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Normal Capacity determination - A Crucial tool of Costing for Decision Making
Example:
Let's consider a manufacturing company, XYZ Ltd., that produces pens. The company has the following costs:
- Fixed costs: INR 200,000 (costs that do not change with the level of production, such as rent, salaries, etc.)
- Variable costs: INR 5 per unit (costs that vary with the level of production, such as materials, labour, etc.)
The company's normal capacity is 50,000 units per year.
Calculation of Fixed Cost per Unit:
Total Cost per Unit:
Total Cost per Unit=Fixed Cost per Unit+Variable Cost per Unit=4+5=9
If the company only produces 40,000 units, the fixed cost per unit calculated on actual production would be higher (200,000 / 40,000 = 5). However, using normal capacity, the company can maintain the fixed cost per unit at 4, which reflects more realistic product costing.
Moving further let's have another example to understand why we need to have critical analysis of Normal Capacity for budgeting and forecasting, performance evaluations and pricing decision
Company: JKL Furniture (India)
- Fixed Costs: ₹48,00,000 per year (includes rent, salaries, equipment depreciation, etc.)
- Variable Costs: ₹4,000 per chair (includes raw materials, direct labour, etc.)
- Normal Capacity: 20,000 chairs per year
1. Budgeting and Forecasting
Objective: To create an annual budget and forecast based on normal capacity.
Steps:
Calculate Total Expected Costs:
- Fixed Costs: ₹48,00,000
- Variable Costs at Normal Capacity:
- Total Expected Costs:
Revenue Forecast:
- Selling Price per Chair: ₹6,000
- Revenue at Normal Capacity:
Profit Forecast:
- Expected Profit:
2. Performance Evaluation
Objective: To evaluate operational efficiency by comparing actual production with normal capacity.
Scenario:
- Actual Production: 18,000 chairs
- Actual Costs Incurred: 8,20,00,000
Performance Evaluation:
- Expected Costs at Normal Capacity: ₹8,48,00,000
- Actual Costs: ₹7,20,00,000
By comparing actual production to normal capacity, JKL Furniture can assess whether they are operating efficiently and identify areas for improvement.
3. Pricing Decisions
Objective: To set a competitive price that covers costs and ensures profitability.
Steps:
Calculate Cost per Chair at Normal Capacity:
- Fixed Cost per Chair:
- Variable Cost per Chair: ₹4,000
- Total Cost per Chair:
Determine Selling Price:
- Desired Profit Margin: 50%
- Selling Price:
By using normal capacity for cost calculations, JKL Furniture ensures that their pricing strategy is competitive and covers all costs while achieving the desired profit margin.
By above examples hoping that you have understand why normal capacity calculation is crucial for any company and as a Cost Accountants its our duty to guide to the managements not about only Normal capacity characteristics but also about the capacity determination characteristics.
Milte hai next blog main
Your Costing Friend
CMA Mohit
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