How to Calculate the Costs of Idle Capacity in the Manufacturing Industry

Introduction Issues relating to the costs of unused capacity have gained in importance in recent years. This is due to further fluctuating changes in customer demands, in combination with the seasonal nature of products and rising costs in fixed capacity. The financial crisis, which has been destabilizing world markets, has also had a very negative influence on the ability of producers to sustain the profitability of operations in situations of a high portion of fixed costs of a company. All these factors have made executives take a closer look at the management of idle capacity. Unused capacity has been a topic widely researched by many authors. Some unused capacity is needed to ensure flexibility, but an excess of it unnecessarily weakens the utilization rate of resources. Some research studies have presented strong evidence that a high quantity of unused capacity exists within companies (Brausch and Taylor, 1997), (Cokins, 1996). Most of this research has focused on measuring production department capacity but overlooked capacity measurement of non-production and service departments, where the costs of unused capacity could seriously impact on profit. Typical systems concentrating on capacity usually only serve to highlight the quantifying output sacrificed due to low capacity utilization. Conventional capacity measurements do not include the value of equipment in the production system. As a consequence, their application can lead to erroneous operation decisions being made at management level. In such a situation, unused capacity costs gain in significance in terms of decision-making by management. To compound matters further, this problem is followed by another, that being of how to allocate such unused capacity costs. In traditional costing systems that do not tackle capacity problems, all costs are allotted to the products produced, which absorb all the fixed costs. In such cases, the costs relating to products could end up exaggerated, meaning they are unable to compete in the marketplace. Costs of unused capacity As mentioned above, capacity is one of the most important measures of resources used in production. Traditional concepts of capacity measurement very often omit the economical aspect that proves so important for informing managerial decisions. One of the areas that could be highly affected by changing capacity is product costing. Traditional absorption costing methods, which are based on proportional allocation of overhead costs according to direct costs consumed by products, are unable to calculate costs relating to capacity changes. The calculation for the rate of overhead is normally based on past data, with no consideration for possible capacity changes (Drury, 2001). Analyzing the dependence of costs and capacity usually involves the process of classifying costs as variable and fixed. In this approach, costs are attributed according to their reaction to changes in the volume of production. Distinguishing between the variable and fixed parts of company costs is also fundamental to the variable costing method, which is the simplest way of bypassing the shortfalls of absorption costing methods. It can prove most effective when short-term decisions based on capacity utilization are required. Some authors have stated that the variable costing method is a means to providing useful, extra information for decision-making (Drury, 2001). The variable costing method separates the fixed costs of a company that are not related to its outputs. These costs should not be allocated to products as they can distort the profitability of a product when incorrectly allotted. Two forms of variable costing exist (Kral, 2006). The first of these is single step variable costing, which gathers all fixed costs in one cost pool and treats these costs as applicable throughout a firm. This form of variable costing only allows for measurement of capacity for a company in its entirety. …