2015
Week 3 – Project
Three types of capacity constraints that would potentially play a part in the business type. How would you use absorption costing to reduce the overall risks associated with these constraints?
The capacity level chosen will affect the budgeted fixed overhead cost rate. As a lower capacity level is chosen, the fixed cost per unit increases. Determining the appropriate level of capacity takes a lot of planning, thought, and evaluating. Too much capacity means incurring costs of unused capacity, while too little capacity means that demand may go unfilled.
The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect the operating income reported under normal costing or standard costing and the product-cost information available to managers. Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. This helps managers to set a price for products that will produce the most products, without costing the company money, and knowing how much inventory to keep on hand without costing the company too much money in the process.
Theoretical capacity is the level of capacity based on producing at full efficiency all the time. However, theoretical capacity does not allow for any shutdown periods or interruptions because of downtime on the assembly lines, or any other factors that may cause production to delay. Theoretical capacity represents an ideal goal of capacity utilization. This can be used
Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions, such as scheduled maintenance time, shutdowns for holidays, and so on. Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions—scheduled maintenance or holidays, for example. This level of capacity is much more realistic then theoretical.
Normal capacity is the level of capacity application that fulfils average customer demand over a period (say, two to three years) that includes seasonal, cyclical, and trend factors. Normal capacity is the level of capacity utilization that satisfies average customer demand over a period of time—often two to three years.
In the long run, it is important that manufacturers plan and control their theoretical, practical, normal and next year's budgeted capacity levels. A company needs to be able to…