Inventory Costing and Capacity Analysis Example 2

Summary

In this video, Leo Ray Meadows walks through the concept of capacity analysis using Thunderbolt, a motorcycle manufacturer, as a case study. The company is evaluating various denominator levels (theoretical, practical, normal, and master budget capacities) to allocate fixed manufacturing overhead costs effectively. Meadows explains how each capacity level impacts the cost per unit and discusses the benefits and drawbacks of using each. The video also explores the implications for cost-based pricing and the importance of aligning production capacity with market demand to avoid pricing errors and inefficiencies.

Takeaways

• 😀 Thunderbolt manufactures G36 motorcycles and is evaluating different capacity levels for cost allocation using absorption costing.
• 😀 The company has fixed manufacturing overhead costs estimated at $6.48 million for 2017.
• 😀 Theoretical capacity is the maximum possible production (5400 units per year) assuming no interruptions or downtime.
• 😀 Practical capacity adjusts theoretical capacity to account for unavoidable interruptions, such as maintenance and holidays, resulting in 3840 units of production.
• 😀 Normal capacity reflects expected production based on long-term demand and averages 2400 units over several years.
• 😀 Master budget capacity is based on the current year's expected demand, with a forecasted production of 3600 units.
• 😀 The fixed manufacturing overhead cost per unit varies depending on the denominator level used: $1200 for theoretical capacity, $1687.50 for practical capacity, $2700 for normal capacity, and $1800 for master budget capacity.
• 😀 Theoretical and practical capacity are supply-side concepts, focusing on production capabilities, while normal and master budget capacities are demand-side concepts, focusing on market demand.
• 😀 Using lower denominator levels (like normal or master budget capacity) can lead to more accurate pricing decisions based on actual or expected demand.
• 😀 Cost-based pricing systems may lead to higher prices if fixed manufacturing costs are spread over fewer units, potentially causing businesses to lose market share to competitors with lower prices.

Q & A

What is the main purpose of this session by Leo Ray Meadows?

The main purpose of this session is to explain capacity analysis in the context of cost accounting, specifically using the different denominator level concepts to calculate budgeted fixed manufacturing overhead costs for Thunderbolt, a manufacturer of G36 motorcycles.

What are the four denominator level concepts discussed in the session?

The four denominator level concepts discussed are: theoretical capacity, practical capacity, normal capacity, and master budget capacity.

How is theoretical capacity calculated, and what does it represent?

Theoretical capacity is calculated by assuming maximum production without any interruptions. It is determined by multiplying the number of shifts (3 shifts/day) by the number of motorcycles produced per shift (5 motorcycles/shift) and then multiplying by the number of days in a year (360 days), resulting in 5400 units. It represents the maximum output achievable without downtime.

What adjustments are made in practical capacity compared to theoretical capacity?

Practical capacity adjusts theoretical capacity by accounting for unavoidable interruptions, such as breakdowns and holidays. In the case of Thunderbolt, practical capacity is calculated as 12 motorcycles per day for 320 days, leading to a total of 3840 units.

What is the difference between normal capacity and master budget capacity?

Normal capacity represents the average expected capacity over several years based on historical demand patterns, while master budget capacity reflects the forecasted production for the current year based on specific demand estimates for that period.

How do you calculate the fixed manufacturing overhead cost per unit under different capacity levels?

The fixed manufacturing overhead cost per unit is calculated by dividing the total fixed manufacturing costs by the production capacity at each denominator level. For example, under theoretical capacity (5400 units), the cost per unit is $1,200, under practical capacity (3840 units), the cost is $1,687.50, under normal capacity (3240 units), the cost is $2,000, and under master budget capacity (3600 units), the cost is $1,800.

Why is the theoretical capacity not always a practical measure for cost allocation?

Theoretical capacity does not account for real-world constraints like downtime, maintenance, and holidays, which makes it an unrealistic measure for cost allocation in most practical scenarios. It assumes ideal conditions, which often don't reflect the actual manufacturing environment.

What are the potential drawbacks of using master budget capacity in a cost-based pricing system?

Master budget capacity may lead to higher unit costs if actual demand falls short of the forecasted demand. This can result in higher prices for the product, potentially making the company less competitive, especially if competitors adjust their prices based on actual demand.

What are the benefits of using normal capacity in cost allocation?

Normal capacity provides a more stable and realistic long-term estimate of production capacity based on average demand over several years. This helps avoid the volatility of adjusting costs based on short-term fluctuations in production or demand.

How can managers use master budget capacity to evaluate performance?

Managers can use master budget capacity as a benchmark to evaluate how well the company is meeting current demand and managing its production costs in relation to actual sales. It helps assess whether the company is effectively utilizing its available capacity and adjusting to market conditions.