Normal Capacity determination - A Crucial tool of Costing for Decision Making

Hello Friends, Hoping all is fine from your side.  In todays blogger we are going deep into Normal Capacity concept. In layman language  Normal capacity in costing refers to the average production volume that a company expects to achieve over a period of time under normal operating conditions. As per  CAS 2 issued by the The Institute of Cost Accountants of India "The normal capacity is the volume of the production or service achieved or achievable on an average over a period under normal circumstances taking into account the reduction in capacity resulting from planned maintenance. But my friends it is more critical and crucial to understand than as its name suggest. It's a key concept in cost accounting and management accounting as it helps in cost allocation, budgeting and forecasting, performance evaluation and pricing decision. We will understand it one by one with  live examples. 

1. Cost Allocation: It aids in allocating fixed costs to units of production, helping in accurate calculation of product costs. For example, if a factory has fixed costs of INR 100,000 and normal capacity is 10,000 units, the fixed cost per unit is INR 10. If actual production is only 8,000 units, using normal capacity for cost allocation prevents overloading the products with fixed costs, which could distort product costing.

2.Budgeting and Forecasting: Normal capacity is used in preparing budgets and forecasts. It provides a benchmark for expected production levels and helps in planning resources, materials, and labour.

3. Performance Evaluation: By comparing actual capacity with normal capacity, companies can assess their operational efficiency. If actual production consistently falls below normal capacity, it might indicate issues like inefficiencies, low demand, or other operational problems.

4.Pricing Decisions: It helps in setting the prices of products by determining the cost base. When companies understand their normal capacity, they can price their products in a way that covers both fixed and variable costs, ensuring profitability.

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:

$\text{Fixed Cost per Unit}=\frac{\text{Total Fixed Costs/}}{\text{Normal Capacity}}=\frac{200,\mathrm{000/}}{50,000}=4\text{ per unit}$

Total Cost per Unit:

$\text{Total Cost per Unit}=\text{Fixed Cost per Unit}+\text{Variable Cost per Unit}=4+5=9$

$If\; the\; company\; only\; produces\; 40,000\; units,\; the\; fixed\; cost\; per\; unit\; calculated\; on\; actual\; production\; would\; be\; higher\; (200,000\; /\; 40,000\; =\; 5).\; However,\; using\; normal\; capacity,\; the\; company\; can\; maintain\; the\; fixed\; cost\; per\; unit\; at\; 4,\; which\; reflects\; more\; realistic\; product\; costing.$

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:

1. Calculate Total Expected Costs:

   • Fixed Costs: ₹48,00,000
   • Variable Costs at Normal Capacity: $20,000 \text{ chairs} \times ₹4,000 \text{ per chair} = ₹8,00,00,000$
     
   • Total Expected Costs: $₹48,00,000 + ₹8,00,00,000 = ₹8,48,00,000$
     

2. Revenue Forecast:

   • Selling Price per Chair: ₹6,000
   • Revenue at Normal Capacity: $20,000 \text{ chairs} \times ₹6,000 = ₹12,00,00,000$
     

3. Profit Forecast:

• Expected Profit: $₹12,00,00,000 - ₹8,48,00,000 = ₹3,52,00,000$
  

By using normal capacity, JKL Furniture can set realistic financial goals and allocate resources efficiently.

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

In first look its seems that company has outperformed by  ₹28,00,000 but let check on the parameter of normal capacity As we know that normal capacity of the company is  20,000 units at the expected cost on normal capacity is ₹8,48,00,000 i.e. fixed cost + 20,000 x variable cost per unit

Fixed cost per unit to be charged at normal capacity is 48,00,000/20,000 =  ₹240 per unit

Lets allocate this cost to actual production for comparability

Fixed Cost based on normal capacity 18000 units X 240 = ₹43,20,000  

Total Actual variable cost after excluding fixed cost at normal capacity parameter = (8,20,00,000-43,20,000)/18000 = ₹4315.55 which is higher than the expected variable cost shows the inefficiency of the company. The company underperformed the variable cost by ₹315.55 per unit. 

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:

1. Calculate Cost per Chair at Normal Capacity:

   • Fixed Cost per Chair: $\frac{\text{₹}48,00,000}{20,000}=\text{₹}240,\; per chair$
   • Variable Cost per Chair: ₹4,000
   • Total Cost per Chair: $₹2,400 + ₹4,000 = ₹6,400 \text{ per chair}$
     

2. Determine Selling Price:

   • Desired Profit Margin: 50%
   • Selling Price: $\text{₹}\mathrm{4,240}\times (1+0.50)=\text{₹}\mathrm{6,360\; per chair<span\; class="base"><br></span>}$

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