Measuring the cost of capacity

Statements on Management Accounting

P R A C T I C E O F M A N A G E M E N T A C C O U N T I N G

C R E D I T S

T I T L E

This statement was approved for issuance as aStatement on Management Accounting by theManagement Accounting Committee (MAC) of theInstitute of Management Accountants (IMA). IMA appre-ciates the collaborative efforts of The Society ofManagement Accountants of Canada (SMAC) and theConsortium for Advanced Manufacturing—International(CAM-I). Appreciation also is extended to C.J. McNair,Babson College, and Richard Vangermeersch,University of Rhode Island, authors of the manuscript.

Special thanks go to Randolf Holst, SMAC Manager,Management Accounting Guidelines, for his continuingproject supervision and to the members of the focusgroup for their suggestions that improved the document.IMA representatives on the focus group were MACChairman Alfred King, MAC members Sally Clayboum-Evans and Dennis Daly, and Lou Jones, trustee of the Foundation for Applied Research, Inc. Alan Vercio represented CAM-I on the focus group.

Measuring the Cost of Capacity

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645-1760www.imanet.org

Copyright © 1996Institute of Management Accountants

All rights reserved

Statements on Management Accounting

T A B L E O F C O N T E N T S

Measuring the Cost of Capacity


I. Rationale . . . . . . . . . . . . . . . . . . . . . . . 1

II. Scope . . . . . . . . . . . . . . . . . . . . . . . . . 1

III. Defining Capacity Cost Management . . . .2

IV. The Role of Management Accountants . . .4

V. A Common Language for Capacity Cost Measurement . . . . . . . . . .4

VI. Capacity Cost Measurement Tools and Techniques . . . . . . . . . . . . . . . . . . . .9

Theoretical Capacity Focused Models . .11

Resource Effectiveness Model . . . . . . . .11

Capacity Utilization Model . . . . . . . . . . .13

Capacity Variance Model . . . . . . . . . . . .14

CAM-I Capacity Model . . . . . . . . . . . . . .15

CUBES Model . . . . . . . . . . . . . . . . . . . .17

Cost Containment Model . . . . . . . . . . . .18

Practical Capacity Focused Models . . .20

Gantt Idleness Charts . . . . . . . . . . . . . .20

Supplemental Rate Method . . . . . . . . . .20

Theory of Constraints Capacity Model . . .22

Normal Capacity Focused Models . . . . .24

Normalized Costing Approach . . . . . . . . .24

ABC and Capacity Cost Measurement . . .25

Integrated TOC-ABC Model . . . . . . . . . . .26

VII. Selecting a Capacity Cost Measurement Model . . . . . . . . . . . . . . .27

VIII. Determining the Cost of Idle Capacity . . .28

IX. Assessing the Impact of Capacity CostMeasurement on Organizational Behavior .30

X. Organizational and Management Accounting Challenges . . . . . . . . . . . . . .30

XI. Conclusion . . . . . . . . . . . . . . . . . . . . .32

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Bibliography . . . . . . . . . . . . . . . . . . . . . . . .35

ExhibitsExhibit 1: The Basic Economics of Business . .2

Exhibit 2: Baseline Capacity Measures . . . . .5

Exhibit 3: Tools and Techniques for Measuring the Cost of Capacity . .10

Exhibit 4: Resource Effectiveness Model . . .12

Exhibit 5: Diagnosing Capacity Utilization . . .13

Exhibit 6: Capacity Variance Analysis . . . . . .14

Exhibit 7: CAM-I Capacity Model . . . . . . . . .16

Exhibit 8: CUBES Analysis of Potential Capacity Utilization . . . . . . . . . . .17

Exhibit 9: Spending Effectiveness: Cost Containment in Action . . . . .19

Exhibit 10: Gantt Idleness Chart . . . . . . . . . .21

Exhibit 11: Supplemental Rate Method . . . . .22

Exhibit 12: TOC Contribution Report . . . . . . .23

Exhibit 13: Normalized Cost Approach . . . . . .24

Exhibit 14: ABC Income Statement . . . . . . . .25

Exhibit 15: Comparative Analysis of ABC,TOC and Integrated Models . . . . .26

Exhibit 16: Comparison of Capacity Cost Management Models . . . . . .29

I . RAT IONALEEvery organization has a capacity, or potential, todo work. No matter what resources a companyhas or what types of goods or services it provides,maximizing the utilization of this capacity is anecessity, not an option. In the demanding globalmarketplace, eliminating all forms of waste isthe key to gaining and maintaining a sustainablecompetitive advantage.

Maximizing the value created within an organiza-tion starts with understanding the nature andcapability of all the company’s resources. Neverbefore has this understanding been so difficultto gain. Competition, capital decay and a techno-logical explosion are forcing more rapid changein the processes used to deliver value, even asproduct life cycles shorten. Given these forces,and given advances in engineering and generalbusiness practices, the survival—let alone pros-perity—of a company depends on the effectivedeployment of its physical assets, people andprocesses.

Effectively managing the cost of capacity is a keyto unlocking the value-creating potential of acompany’s resources. The concept focuses onidentifying improvement opportunities. Consistingof a set of action-based tools for making productsand providing better, faster and cheaper servicesto customers, the development of capacity management systems is synonymous with bestmanagement practice in management account-ing. Reaching this goal is a journey, not a destination; there is no one, universally correctmodel, measure or approach to capacity management and measurement in complex,modem organizations.

I I . SCOPEThis guideline is intended to accomplish severalpurposes. First, it has been written to increaseawareness and understanding of the wide varietyof capacity cost measurement practices.

Second, it defines capacity from several differentperspectives while describing various approach-es that organizations use to better determinetheir cost of capacity utilization.

Third, the guideline provides an overview ofimplementation issues, and the organizational andmanagement accounting challenges embodied incapacity cost measurement.

The concepts, tools, techniques and examplescontained in this guideline are structured toapply to all organizations that produce and sell aproduct or service including:

l large and small organizations;l enterprises in all business sectors; andl all managerial or organizational levels.

This guideline will help management account-ants and others:

l understand the relationship of capacity costmeasurement to the organization’s goals,strategies and objectives;

l appreciate the organizational and manage-ment accounting challenges inherent in meas-uring the cost of capacity; and

l broaden employee awareness and obtain buy-infor more effectively measuring and reportingthe cost of capacity.

1


I I I .DEF IN ING CAPACITY COSTMANAGEMENTThis guideline is based on the underlying beliefthat capacity, and capacity cost management, isan essentially elusive concept. No single tool orsingle view of capacity cost management is best.No single, magical capacity number will work in allcompanies, all settings or all decision contexts.Rather, an overall philosophy or approach tocapacity supports a company’s efforts to improveperformance through better management and utilization of its resources.

As a starting point, capacity cost managementincorporates the basic economics of the market-place. Market price is heavily influenced by thecustomer's willingness to pay for the perceivedvalue delivered by a product or service. As suggested in Exhibit 1, the market price represents an upper boundary on the amount ofresources a company can use in providing goodsand services to its customers. If the companyuses excess resources, then it suffers a loss. Thelogic of the market dominates, whether the organ-ization operates in the public or private sector.1

2


NON-V

ALUE ADDED BUT REQU

IRED

PROFIT

Value-Adding

Core of Activities

(VAC)PR

OFIT

WA

STE

PR

OFIT

WA

STE

PROFIT

WASTE

WASTE

EXHIBIT 1: THE BASIC ECONOMIES OF BUSINESS

Source: McNair, 1995

Market-DefinedPrice Barrier

The ProfitSqueeze

Total Available for Profit and Waste

EXHIBIT 1. THE BASIC ECONOMIES OF BUSINESS

Source: McNair, 1995.

1 In applying Exhibit I to the public sector, the concept of a market-defined barrier for the total resources consumed by an activity remains. Instead of “price,” though, the willingness ofthe populace to pay the taxes and support the individuals andprograms that constitute the bulk of government servicesbecomes the constraining factor. Regardless of the source of thefunds used to finance the activities of an organization, it is sub-ject to the ongoing assessment and demands of the “market.”

Exhibit 1 also illustrates that market price isbased on a core set of value-adding activities(VAC) and attributes of a product or service. Ifthis value-adding core is reduced, market pricemay fall. Increasing the size and quality of theVAC has the opposite effect: market price mayincrease. Thus, understanding the VAC is theessential first step in ensuring a company’s long-term success. (In employing this logic, it is crucialto note that value to the customer does not, andshould not, be equated to cost to the seller).

Profit, waste and non-value-adding activities fillthe area between the VAC and market price.Effectively managing the utilization of all elements of the organization and the greatervalue chain—their capacity—adds to profit.Ineffectiveness and waste reduce profit.

From this perspective, the essence of capacitycost management is:

To profitably manage the value-generatingcompetencies, processes and capacities ofan organization in ways that support thestrategic direction of the business.

A company achieves this objective by pursuingthe following goal:

To minimize the unit cost of production withinthe VAC and to minimize waste by establishingappropriate benchmarks, improving relatedprocesses and utilizing resources moreeffectively.

Managing capacity cost starts when a product orprocess is first envisioned, and continuesthrough the subsequent disposal or reassign-ment of resources downstream. Effective capacitycost management requires:

l in the short run, optimizing capital decisionsand the effective and flexible use of invest-ments that have already been made;

l maximizing the value delivered to customers; l helping minimize requirements for future

investment;l supporting effective matching of a firm’s

resources with current and future marketopportunities;

l closing any gap between market demands anda firm’s capabilities. At times, the firm mayhave excess capabilities; at others, shortagesmay exist. These capabilities may be physical(i.e., bricks and mortar), labor, technology orcapital;

l eliminating waste in the short, intermediateand long run;

l providing useful costing information on currentprocess costs versus those proposed in currentor future investment proposals (e.g., theopportunity cost of not investing in a newasset which could provide better capacity/costresults);

l supporting the establishment of capacity utilization measurements that identify the costof capacity and its impact on business cyclesand overall company performance;

l identifying the capacity required to meetstrategic and operational objectives, and toestimate current available capacity;

l detailing the opportunity cost of unused capacityand suggesting ways to account for that cost;

l supporting change efforts, providing pre-deci-sion information and analysis on the potentialresource and cost implications of a plannedchange; and

l creating a common language for, and under-standing of, capacity cost management.

Capacity cost management creates a number ofchallenges, at all levels of the enterprise.Organizations must redefine capacity and focus

3


their capacity management efforts so that theactual costs and implications of current utilizationlevels and idleness are understood and actedupon. Only utilized capacity results in profits; allother states of capacity reduce the firm’s potentialprofits. The capacity cost measurement systemmust make this basic economic fact visible.

IV. THE ROLE OF MANAGEMENTACCOUNTANTSManagement accountants collaborate with otherson a cross-functional basis in creating, imple-menting and monitoring capacity cost measure-ment and reporting policies and practices.Because management accountants have in-depthknowledge of costs and their behavior under various operating conditions, they can provideessential information and estimates of thevalue-creating potential of a company’sresources.

Management accountants can advocate programsto improve capacity utilization, providing solid economic and strategic analysis of the risks andreturns of various plans to enhance or modifyexisting capacity. By defining and reporting thecosts and causes of idle and nonproductivecapacity, management accountants can directattention and activity toward improving overallorganizational performance.

Management accountants should assist in defin-ing and developing a comprehensive capacitycost measurement and reporting system thatprovides vital information about current utilizationrates, the costs by cause of idle and nonproduc-tive capacity, and the current available capacityof the company by operating unit and process.

Management accountants can instigate strategicplanning involving the critical reappraisal of productlife/market growth and market share through a

forecast of capacity costs and limits.

These efforts can enhance the role of manage-ment accountants in the organization, allowingthem to help in improving profitability in theshort, intermediate and long term.

V. A COMMON LANGUAGE FORCAPACITY COST MEASUREMENTIt is difficult to accomplish the essence of capacitycost measurement without a common languagefor discussing and measuring capacity utilization.While different contexts or settings may shift thefocus and critical elements of success in capacitycost measurement, the basic definitions andconcepts that guide best management practicein this area remain unchanged.

Six key issues that combine to create the basiclanguage of capacity cost measurement are:

l resource capability;l baseline capacity measures;l capacity deployment;l capacity utilization measures;l time frame of analysis; andl organizational focus.

Resource CapabilityA business requires enabling resources and anorganization ready to use them. These resourcesprovide the capability to produce revenue. Theflexibility of resources and the ability to matchthem to the specific needs of the organizationand its customers set the limits for capacitymanagement. Specific concepts and definitionsof resources include:

l resource—the potential for creating value thatan organization buys and uses to support itsactivities and outputs;

4


l resource capability—the amount and type ofwork that a resource can support; the storability,flexibility and useful life of a resource;

l cost of preparedness—the initial and continuingcosts of readying resources for activity or use;

l estimated cost—the total economic value of allresources consumed in performing an activityover a predetermined period of time, or:

l behavior of costs—the patterned matching ofinputs (resources) to the outputs (activities,products and services) that they support;

l cost variability—the relationship between theamount of work that is done and the units oramount of resources consumed, stated ineither physical units or time; the change intotal cost that occurs when a firm makes onemore unit of output or provides one more unitof service to a customer; and

l relevant range—the range of output volume,assumptions or practices over which a costestimate is reasonably accurate.

Resources, and their capability to support valuecreation, lie at the heart of capacity cost manage-ment. The ultimate goal is to ensure that everyresource is effectively and efficiently used. Thebenefits of preparedness must outweigh its costs.

Baseline Capacity MeasuresResources represent the capability to do work.Applying resources to specific processes andoutputs determines how much of that capabilitycan be converted to profits. Just as important asthe size or total cost of preparedness is theassumption about how much work or outputthese resources can support. The total expectedwork, or baseline capacity measure, for a capacitymanagement system consists of one or more ofthe following measures, as illustrated in Exhibit 2:

l theoretical capacity;l practical capacity;l normal capacity;l annual/budgeted capacity; andl actual capacity utilization.

5


estimated cost peractivity completed =

total cost of required resourcesmaximum number of activities supported

EXHIBIT 2: BASELINE CAPACITY MEASURES

Source:

Defined Capacity Utilization

Perc

ent

of

Capacit

y U

tilize

d

Theoreticalcapacity

Practicalcapacity

Normalcapacity

Annual budgeted capacity 63%

Actual capacityutilization 58%

100%

80%

63%

60%58%

40%

20%

0

EXHIBIT 2. BASELINE CAPACITY MEASURES

l theoretical capacity—the optimal amount ofwork that a process or plant can completeusing a 24-hour, seven-day operation with zerowaste, i.e., the maximum output capability,allowing no adjustment for preventive mainte-nance, unplanned downtime, shutdown, etc.Because theoretical capacity by definition haszero nonproductive capacity, this is the only situation in which productive capacity canequal 100 percent of total capacity. All otherdefinitions of capacity consist of both produc-tive and nonproductive capacity;

l practical capacity—the level of output generallyattainable by a process, i.e., theoretical capacityadjusted downward for unavoidable nonproduc-tive time: such as set-ups, maintenance orbreakdowns;

l normal capacity—the average, expected, utilizedcapacity of a machine, process or plant/unitover a defined period of time (day, week,month, year, etc.);

l annual budgeted capacity—the planned utiliza-tion of a machine, process or plant/unit for thecoming year, often stated as earned hours,machine hours, units of output or percentageof normal capacity; and

l actual capacity utilization—the capacity actuallyused for period production, often stated asearned hours, machine hours, units of outputor percentage of budgeted or normal capacity.

The choice of the baseline capacity measure hasa significant impact on the calculated cost ofcapacity and on overall management policies andprocedures. While companies use each of thesebaselines, it is best practice to define and utilizetheoretical capacity for management reporting.Theoretical capacity baselines ensure that allvalue-creating potential is actively managed,reducing the potential for unneeded plant expan-sions and for incurring other forms of waste.2

These basic definitions establish the nature andmagnitude of the reported cost of capacity.Representing the rated, or baseline, capacity fora process, this measure provides a frameworkfor identifying and valuing various forms ofcapacity deployment and their impact on overallutilization.

Capacity DeploymentHaving established the baseline capacity of aprocess, capacity cost management turns toplanning, assessing and managing the deploy-ment of a firm’s value-creating potential to meetcustomer needs3. Effective capacity deploymentrequires an understanding of the following:

l productive capacity—capacity that providesvalue to the customer. Productive capacity isused to produce a product or provide a service.It must be based on the theoretical, or maximum,value-creating ability of the company’sresources;

l nonproductive capacity—capacity neither in aproductive state nor in one of the defined idlestates. Nonproductive capacity includessetups, maintenance and scrap;

6


2 Several issues need to be recognized in developing andusing theoretical capacity baselines. First, in service indus-tries it may be very difficult to pinpoint the “maximum” workan individual can do in the allotted time. In addition, therecognition that “24 hour-7 day, the best you can be” is nota concept that can be applied to one individual, but rather theentire team and process.

A second, and equally important, issue revolves around thefact that, while easy to talk about “in theory,” theoreticalcapacity is difficult to isolate in any setting due to the constantlychanging nature of work and resources. New concepts, such as“fuzzy set theory,” promise to provide a way to recognize theuncertain nature of capacity (see Siegel, 1995).

3 A company’s value-creating ability should not be equated,at any time, with its cost of doing business, given the currentassets and processes at its command. The objective ofcapacity cost management is to ensure the minimization ofwaste, and through improved management awareness andtechniques, to increase the cost-to-value ratio reflected in acompany’s profitability and marketability.

l planned nonproductive capacity—capacityplanned for use that is temporarily out of use dueto process variability, such as the lack of materi-als, machine or process breakdown, or delays;

l planned idle capacity—capacity not currentlyscheduled for use; planned idle capacity mightbe planning for preventive maintenance; and

l excess capacity—permanently idle capacitythat is not marketable or usable under existingoperating or market or policy conditions.

Through effective deployment and design of workand daily management processes, organizationscan productively use much capacity that hadbeen reserved for contingencies. This opportunityto adjust capacity is the most attractive from acost management viewpoint because it utilizesthe inherent flexibility in existing capacity. Forexample, by reducing process flow time, anorganization effectively increases its availablecapacity without any investment in fixed assets.

The best time to control capacity costs comesduring the initial decision and design of thecapacity. Design dictates the cost of capacity.Reserving capacity also dictates the cost, notjust when that capacity is used to meet height-ened demand but long afterward. If demandslackens or the nature of the product’s ability togenerate customer value changes, excess orreserve capacity increases the burden that theorganization must carry.

Assessing specific capacity investments beginsafter the organization has eliminated all optionsfor capacity realignment and reduced capacityrequirements. It is important to evaluate whetherthe capacity that is put into place is the appropriateinvestment and whether or not the risk associatedwith achieving the investment’s objective isacceptable. This risk is driven by the situationsthat organizations encounter outside the

traditional boundaries of capital investmentanalysis, and include economic, commercial,technological and implementation issues.

Underestimating, or failing to estimate, theimpact of risk can completely eliminate any gainsought in managing the capacity. Organizationalrisk can include aspects such as training,synchronization with ongoing production andorganizational performance responsibilities.

When making capacity decisions, organizationsmust balance the impact of the decision on cus-tomer value measurements, such as defectescapes, product delivery performance and prod-uct prices. Decisions to alter capacity utilizationshould match the company’s ability to alter itscapacity utilization according to current andfuture market demands.

Capacity Utilization MeasuresOnce a process or system has been deployed, orplaced into one of the key productive states, thefocus of capacity cost management turns totracking and reporting current capacity utilizationand its profit and cost implications. The key factors in assessing capacity utilization include:

l throughput—the total value obtained from aprocess during a specified time period; therate at which a system generates revenuesthrough sales;

l activation—the amount of time that a processis physically used or is active during a period,whether or not the resulting output is requiredto meet customer needs (e.g., rework repre-sents activation, not utilization);

l waste—nonproductive use of a company'sresources;

l efficiency—total utilization as a percentage ofbaseline capacity;

7


l standby capacity—excess capacity that isused as a buffer to absorb unplanned shifts intotal activity and the impact of other forms ofvariation on a process;

l actionable capacity—capacity utilization thatcan be affected by a specific manager or man-agement group, resulting in higher or lowertotal resource requirements; and

l cost of capacity—the total economic value ofall resources needed to keep a process at aspecific stage of deployment or preparedness.

Capacity utilization costs are not limited tomachine or asset depreciation charges. Theyinclude all of the indirect resources, or overhead,that are consumed in order to keep a process ina state of preparedness. Theoretical capacity isderived from those physical assets, tools andresources that can sustain round-the-clock operation. Because people cannot achieve thissustained level of operation, they should be considered as a variable contribution to the theoretical capacity. The separation of committedcapacity costs (unavoidable costs in the short tointermediate term) and managed capacity costs(avoidable in the short to intermediate term) iscritical in developing an effective capacity costmanagement system.

The estimated cost of capacity for a process thatis in a planned idle mode should be lower thanthat experienced during its productive periods.The cost estimates developed for capacity costmanagement should reflect actual resourceimplications of current capacity deployment aswell as the opportunity cost (i.e., forgone profits)of planned idle and excess capacity.

Reflecting actual performance and its effective-ness, capacity utilization measures are the rawdata for constructing management reports and

the basis for future planning and deployment ofa firm’s total capacity.

When matched with the appropriate cost ofcapacity estimate, utilization measures providemanagement with detailed information on theefficiency and effectiveness of current opera-tions as well as the potential for short-term,intermediate and long-term profit improvements.

Organizations should assess the impact of sup-porting a capacity cost measurement system.Such an assessment includes what informationis required continuously rather than on an ad hocbasis. The assessment should also include whythe company would force the accounting systemto continually collect data if spot checks wouldsuffice. This analysis alone can save resources,thereby increasing a firms capacity to meet customer requirements.

Time Frame of AnalysisThe time frame of decision analysis has a majorimpact on a company’s ability to change the costof its capacity and the critical issues addressedby the capacity cost management system.

In the short run, theoretical capacity is constant;very little can be done to change the theoreticalcapacity of a process. Capacity cost manage-ment focuses on improving the utilization ofexisting resources and processes (e.g., eliminationof waste).

As the period of time, or time frame, extends tothe intermediate term, a company can act tochange how the process operates. Thesechanges can impact the theoretical capacity ofthe process. In the intermediate term, however,the physical structure of the process cannot bechanged. In the long run, the entire process canbe restructured. Here, theoretical capacity can

8


be entirely changed, resulting in a new processstructure, a new flow and a new level of potentialoutput. The focus of capacity cost managementshifts to maximizing the flexibility of existingprocesses in order to decrease future invest-ment requirements.

In the long run, it is possible to employ a widerange of techniques and costing approaches tosupport management’s efforts to adjust capacityand its utilization. These techniques may includeoptions to acquire new capacity, outsource, sellexcess capacity, lease plant and personnel,license redesign existing products and process-es, and related methods to improve current andfuture utilization.

The second element of a capacity cost estimateis the resources required to support theprocess. With most costs fixed over the shortrun, it is difficult to change the type and amountof resources needed to make a product or provide a service. Into the intermediate period, acompany can begin to change the type andamount of resources it uses; as the process ismodified, so are the demands for resources.Finally, in the long run, all costs are variable. Inthe same way that the entire capacity of the linecan be affected, all of the resources used to provide this capacity can be changed.

Organizational FocusAnother important dimension of capacity costmanagement is organizational focus. The issuesimpacting capacity cost management at theprocess level often differ from those faced inexamining the entire industry value chain.4 Fourspecific levels are typically considered, including:

l process level;l plant or sub-unit level;

l company level; andl value chain.

The first three levels are defined by an organiza-tion and its existing structure and capabilities.The process level, which can range from one taskto an assembly line, focuses on individual unitsof output. The plant or sub-unit level suggests several processes and several uniquetypes of outputs (e.g., different product lines). Atthe company level or strategic unit, many differentplants or sub-units (e.g., strategic businessunits) combine to create a complex organizationthat serves many markets with many differenttypes of products and services.

Finally, the value chain level returns to a productor product line focus, but shifts its attention toall of the activities and resources of all organiza-tions used to bring a good to the consumer.

V I .CAPACITY COST MEASURE-MENT TOOLS AND TECHNIQUESCombining the issues of baseline capacity meas-ures, timeframe of analysis and organizationalfocus creates a framework for analyzing capacitycost management issues and for sorting andchoosing from among various capacity costmeasurement models as illustrated in Exhibit 3.These models are grouped according to whichparticular capacity baseline measure theyemphasize: theoretical, practical or normalcapacity. Each cost measurement tool, or modellisted, takes a different view of the capacity costmeasurement problem.

9


4 The term “value chain” refers to the complete value-creatingprocess from the time the raw materials are pulled from theground until a final product or service is delivered to its ultimate consumer. This approach is that taken in Michael Porter’swork on organizations. When this analysis is conducted overthe life cycle of a product, it expands to include a product’s costand performance profiles from “cradle to grave,” or from initialdesign until ultimate disposal.

These tools and techniques are not mutuallyexclusive; effective capacity cost managementmay require multiple models at the same time toassess current performance and plan futurecapacity deployment and utilization.5

10


Model

Capacity BaselineEmphasized

Primary TimeFrame of Analysis

OrganizationalFocus

Features

EXHIBIT 3: TOOLS AND TECHNIQUES FOR MEASURING THE COST OF CAPACITY

Source:

ResourceEffectiveness Model Theoretical Capacity Short- to Long-Term

Process/Plant/Company Levels

Capacity Utilization Model Theoretical Capacity

Short- toIntermediate-Term




Theory ofConstraints

Capacity Model

Practical Capacity(Marketable)




Capacity Variance Model Theoretical Capacity Process/Plant Levels

Short-TermGantt Idleness

Charts Practical Capacity Process Levels

Short-TermSupplemental Rate

Method Practical Capacity Process/Plant Levels

Intermediate-TermNormalized Costing

Approach Normal Capacity Process/Plant Levels

ABC and CapacityCost Measurement Normal Capacity

CAM-I CapacityModel Theoretical Capacity Short- to Long-Term

All Levels(Potential)

Cost ContainmentModel

Implicit TheoreticalCapacity Intermediate-Term

All Levels(Potential)

CUBES Model Theoretical CapacityProcess/Plant/Company Levels



Integrated TOC-ABC Model Various

Process/Plant/ValueChain Levels

EXHIBIT 3. TOOLS AND TECHNIQUES FOR MEASURING THE COST OF CAPACITY

5 It should be recognized that the 12 tools and techniquesselected reflect the general state of the art as of this writing,and should by no means be seen as being the only approach-es available to companies. Before embarking on a capacitycost measurement project, companies should analyze their current demands, their strategic objectives and constraints,and then search for other companies facing, and having solved,similar challenges or for an existing model that meets theirneeds. With the increased interest in capacity cost manage-ment, the number of tools and models can be expected to multiply in the coming years.

Managing the cost of capacity involves morethan applying a certain capacity measurementmodel to understand existing capacity utilization.It encompasses the entire strategic planningprocess. While the tools and techniques discussed in this guideline can be simply appliedto track current capacity utilization and costs,they are more beneficial if incorporated as partof the intermediate- and long-term planningprocess. In addition, the models, while presentedin light of machine or process capacity, can beapplied to the performance of the entire value chain.

Under this approach, organizations could usethese models to assess how well the capacitymeets their original objectives and the subse-quent impact on business risk. A statisticalprocess control run chart that tracks how thecapacity of the process responds to the risk factors used in the original investment is oneway to apply these capacity cost managementmodels in a broader setting.

The information provided by these models canbe used to influence future decisions, to controlpast ones, or to provide management with theability to analyze the impact of various alternativeways to increase or decrease utilization before adecision is made. Capacity cost management isa set of living techniques, consistently applied atall stages of the life cycle for a process, productor value chain.

Theoretical Capacity Focused ModelsResource Effectiveness ModelA capacity cost measurement model that ana-lyzes the economic impact of capacity manage-ment decisions on company performance is the Resource Effectiveness Model. Primarily concerned with supporting planning and analysisof current and future capacity investments, theResource Effectiveness Model is used by Hill’s

Pet Food to support its short-, intermediate-, andlong-term capacity decisions.

Four key measures are tracked by this model asillustrated in Exhibit 4: resource effectiveness,asset utilization, operating efficiency and runtimeefficiency. Standard runtime is examined as apercentage of total available time under differentoperating assumptions. For instance, resourceeffectiveness compares standard runtimeagainst pure theoretical capacity, while asset utilization adjusts this equation for reductions intheoretical capacity due to management policiesto get plant available time.

The results of this time-based analysis are easi-ly translated into dollars through a process cost-ing model defined on minutes of process timeconsumed rather than equivalent units of pro-duction. Combining operational and financialdata creates a powerful basis for analysis anddecision-making that can be easily placed intocapital investment models.

The key features of the Resource EffectivenessModel are:

l analyzes economic impact of capacity manage-ment decisions;

l supports decisions across all time frames;l assumes that “zero waste” is the goal; andl provides an integrated financial and opera-

tional analysis of resource decisions.

If an organization combines the information inthis model with real-time data collection andreporting on the plant floor, it can gain capacityinformation that spans all organizational levelsand time frames.

11


12


EXHIBIT 4: RESOURCE EFFECTIVENESS MODEL

Source:

POLICY DOWNTIME

RESOURCE EFFECTIVENESSR

UN

TIM

E

ASSET UTILIZATION

OPERATING EFFICIENCY

RUNTIME EFFICIENCY

PLANT DECISION DOWNTIME

PRODUCTION DOWNTIME

RUNTIME LOSSES

TO

TA

L A

VA

ILA

BLE T

IME

STANDARD RUNTIME(EFFECTIVE RUNTIME)

PRO

DU

CTI

ON

AVA

ILAB

LE T

IME

PLAN

T AV

AILA

BLE

TIM

E

STANDARD RUNTIMERESOURCE AVAILABLE TIME

=

STANDARD RUNTIMERUNTIME

=

STANDARD RUNTIMEPLANT AVAILABLE TIME

=

STANDARD RUNTIMEPRODUCTION AVAILABLE TIME

=

EXHIBIT 4. RESOURCE EFFECTIVENESS MODEL

Like several new approaches to capacity costmanagement, the Resource Effectiveness Modelrecognizes that a firm should make new capitalinvestments only if it makes full use of its cur-rent resources. The approach is recommendedfor all firms that use process, cellular or assem-bly-line manufacturing methods.

Capacity Utilization ModelMaximizing capacity utilization under the contin-uous improvement philosophy is based on thebelief that unused resources, or resources usedin ways that do not increase the value deliveredto the customer, are waste. The CapacityUtilization Model focuses on identifying specifictypes of capacity waste using an Ishikawa fish-bone diagram as illustrated in Exhibit 5.

l structural waste—results from a mismatchbetween a company’s actual capacity and thatrequired to most effectively meet demand. It isexcess capacity that should be eliminated orredeployed to other products or services in theintermediate to long term.

l definitional waste—results from choosing acapacity baseline measure other than theoret-ical capacity.

l technical waste—is caused by mix variation orunbalanced production.

l accounting-based waste—focuses on the excessinventory, standards that include scrap or waste,and related measurement problems that affectbehavior and decisions in organizations.

l management-based waste—is driven by existingpolicies (e.g, five-day, two-shift operation

13


EXHIBIT 5: DIAGNOSING CAPACITY UTILIZATION

Definitional waste

Technical waste

Effective

utilization

• Normal capacity

Structural waste

Management-based waste

Accounting-based waste

• High fixed costs• Obsolescence

• Focus on output units• Focus on earned hours by man/machine

• Adding capacity at nonbotlenecks

• Changing cost structures

• Unbalanced production

• Waste in standards• Absorption management

EXHIBIT 5. DIAGNOSING CAPACITY UTILIZATION

versus a seven-day, 24-hour approach). It canbe affected by decisions in the short to inter-mediate run.

The important features of the Capacity UtilizationModel are:

l focuses on waste as key capacity measure;l separates causes of capacity waste by time

frames and actionability;l supports analysis and prioritization of key

capacity issues; andl consists of systemic capacity measures.

While many capacity cost tracking models focuson linking financial and non-financial measures,the Capacity Utilization Model focuses on thewaste embedded in a process or system. Wasteis a systemic, or total organization, measure thatemphasizes the resources lost to the companyrather than the work it currently completes.

Helene Curtis is one company using this modelto better understand its capacity utilization andopportunities for improvement. As part of a total

set of waste-based measures, the model pro-vides a unique view of the capacity managementissue. It is recommended for use in conjunctionwith other continuous improvement-supportingcapacity models, such as Theory of Constraints.

Capacity Variance ModelThe Capacity Variance Model emphasizes the differences between potential throughput or production and actual results. The traditionalvariance analysis approach is a natural one foraccountants, but it often means less to users ofaccounting data. Exhibit 6 suggests an alternativeway to present capacity variance information.Four different segments of a brewery’s opera-tions (brewhouse, aging, fermenting and bottling)are combined into one report.

The first set of measures reflects the theoreticalcapacity of these four interlocked components.This graph shows that the entire plant is con-strained by the output capacity of the brewhouse.Excess capacity exists in aging, fermenting andbottling that cannot be utilized unless brew-house capacity is expanded.

14


EXHIBIT 6: CAPACITY VARIANCE ANALYSIS

Unavailable Capacity

Efficiency-based

Idle Capacity Waste

Theoretical0

10000

20000

30000

40000

50000

60000

70000

Available Actual Opportunity

Brewhouse Aging Fermenting Bottling

EXHIBIT 6. CAPACITY VARIANCE ANALYSIS

A second critical point is made by Exhibit 6: efficiency-based capacity waste is a loss againsttheoretical capacity. No matter how long theplant runs, efficiency losses will take their toll ontotal throughput. As shown by the graphical version of variance analysis, management deci-sions to run the plant for less than 24 hours,seven days a week, show up clearly in the drop-off from theoretical to available capacity. Actualcapacity utilization is interesting in that a “level-ling-off” of throughput in the four major parts ofthe brewery appears for the first time. In theend, the plant is constrained not by the brew-house, but by fermenting.

Finally, the last grid details the opportunity, orpotential production, of the balanced system.

The key features of the Capacity Variance Modelare:

l details actual performance against theoreticalcapacity:

l identifies causes of capacity losses; l supports opportunity cost analysis; and l can be tracked against improvement goals.

Capacity variance analysis is easily combinedwith existing monthly or quarterly reports to provideinformation on ongoing performance against theoretical standards. While this model is primarilyfocussed on short-run, control-driven reporting,the measures created can be tracked over timeas part of a continuous improvement program.

This approach is recommended for companiesthat wish to add some level of capacity costmanagement reporting to existing managementreport packages. Anheuser-Busch is exploringthe use of this model as a supplement to itsexisting reporting package.

CAM-I Capacity ModelThe CAM-I Capacity Model is primarily a strategiccommunication tool. It is designed to supportthe strategic decision process by helping man-agers understand and define the many states of capacity, measure these states, and thencommunicate them in a simple format.

The CAM-I Capacity Model can be used in theannual planning process and during interim quar-terly update processes. Management can usethis model to assess current capacity status,identify trends and plan changes in capacity.Manufacturing can use the model to communi-cate and sell new business initiatives requiringinvestment and operating changes. It can alsobe used to access the cost, causes and respon-sibility for capacity performance levels.

The CAM-I Capacity Model is built from activitiesat the operational level that can be reportedusing several different formats. Developed byCAM-I6 in conjunction with Texas Instruments,this model is a collection of capacity data thatincludes the supply of capacity, the demand on thatcapacity by specific products, and the constraintwithin a process that limits the production ofgood units.

The model is implemented through a series oftemplates that form the backbone of the capacitycost management database. The basic CAM-Imodel is captured in a simple formula as illustrated in Exhibit 7:

rated capacity = idle capacity + nonproductivecapacity + productive capacity

15


6 Consortium for Advanced Manufacturing-International (CAM-I)is a not-for-profit, cooperative membership organization estab-lished to support research and development in areas of strategic importance to the manufacturing industries. ItsHeadquarters are located in Arlington, Texas.

l idle capacity: Capacity not currently scheduledfor use. The CAM-I Model breaks idle capacityinto three specific classes: not marketable (nomarket exists or management made a strategicdecision to exit the market), off limits (capaci-ty unavailable for use) and marketable (a mar-ket exists but capacity is idle).

l nonproductive capacity: Capacity not in a pro-ductive state or not in one of the defined idlestates. Nonproductive capacity includessetups, maintenance standby, scheduled

downtime, unscheduled downtime, rework andscrap. Variability is the primary cause of non-productive capacity.

l productive capacity: Capacity that providesvalue to the customer. Productive capacity isused to change a product or provide a service.Productive capacity results in the delivery ofgood products or services. It may also represent the use of capacity for process orproduct development.

16


EXHIBIT 7: CAM-I CAPACITY MODEL

Source: CAM-I, 1995.

Rated

Capacity

Summary

Model

Traditional

Model

Industry

Specific

Model

Strategy

Specific

Model

Not Marketable

Off LimitsIdle

Marketable

Standby

Waste

Maintenance

Setups

Process Development

Product DevelopmentProductive

Non-productive

Good Products

Excess Not Usable

Management Policy

Contractual

Legal

Idle But Usable

Process Balance

Variability

ScrapReworkYield Loss

ScheduledUnscheduled

Practical

ScheduledRated Capacity

Theoretical

Time Volume Change-Over

EXHIBIT 7. CAM-I CAPACITY MODEL

Source: CAM-I, 1995.

The key features of the CAM-I Capacity Model are:

l integrates capacity data across many dimensions;l ties to the financial reporting system;l details responsibility for capacity losses; andl uses time as a unifying measure.

The CAM-I Model uses a comprehensive capacityanalysis approach. It can be utilized in simplesettings, relying on a small, focused relationaldatabase structure. At a more elaborate level, itcan allow a company to obtain the maximumbenefit from its data warehouse/database capa-bilities to provide an integrated, flexible reportingpackage to be used across an organization.

CUBES ModelThe Capacity Utilization Bottleneck EfficiencySystem (CUBES) has been developed by JohnKonopka while at SEMATECH, a consortium ofsemiconductor manufacturers in the UnitedStates. Developed for a capital-intensive environ-ment, this model focuses on both capacity planning and identifying/implementing continuousimprovement efforts in capacity utilization.CUBES combines the logic of cycle time analysisand activity-based analysis to generate an integrated view of capacity cost managementissues that moves beyond the process level toincorporate key opportunities across the entireindustry value chain.

17


EXHIBIT 8. CUBES ANALYSIS OF POTENTIAL CAPACITY UTILIZATIONCUBES (E10 TEMPLATE) EFFICENCY ANALYSIS GRAPH

Source: Konopka, John M. 1995. Capacity utilization bottleneck efficiency systems—CUBES,

IEEE Transactions on Components, Packaging, and Manufacturing Technology (18 September): 484-91.

EXHIBIT 8: CUBES ANALYSIS OF POTENTIAL CAPACITY UTILIZATIONCUBES (E10 TEMPLATE) EFFICIENCY ANALYSIS GRAPH

Source: Konopka, John M. 1995. Capacity utilization bottleneck efficiency system — CUBES, IEEE Transactions on Components,Packaging, and Manufacturing Technology (18 Septem ber):484-91.

H

I

J

F E D C B A

K

G

Percentage of Hours of Operation (of total time)

A Non-Scheduled TimeB Scheduled DowntimeC Engineering TimeD Unscheduled DowntimeE Standby/Idle TimeF Other Time Losses

Perc

enta

ge o

f The

oret

ical

Too

l Spe

ed

1

100

90

80

70

60

50

40

30

20

10

06 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96

G Tool Speed Loss (Plan vs. Theory)H Tool Speed Loss (Act vs. Plan)I Batching LossesJ Quality LossesK CUBES EFF. (%)

Building from the rich database required to runsemiconductor processes effectively, the modelcombines static capacity measures and modelswith a dynamic simulation that predicts capacityutilization under various assumptions and operating conditions.

Exhibit 8 illustrates a CUBES analysis of potential capacity utilization. Management policies,defined on several key dimensions (unscheduled,standby, etc.), as well as the existing capabilities ofthe process (e.g., theoretical tool speed), are inputsthat form a constraint on the potential throughputof the system. Given this potential throughput, themodel then analyzes the utilization of availablecapacity. CUBES efficiency is determined by multi-plying the percentage of theoretical tool speed bythe percentage of hours of operation (e.g., .58 X.67 = .39 efficiency rating).

The results are stated as outputs of the currentoperating plan and the relative impact on variousforms of productive, nonproductive, idle and wasteelement of capacity. The model allows companiesto chart their overall efficiency, breaking down thecauses for efficiency losses by category.

The key features of the CUBES model are:

l integrates financial and nonfinancial data;l builds from activity-based costs;l uses Theory of Constraints, or constraint, logic;

andl provides a dynamic analysis and least-cost

solution.

The CUBES and the CAM-I models are comparableapproaches to the capacity cost managementproblem. While CUBES builds more directly fromactivity-based logic and provides a simulationcapability, the CAM-I Capacity Model emphasizesresponsibility accounting issues and communication

in a static model. The CUBES Model is recommendedfor companies facing challenges similar to thesemiconductor industry (high capital investmentwith short product life cycles).

Cost Containment ModelSeveral of the models presented in this guidelinecan be adapted for use in service companies, orfor analyzing capacity utilization in service orsupport areas of a manufacturing business.Occasionally, however, the unique characteristicsof a process or activity make it difficult to accu-rately assess the baseline capacity measure orthe actual utilization made of this capacity. Inthis situation, companies might focus on thetotal resources dedicated to certain activities orthe effectiveness of total spending. In addition,it is often much easier to control or contain thegrowth of service costs than it is to eliminatethese costs downstream.

The objective of the Cost Containment Model is toanalyze and control future spending, not by enactingacross-the-board cost reduction mandates, but byisolating the non-value-adding activities fromthose that are value-adding. Spending guidelinesserve as the basis for implementing the cost con-tainment approach. These guidelines can be basedon internal analysis, best-in-class benchmarking,customer survey or management judgment.

Exhibit 9 illustrates the impact of this type oflogic. An analysis of the value-adding, or priority 1,activities in this shipping example suggests thatthe company is spending too few resources onvalue-adding work. In order to maintain the currenttotal costs of serving a customer, the 7 percentshortfall in spending on value-added work mustbe offset by reductions in spending on non-value-adding activities. The most obvious place to lookfor these savings is in the level 3 and level 4activities that are not valued by the customer.

18


19


EX

HIB

IT 9

: S

PE

ND

ING

EFF

EC

TIV

EN

ES

S:

CO

ST C

ON

TAIN

ME

NT I

N A

CTIO

N

Sou

rce:

McN

air,

19

95

.

Cus

tom

erca

lls in

ord

er

1.

Answ

er p

hone

$ 2

5,0

00

Less

tha

n 1%

1 (P

riorit

y ac

tivity

)

2.

Take

ord

er/c

heck

500,0

00

11.6

%

1 (P

riorit

y ac

tivity

)

cred

it an

d in

vent

ory

3.

Proc

ess

orde

r/se

nd

150,0

00

3.5

%

3 (L

ow v

alue

)

to s

tore

room

4.

Pick

item

s on

ord

er

750,0

00

17.4

%

1 (P

riorit

y ac

tivity

)

5.

Not

e ba

ckor

ders

750,0

00

17.4

%

2 (L

ow v

alue

; sho

uld

an

d ex

pect

edbe

don

e rig

ht)

sh

ip d

ates

6.

Pack

ord

er

500,0

00

11.6

%

1 (P

riorit

y ac

tivity

)

7.

Sea

l and

labe

l box

125,0

00

2.9

%

2 (L

ow v

alue

; sho

uld

be

done

rig

ht)

8.

Wei

gh a

nd c

ompl

ete

125,0

00

2.9

%

3 (L

ow v

alue

)

pape

rwor

k

9.

Mov

e 75,0

00

1.7

%

4 (N

o va

lue)

10.

Shi

p 500,0

00

11.6

%

1 (P

riorit

y ac

tivity

)

11.

Invo

ice

350,0

00

8.1

%

2 (L

ow v

alue

; sho

uld

be

done

rig

ht)

12.

Col

lect

cas

h 450,0

00

10.5

%

2 (L

ow v

alue

; sho

uld

be d

one

right

)$4,3

00,0

00

100.0

%

Item

s pi

cked

by S

tore

room

Box

sea

led

and

labe

lled

Box

wei

ghed

and

pape

r-w

ork

done

Mov

ed t

o pi

ck-u

par

ea

Shi

pto

Cus

tom

erIn

voic

eC

olle

ctC

ash

Tota

l res

ourc

es u

sed:

$4,3

00,0

00

% s

pent

on

prio

rity

1ac

tiviti

es:

$2,2

75,0

00/$

4,3

00,0

00 =

53%

Des

ired

spen

ding

on

prio

rity

1 a

ctiv

ities

:

60%

, or $2,5

80,0

00

Spe

ndin

g ga

p: 7

%, o

r

$305,0

00

Ord

erpa

cked

Mail O

rder

Busin

ess

Ste

p O

ne:

Det

ail t

he V

alue

Cha

in Annual

Resourc

es U

sed

% o

f Tota

lC

usto

mer-

Defi

ned

Valu

eA

cti

vit

y

Ste

p T

hre

e:D

eter

min

e Sp

endi

ng G

ap

Ste

p T

wo:

Atta

ch R

esou

rces

to

the

Activ

ities

and

the

n ev

alua

te the

se s

pend

ing

leve

ls a

gain

st c

usto

mer

-def

ined

val

ue

Inve

ntor

y an

dC

redi

t C

heck

Don

e on

-line

Ord

er

proc

esse

d/

Pack

ing

slip

prin

ted

Bac

kord

ers

note

d w

ithex

pect

edsh

ippi

ng d

ates

EXHIBIT 9. SPENDING EFFECTIVENESS: COST CONTAINMENT IN ACTION

Source: McNair, 1995.

In Exhibit 9, these items account for $350,000of the total cost of the process, which is suffi-cient to meet the $305,000 shortfall in spend-ing on priority 1 activities and possibly permit a$45,000 spending reduction overall.

The key features of the Cost Containment Model are:

l focuses on support/service costs;l supports/integrates with activity-based costing;l builds on value-added, market-based models;

andl supports analysis and cost containment

across many settings.

This model has been used by companies like AppleComputer and Stratus Computer to identify wherethey fail to spend enough money to meet customerneeds, and to determine where to shift resourcesfrom non-value-adding work to value-adding activities.

Containing service capacity costs is typically anongoing process of negotiation, compromise,reflection and analysis. This model is recom-mended for companies that are embarking oncompetitive bidding for internal services; that areconducting benchmarking studies that focus oncosts per process/activity as a key data point;and that seek to continuously improve the qualityof service delivered while reducing or containingthe total cost of providing this service level.

Practical Capacity Focused ModelsGantt Idleness ChartsHenry Gantt, an early 20th-century industrialengineer, developed one of the earliest tools forcapacity cost measurement. The objective of hisidleness chart was to identify and eliminateavoidable idle time at the machine or processlevel. Gantt’s approach focuses on operationsand translates into financial terms using standardcost estimates.

Exhibit 10 illustrates a Gantt Idleness Chart. Idlecapacity is reported by department or machineclass, focusing first on physical capacity utiliza-tion both in percentage and bar chart terms. Thenext segment of the chart details the expense of idleness due to various common causes,such as lack of labor, repairs and poor planning.The expense of idleness is then classified intoavoidable and unavoidable components, allowingthe company to act to improve performance.

The key features of Gantt Idleness Charts are:

l efficiently highlight key capacity issues;l summarize performance in operational and

financial terms;l detail costs and causes of idleness; andl easy to implement and use.

Gantt’s Idleness Chart contains a tremendousamount of information for managers. While thechart was designed more than 75 years ago,it can easily be adapted to a modern factoryusing departmental or cellular manufacturingapproaches. As designed, this chart is a usefuladdition to the measurements maintained byworkers on the plant floor. Its value in this setting is to underscore the cost of variation,or unplanned idleness, at the point of action.

Supplemental Rate MethodThe Supplemental Rate Method was initiallydeveloped in the early 1900s by A.H. Church aspart of a comprehensive system of cost account-ing. Focused on serving the needs of both internaland external reporting with the same set of numbers, the supplemental rate method providesa useful model for a company that is just beginning to explore the issue of idle capacityand its costs on a local, or plant/process, level.

20


This model uses two overhead rates: one rate forthe plant or department operating at its baselinecapacity, and a supplemental rate for chargingidle capacity costs to current production as illustrated in Exhibit 11. This approach yields a

fully absorbed cost for external reporting whileproviding a useful measure of the magnitude ofidle capacity costs and their impact on companyprofits for management's use.

21


EXHIBIT 10: GANTT IDLENESS CHART

Source:

Symbol

Symbol

B 19 40 20 92 6 39 3122 44 20 868 31 18.2 2254 12

C A 15 54 194 14 493.89 136 42 3436 07 20 5646 65 18.2 2210 58

D A 1 28 3 55 41 32 6 30 42 39 1069 83 20 7 71 1151 66 18.2 50 10 81 83

E 4 65 14 30 38 99 463 67 30 207 02 36.0 256 65

F A 84 319 57 288 53 271 15 24 77 2888 35 30 8 92 3895 80 36.0 33 69 1007 45

G 1 95 54 78 20 9 92 18.2 44 86

H 48 41 50 20 3 10 18.2 38 40

Lack of WorkedMaterial

Increase in Expense ofProducts %

PoorPlanningRepairs Total % Amount Avoidable

Unavoidable

B 200 - 45” Looms 80 F47 32 2892 31 136 10

C 687 - 54” & 58” Looms 80 F267 80 854 76 1473 52

D 136 - 65” & 68” Looms 80 F142 62 432 83 441 94

E 9 - 58” Looms 70 F5 53 376 19 24 95

F 111 - 68” & 72” Looms 70 F194 68 1088 22 725 36

G 1 - 72” Loom 80 c52 82

H 1 - 58” Loom 80 C30 12 10 90

Department or Mach. Class 10 20 30 40 50 60 70 80 90

% of Capacity used onDay Turn

% Capacityto Attain

Lack of Orders

Details of Expense of Idleness Due to

Details of Expense of Idleness Due to Expenses of Idleness

Lack of Help

Lack of Raw

Material

Working Period 4 Weeks 22 Days 192.0 Hours _____ Period Ending May 28 1927

Weaving (Inc.) Total Machine Expense Used 56713.46 Total Unused 16112.21

Total Capacity Used 77.9% Total Credit .092%

The key features of Gantt Idleness Charts are:

– efficiently highlight key capacity issues;

– summarize performance in operational and financial terms;

– detail costs and causes of idleness; and

– easy to implement and use.

EXHIBIT 10. GANTT IDLENESS CHART

The key features of the Supplemental RateMethod are:

l supports internal and external reporting;l easy to implement in existing systems;l focuses on profit impact of idleness; andl provides summary statement of the total cost

of idleness in a period.

Church’s approach is a small variation on theexisting accounting practices of tracking volumevariances, and then charging those variancesagainst current output. The approach differsfrom conventional accounting practice in itsadherence to practical capacity as its baselinecapacity measure; most conventional accountingsystems use budgeted capacity for this purpose.

For a small company with easily defined capacitycosts and issues, the Supplemental RateMethod provides a low-cost means of identifyingand assessing the impact of idle capacity costson overall performance.

Theory of Constraints Capacity ModelThe objective of the Theory of Constraints (TOC)model is to support continuous improvementthroughout an organization. Several key princi-ples underpin the TOC model:

l throughput capacity is defined by the underlyingconstraints of a system, which may be physical(i.e., a bottleneck) or invisible (i.e., policy,measurement, training) in nature;

22


EXHIBIT 11: SUPPLEMENTAL RATE METHOD

Source:

PlannedProcessCapacity

Total ResourcesPractical Capacity

= Standard Cost= Supplemental

Rate

Charged direct toproduct usingstandard cost.

Combines & chargedto product costs (COS

& Inventory) in General Ledger

+

Reported to Management

UtilizedCapacity

IdleCapacity

Total Idle CostsUnits Made

EXHIBIT 11. SUPPLEMENTAL RATE METHOD

l “the goal” is to increase throughput whilesimultaneously decreasing investment (inven-tory) and operating expense, subject to meetingthe needs of employees and customers;

l capacity of the organization is infinite. In orderto enable an organization to move closer to its goal, TOC focuses on removing the root problems that prevent improvement; and

l the cost of idle capacity is not an opportunitycost unless customer orders exist that are notbeing filled.

Exhibit 12 details one type of report that can beused in a TOC setting. Based on the costingapproach promoted by TOC, emphasis is placedon the contribution made by an order (itsthroughput) and the relationship of this contribu-tion to the order's impact on the constrainingresource. The objective is to maximize through-put and, hence, profit by actively and effectivelymanaging bottleneck resources.

The key features of the TOC Capacity Model are:

l emphasizes company profitability over keepingpeople/machines busy;

l highlights key constraints inhibiting processperformance;

l useful in plants or processes using TOC intheir management processes;

l provides solid baseline for action; andl strong track record of effectiveness.

The TOC Model provides unique strengths for com-panies that are managed under systemic, orprocess flow, approaches. By focusing attention onthe primary process constraint, or bottleneck, TOCseeks to prevent the waste caused when resourcesare activated without any real demand for the sub-sequent output. It is recommended for companiesusing TOC approaches elsewhere in the organiza-tion, especially if existing information systems cansupport traditional, external and TOC-based man-agement reporting. The TOC model is used exten-sively at Champion Paper.

23


EXHIBIT 12: TOC CONTRIBUTION REPORT

Source: Noreen et al, 1995.

Order Contribution Report for 06/21/93 through 06/21/93Report date 06/21/93

Cutting tools

Order

Number

Gross

Sales

Variable

Costs Throughput

Constraint

Hours

Throughput

per Hour

41631 796 394 402 N/A N/A41910 156 40 116 .51 22742424 306 41 265 1.50 17742659 262 79 183 .66 27842692 288 61 227 .34 66843227 422 63 359 .50 718

EXHIBIT 12. TOC CONTRIBUTION REPORT

Source: Noreen et al, 1995.

Normal Capacity Focused ModelsNormalized Costing ApproachNormalized Costing is a capacity cost measure-ment model that uses average performance overtime, adjusted for abnormal events, in its calcu-lations. The key elements of the NormalizedCosting Approach are:

l asset depreciation is calculated on hours ofmachine use;

l abnormal expenses are eliminated from opera-tional cost pools (e.g., plant modernizationcosts);

l the behavior of costs within a process is determined and defined within a formula thatrecognizes key elements affecting the cost ofcapacity within a process;

l the capacity of the process is then deter-mined, using practical capacity baselines setover a three- to five-year period; and

l normalized cost is then determined by combin-ing cost and capacity information to create acost estimate under a given set of operatingconditions.

The resulting capacity cost measure representsa multi-year average that does not charge idlecapacity costs to current production as illustratedin Exhibit 13. Idleness costs are summarized ina separate account, which becomes manage-ment’s responsibility to eliminate or redeploy.

Caterpillar finds this approach to be a viablebasis for constructing management accountinginformation. Incorporated within an elaborate,detailed, and highly flexible management infor-mation system, normalized costing is used for allmanagement reports at Caterpillar. It is recom-mended for complex manufacturing companies.

24


EXHIBIT 13: NORMALIZED COST APPROACH

Total Planned Cost – Next3 to 5 years

NormalCosts Normalized Cost

Estimate

(including idle capacity costs)

StrategicPlanning

Cost Analysis

OperationalAnalysis

1. Driver chosen2. Cost behavior

determined3. Average practical Capacity determined in units of time

AbnormalCosts

EXHIBIT 13. NORMALIZED COST APPROACH

ABC and Capacity Cost MeasurementActivity-Based Costing (ABC) is a major innova-tion in costing methods being implemented inmany large, medium-sized and small companiesin North America and Europe. As described bykey proponents R. Cooper and R. Kaplan (1992),“Activity-based cost systems estimate the costof resources used in organizational processes toproduce outputs.” Idle, or unused capacity, is thekey link in activity-based cost models and thegeneral ledger system used for external reporting.Specifically:

Activity Availability = Activity Usage + Unused Capacity

According to this equation, unused capacity rep-resents the difference between the cost ofresources actually used to complete variousactivities and the cost of resources supplied oravailable to do that work. Unused, or idle, capac-ity is the gap between what could have beendone and the work actually accomplished, statedin financial terms.

The information developed under ABC can bepresented in a format similar to that in Exhibit 14.The sorting of costs between used and unusedcategories indicates that excess resources arebeing consumed. The exhibit also highlights theimpact of unused activity capacity on operating

25


EXHIBIT 14: ABC INCOME STATEMENT

Source: Cooper and Kaplan, 1992.

SALES $20,000

Less: EXPENSES OF RESOURCES SUPPLIED AS USED

Materials 7,600 Energy 600 Short-term labor 900 9,100

CONTRIBUTION MARGIN 10,900

Less: ACTIVITY EXPENSES:COMMITTED RESOURCES Used UnusedCapacity Capacity

Permanent direct labor 1,400 200 Machine run-time 3,200 Purchasing 700 100 Receiving/Inventory 450 50 Production runs 1,000 100 Customer administration 700 200 Engineering changes 800 (100) Parts administration 750 150 TOTAL EXPENSES OF COMMITTED RESOURCES 9,000 700 9,700

OPERATING PROFIT $1,200

EXHIBIT 14. ABC INCOME STATEMENT

Source: Cooper and Kaplan, 1992.

profits. Combined with other forms of reporting,this model can be used to highlight the often-overlooked components of sub-unit or organiza-tional capacity.

In using this model, organizations can track thecapacity costs related to resources directly con-sumed by an activity. They can also better manageassets not directly used by their core activities.

The key features of the ABC capacity approach are:

l fits into activity-based cost model;l reports both the quantity and cost of idle capacity;

l supports analysis of alternative solutions tocapacity issues; and

l strong emphasis on resources.

ABC helps managers predict the impact ofchanges in volume and mix, process changesand improvements, introduction of new technology,and product and process design changes onactivity costs. Serving as a useful bridgebetween more conventional views of capacitycost management and ABC, this model is usefulin any company using or implementing ABC.Hewlett-Packard Corp. is an example of a firmthat makes extensive use of this model.

Integrated TOC-ABC ModelRobert Kee recently developed a new capacitymodel that integrates the basic concepts of TOCand ABC models to generate a mathematical,least-cost solution to the capacity utilizationissue.7 Utilizing a mixed-integer programmingapproach, this model gives the optimal productionmix subject to the capacity of the individual activ-ities comprising the firm's production structure.

In this model, unit-level costs and resources aretreated as continuous variables, while batch- and

product-related costs are represented as dis-crete variables. The resulting equations andmodel capture the interactions among the cost,physical resources and capacity of productionactivities, which effectively integrate the ABC andTOC approaches as illustrated in Exhibit 15.

The solution resulting from the mathematicalcombination of ABC and TOC captures the bestof both worlds in terms of assumptions andtreatment of the firm's economic realities.Specifically, the opportunity cost of the resourcesis used to determine an optimal product mix, onethat allows a company to select products withthe highest contribution margin per unit and high-est profit per unit for a bottleneck activity. Theopportunity cost from using the resources of thebottleneck activity is reflected in the relative profitability computed for each product.

The key features of the Integrated TOC-ABCModel are:

l uses mathematical modeling to solve for optimal capacity utilization;

l effectively combines both operational andfinancial views of the capacity problem;

l can be easily added to existing ABC applications;

l when at least one bottleneck operation exists,provides a superior solution to a pure TOC or pure ABC methodology; and

l uses marginal revenue as its decision basis.

V I I . SELECT ING A CAPACITYCOST MEASUREMENT MODEL

Choosing a capacity cost measurement modelfrom those presented in this guideline is a second-level decision in deploying capacity costmanagement practices. Only after a strategy forthe total value chain’s efforts has been developed—

26


one that ensures maximization of performanceagainst customer-defined components of value—should management attention turn to current utilization patterns.

The 12 models described in this guideline canbe used alone, or in combination, to underpin anorganization’s capacity cost management system.No single model will work under all conditionsnor will one model serve all of management’sneeds for capacity cost analysis. In choosing amodel, companies should address the followingissues:

l What is the overriding goal or focus of thecapacity cost measurement system?

l Is a short-, intermediate- or long-term perspec-tive required? (Some models work very well inthe short run, but provide little guidance forstrategic decision-making. Other capacity costmeasurement models are most informative inthe intermediate to long term but provide little guidance for short-term operational decision-making.)

l Do the critical capacity questions apply at thelevel of process, unit, company or value chain?

l What other programs (i.e., TOC, continuousimprovement, ABC) is the company engaged in?

l What are the company’s information processingcapabilities?

27


7 Kee, 1995.

EXHIBIT 15: COMPARATIVE ANALYSIS OF ABC, TOC AND INTEGRATED MODELS

Source: Kee, 1995.

ABC

Model

Product Mix:

X1 -0 50,000 30,000 X2 -0 100,000 100,000 X3 -0 25,000 30,000 X4 20,000 -0 -0

Excess Resources:

Assembly (labor hours) 100,000 -0 10,000 Finishing (labor hours) 100,000 55,000 55,000 Set-up (hours) -0 -0 -0 Purchasing (orders) 200 235 200 Engineering (drawings) 500 500 500

Profit:

Projected Income $3,180,000 $2,280,000 $4,620,000 Cost Saving Available From Excess Resources* -0 2,307,000 -0 Available Income $3,180,000 $4,587,000 $4,620,000

* The cost savings from excess resources was computed by multiplying the excesscapacity of each activity by its respective cost driver rate. The cost of excess resourcesare excluded from income under ABC and the expanded ABC models.

TOC

Model

Expanded

ABC Model

EXHIBIT 15. COMPARATIVE ANALYSIS OF ABC, TOC AND INTEGRATED MODELS

Source: Kee, 1995.

l What type and amount of data already exist tosupport the capacity cost measurement system?

l How many resources are available to supportthe development and maintenance of thecapacity cost measurement system?

l Is capacity cost measurement primarily a plan-ning tool, or will it become part of the manage-ment control system?

l How important is it to tie capacity costs toexisting financial and operational reports andperformance measures?

The answers to these questions will narrow thelist of available models to a few that will mosteffectively address the specific capacity costmanagement issues for a company as illustratedin Exhibit 16. In addition, as a company gainsmore knowledge about its cost of capacity, it cansubstitute or add more sophisticated models.

The best capacity cost measurement model inany setting is that which facilitates manage-ment’s efforts to continuously improve againstcustomer expectations. Enhancing customer-defined value is the key objective, not simplyimproving internal efficiencies. As such, capacitydecisions that create no additional costs butrather improve the company's performanceagainst customer expectations increase thefirm's value-creating ability, and hence capacity.

V I I I . DETERMINING THE COSTOF IDLE CAPACITYThe choice of a capacity model leaves still unaddressed the critical issue of determiningthe cost of idle capacity. High costs caused bytoo much idle capacity may render the firmunable to compete. Traditional measures usuallyfail to provide management or operating personnelwith significant useful information about theamount and cost of idle capacity.

Key factors influencing the cost of idle capacity are:

l total resources required to keep the process inthe various states of preparedness;

l the cost behavior of these resources in theshort and intermediate term;

l the incremental cost of moving from one levelof preparedness or total available capacity toanother; and

l the flexibility/storability of affected resources.

The type, quantity and overall flexibility ofresources differs markedly from one company toanother. Determining the specific cost of idlecapacity is based on a few overarching rules:

l all resource usage caused by, or driven by,process capacity and its activation should beplaced into the capacity cost pool;

l the denominator or activity level chosen for thepool should be theoretical capacity (24 hours,seven days);

l resources that are flexible, storable (e.g., canbe retained for future use with no loss of value-creating potential) or variable (purchased andconsumed only as needed) should be identified;

l in periods of planned idleness, no matter what thereason for this idleness, only unavoidable costs(fixed, inflexible and/or nonstorable resources)should be charged to idle capacity; and

l in periods of production and unplanned idleness (regardless of cause for this nonpro-ductive time), idle capacity will be charged atthe "full cost" per minute of time available.

The objective in assessing the impact of idle capac-ity on company performance is to match resourceconsumption to the various states of preparednessand utilization to meet customer needs.

28


29


Stro

ng Ti

e of F

inanc

ial an

d

Ope

ratio

nal S

ugge

sted?

Plann

ing or

Con

trol?

Reso

urce

s Req

uired

Data

Req

uirem

ents

Requ

ired

I/S C

apab

ilities

Othe

r Pro

grams

Sup

porte

d

Sugg

este

d Tre

atme

nt

of I

dlene

ss C

osts

Prim

ary F

ocus

of M

odel

Base

line C

apac

ity M

easu

re Em

phas

ized

Feat

ures

/Mod

el

Moderate Moderate Moderate Planning Yes

Moderate Moderate Moderate Both Yes

Minimal Low Minimal Control Yes

Sophisticated High Both Yes

Sophisticated High Both Yes

Moderate Low Minimal Planning No

Minimal Moderate Minimal Control No

Minimal Low Minimal Control Yes

Minimal Low Minimal Both No

Moderate High Both No

Moderate Moderate Moderate Planning Yes

Moderate Moderate Minimal Both Yes

Moderateto High

Moderateto High

Moderateto High

ResourceEffectiveness

Model

Change to Profit & Loss

ResourceUtilization

TheoreticalCapacity

ContinuousImprovementTOC & ABC

CapacityUtilization

Model


CapacityUtilization

TheoreticalCapacity

ContinuousImprovement

& ABC

CapacityVarianceModel

NoneSuggested

Analysis ofPerformance

TheoreticalCapacity


CAM-ICapacityModel

Change to Profit & LossCommunication

TheoreticalCapacity


& ABC

CUBESModel

NoneSuggested

ProcessUtilization

TheoreticalCapacity


& ABC

CostContainment

Model

NoneSuggested

Total Cost/Activity

ImplicitTheoreticalCapacity


& ABC

GanttIdlenessCharts

Change to Profit & LossEfficiency

PracticalCapacity


SupplementalRate

Method

Change to Product

Supporting bothinternal &

external reporting

PracticalCapacity


Theory of Constraints

Capacity Model

NoneSuggestedThroughput

Practical(Marketable)

Capacity


NormalizedCosting

Approach


DecisionAnalysis

NormalCapacity


& ABC

ABC & CapacityCost

Management


Resource costper activity

NormalCapacity


IntegratedTOC–ABC

Model

NoneSuggested

Minimizemarginal costVarious


& ABC

EXHIBIT 16: COMPARISON OF CAPACITY COST MEASURMENT MODELSEXHIBIT 16. COMPARISON OF CAPACITY COST MEASUREMENT MODELS

In reporting this information, a company recog-nizes that the various forms of idle capacity costsare controllable, or can be acted upon, at differentmanagement levels. A decision to maintain stand-by capacity is strategic in nature; changing thesecosts requires action by top management.

Conversely, planned nonproductive capacity dueto equipment breakdowns is an operational issuethat is best addressed on the plant floor, at leastin the short term. In order to be relevant, capacitycost management data, including the cost of idlecapacity, must be actionable and focused on iden-tifying opportunities for improvement.8

IX . ASSESSING THE IMPACT OFCAPACITY COST MEASUREMENTON ORGANIZAT IONAL BEHAVIORCapacity measurement and segregated accountingand reporting of capacity costs are necessary forimproved product costing, maximizing the utilizationof capacity, eliminating waste, and gaining andmaintaining a sustainable competitive advantage.

However,measures impact behavior in organizations.If these measures are used as part of the perfor-mance evaluation process, their impact can be pro-found. In designing and using capacity cost measure-ment systems, it is critical to assess the impact ofvarious types of metrics and reports on the decisionsand behavior of individual managers. For instance,labor efficiency-based measures of capacity can drivea company to produce work-in-process even if no cur-rent or future demand for this product exists. In this-setting, the capacity measurements drive people tokeep busy, not necessarily to create value.

The key behavioral factors to consider whenchoosing a specific capacity measurementmodel include:

l If this measure were made available to me, orone of my key managers, what response wouldit likely create?

l Does the measure reinforce and reward continuous improvement and learning?

l What dysfunctional behaviors might the measure create?

l Will the measure be used in the performanceevaluation process? If yes, is it fair and objective?

l Is the measure actionable? If so, by whom?l In the long term, what would be the implication

of always doing well against this measure?l Will the measure support, or work against,

other management programs and objectives?

The goal of capacity cost management is to sup-port efforts to improve the profitability and capa-bility of a process or organization.

Attaining this goal requires careful attention to specif-ic capacity cost measures and reporting formats. Inthe end, “firms get what they measure and reward.”

X . ORGANIZAT IONAL AND MANAGEMENT ACCOUNTINGCHALLENGESThe primary organizational challenges in imple-menting effective capacity cost measurementpractices are those common to all changeefforts. Top management must support theeffort, ensuring that required resources aremade available and viable solutions are imple-mented. The change process should be completedwith minimal politics and personal maneuvering;everyone wins if capacity utilization is improved.Finally, the recommendations and changes madeas a result of implementing and using a capacitycost management system must be reinforcedthrough incentive and reward systems thatencourage effective resource utilization.

30


8 Global idle capacity is very different from local idle capacity.Global idle capacity becomes marketable, policy or abandonmentopportunities. Local idle capacity may not be available for marketing, policy, or abandonment options.

The management accounting challenge embodiedin capacity cost measurement is to design andimplement an effective cost accounting system tomeet the internal needs of the organization whileretaining the requisite records and systems need-ed to comply with GAAP-based external financialand legal entity tax accounting requirements.

Management accountants must recognize andchange the misconception that GAAP requiresfull absorption product costing and prohibits thecharging of idle capacity costs directly to theincome statement. The GAAP guiding capacityreporting is actually based solely on acceptedpractice. In the United States, FinancialAccounting Standards Board (FASB), the InternalRevenue Service (IRS)9 and the variousSecurities Exchange Commission (SEC) mandatesdo not require full absorption product costing inany of their promulgations except as notedbelow.10 Companies with U.S. Government con-tracts will have to comply with Federal AcquisitionRegulations (FAR) and may be subject to CostAccounting Standards Board (CASB) require-ments. These companies should discuss withtheir government representatives the impact onthe allowability of the costs allocated to govern-ment contracts before selecting a cost methodother than full absorption.

Nor does any regulation affecting Canadian enter-prises require this extreme treatment of cost. Fullabsorption costing is not required; it is simply ahabit. As such, it poses no barrier to implementingmore effective, relevant capacity cost measurementsystems. U.S. Government contracts represent theonly major exception to this blanket statement.U.S. Government contract regulations require fullabsorption costing for negotiating contract prices.In order to apply relevant capacity cost measure-ment systems when pricing these contracts, spe-cial contractual arrangements (such as separate

contracts or contract line item pricing for the costsof capacity) will be necessary.

Management accountants need to reopen thedebate of “best practice” in capacity cost management—debates which led to elaborate idlecapacity reporting practices early in this century. Management accountants need to recognize and address current misconceptionsabout GAAP and its implication for capacity report-ing practices, and openly search for ways to betterreflect economic reality in their reporting practices.

Where they will be effective, major changes incommon reporting practices required to supportcapacity cost measurement include:

l use of theoretical rather than annual budgetedcapacity as the capacity baseline measure;

31


9 In 1987, the U.S. Internal Revenue Service passed a regulation preventing the use of practical capacity (andimplicitly theoretical capacity) as a capacity baseline. Giventhat most companies already maintain separate inventoryand cost records for tax and financial/managerial purposes,the impact of this regulation is minimal. While cash flow, onan after-tax basis, is impacted through the increased capital-ization of overhead costs inherent in choosing normal or budgeted capacity as the baseline measure, the ongoingmovement to minimize work-in-process and finished goodsinventory suggests that this impact can be addressed.

10 The most applicable accounting standard is ARB 43.which deals with inventory pricing. Key comments in this document are: As applied to inventories, cost means in principlethe sum of the applicable expenditures and charges directlyor indirectly incurred in bringing an article to its existing condition and location (28); ...under some circumstances, itemssuch as idle facility expense... may be so abnormal as torequire treatment as current period charges rather than as aportion of inventory cost (29); It should also be recognizedthat the exclusion of all overheads from inventory costs doesnot constitute an accepted accounting procedure. (29) Thekey element in this analysis is the concept of “abnormal.”Paton and Littleton’s (1941) monograph, the seminal work inaccounting theory, clarifies the language of ARB 43 by notingthat abnormal is defined by existing management policy, andthat accounting records should NOT attempt to hide the costof inefficiencies due to management decisions. In the end,the management accountant has to determine what interpre-tation of these guidelines best serves management and supports their decisions, regardless of how these costs arehandled for external financial reporting.

l elimination of idle capacity costs from productcosts; when excess and idle capacity costs arecharged to product, these expenses and theirimplications for long-term growth are hidden;

l analysis and reporting of the cost of capacityin different states of preparedness;

l reporting of all idle, nonproductive and produc-tive uses of capacity and their costs: Whilemany nonproductive costs, such as set-uptime, are logically caused by, and should beattached to, products made, the current cost ofthese activities must be carefully tracked andpresented to management. While a necessarypart of doing business, nonproductive costscan be minimized only if the organization rec-ognizes their impact on effective capacity uti-lization, and hence company profitability;

l recognition that the cost of capacity exceedsthe depreciation or fixed charges to support amachine. Capacity costs include all costs driven or caused by the decision to maintain aprocess in a certain state of preparedness;

l adoption of new types of capacity cost measures,including realistic depreciation methods whichfairly assign cost to all products which use thecapacity and all uses of capacity should be con-sidered. Current accelerated rates of depreciationwith very conservative lives is acceptable for finan-cial accounting but not for managerial accountingor capacity cost management. Managerialaccounting’s objective is to mirror capacity model-ing which uses “average and fair” values;

l development of non-traditional reporting formatsthat highlight key capacity issues in non-numer-ical formats. Numbers are the backup data thatsupport different types and forms of reports;

l enhancement of cost reporting to incorporate factors and operational issues that more effec-tively capture the organization’s key processes,constraints and activities; and

l increasing the emphasis on analysis andassessment of potential costs and opportunitycosts of future capacity decisions.

X I . CONCLUSIONIn the race to gain a sustainable competitive advan-tage, companies need ways to better use theirresources. Value creation does not mean throwingall the resources the company can muster at theproductive process; rather, it means achieving long-term improvements in products and services whilereducing the long-term average cost of providingthese products and services to the customer.

Capacity cost management is a vital part of a com-pany’s arsenal of strategic and operational toolsand models. Focused on improving existing capaci-ty utilization and reducing the need for future invest-ments, capacity cost management enables thecompany to improve its use of resources to meetcustomer requirements.

Dynamic capacity cost measurement focuses man-agement’s attention on opportunities for improve-ment either through using existing process capaci-ty or through reducing the total resources requiredto provide the requisite level of preparedness.Capacity cost measurement addresses the criticalelement in the profit equation: the amount and typeof resources consumed to generate a dollar of rev-enue. It addresses this issue in a precise andfocused way by identifying and supporting the elim-ination of non-value-added uses of resources

In the fiercely competitive global marketplace, acompany requires sound facts about its actual per-formance and its value-creating processes. Effectivereporting of capacity utilization and the waste of thisessential value-creating ability is a critical element ina company’s drive to attain a sustainable competi-tive advantage. In the end, effective capacity costmanagement is a journey. not a destination.

32


GLOSSARYAccounting-based waste – scrap, downtime,

inefficiency and waste built into standards;idle capacity costs charged to product.

Activated capacity – capacity that is being usedto meet an order or customer requirement.

Baseline capacity measure – company-definedcapacity of a process.

Behavior of costs – the patterned matching ofinputs (resources) to the outputs (activities,products and services) they support.

Capacity – the potential of a process to do work;the value-creating potential of a process.

Capacity cost information – cost data that detailthe economic impact of using or idling vari-ous types of capacity in a plant or process.

Capacity cost management – the profitable man-agement of the value-generating competen-cies, processes and capacities of an organi-zation in ways that support the strategicdirection of the business.

Capacity flexibility – the ability of a plant, processor machine to be quickly and efficiently adapt-ed to other value-added activities or uses.

Capacity model – a predefined and focusedapproach to measuring and managing capacityat the level of the process, unit, company orvalue chain.

Capacity planning – analysis of upcoming busi-ness in terms of its impact on the cost, leveland effectiveness of capacity utilization.

Definitional waste – capacity waste that iscaused by a failure to use theoretical capacityas the baseline capacity measure.

Full absorption product cost – a cost accountingsystem that includes fixed manufacturingoverhead costs in the unit product cost. Idlecapacity can be and should be excludedfrom these calculations for managerial product costing.

Idle capacity costs – the economic value ofresources not utilized to make products orprovide services.

Management-based waste – wasted capacity dueto management policies regarding operatinghours, shifts, breaks, etc.

Marketable idle capacity – capacity for which a prod-uct or other forms of market demand exists.

Nonproductive capacity – capacity not in a pro-ductive state nor in one of the defined idlestates. Nonproductive capacity includessetups, maintenance, and scrap.

Off-limits capacity – in the CAM-I capacity model,this capacity is unavailable for use. Examplesinclude government regulations, managementpolicy and contractual arrangements.

Planned nonproductive capacity – capacityplanned for use that is temporarily out ofuse due to process variability, such as thelack of materials or machine or processbreakdowns or delays.

Preparedness – the capability of a process tocomplete the type and amount of work forwhich it was designed.

Rated capacity – manufacturer or industrial engineering estimate of the output capacityof a machine or process. The rated capacityis equal to hours available x efficiency x uti-lization. In Theory of Constraints (TOC) ratedcapacity = hours available x efficiency x activation, where activation is a function ofscheduled production and availability is afunction of uptime.

Required capacity – the amount of capacity needed to meet current production schedules/plans or to respond to customer requirements.

Service capacity – the amount of work a serviceor support system can provide before need-ing additional resources.

33


Standby capacity – in the CAM-I capacity model,this capacity is buffer capacity required todeal with variability, such as the arrival ofmaterials or the distribution of capacitydowntime. It also includes capacity causedby areas of process/factory that can pro-duce at higher output rates than theprocess/factory constraint.

Structural waste – waste embedded in a systemor process due to a lack of balance or the inher-ent nature/capability of the resources used.

Supplemental rate – a second, end-of-period,overhead charge used to allocate unab-sorbed overhead to products.

Value-adding (creating) activities – work or activi-ties that generate products or services thecustomer is willing to pay for; many activitiesremain essential for the effective manage-ment of the business (e.g., non-value-addedbut required), but are not seen as directlyvalue-creating by the customer.

Waste – resources consumed that do not addvalue to customers; costs incurred forunnecessary work, capacity or outputs.

34


BIBL IOGRAPHYBlackstone, John H. 1989. Capacity Management.

Cincinnati, OH: South-Western Publishing Co.Church, A.H. 1931. Overhead—The cost of

preparedness. Factory and IndustrialManagement (January):38-41.

Consortium for Advanced Manufacturing—International (CAM-I). 1995. Capacity: A Manager’s Primer. Arlington, TX: CAM-I.

Cooper, R., and R. Kaplan. 1992. Activity-basedsystems: Measuring the cost of resourceusage. Accounting Horizons (Spring): 1-12.

Coughlan, P., and J. Darlington. 1993. As fast asthe slowest operation: The theory of constraints. Management Accounting UnitedKingdom (June): 14-17.

Goldratt, E., and J. Cox. 1984. The Goal: AProcess of Ongoing Improvement. Croton-on-Hudson, NY: North River Press.

Institute of Management Accountants (formerlyNAA). 1963. Accounting for Costs ofCapacity. Research Report 39 (May 1).Montvale, NJ: Institute of ManagementAccountants.

Kee, Robert. 1995. Integrating activity-basedcosting with the theory of constraints toenhance production-related decision-making.Accounting Horizons (December) :48-61.

McNair, C.J. 1995. The Profit Potential: TakingHigh Performance to the Bottom Line. NewYork: Wiley and Sons.

———. 1994. The costs of capacity. Journal ofCost Management Vol. 8, No. I (Spring). Thisentire issue is dedicated to capacity costmanagement issues.

McNair, C.J., and R. Vangermeersch.Forthcoming. The Movable Feast: The Past,Present and Future of Capacity Reporting.Montvale, NJ: Institute of ManagementAccountants.

Miller, J., and T. Vollmann. 1985. The hidden factory. Harvard Business Review(September-October): 142-150.

Noreen, E., D. Smith, and J. Mackey. 1995. TheTheory of Constraints and Its Implications forManagement Accounting. Montvale, NJ: TheInstitute of Management Accountants.

Siegel, P., A. de Korvin and 0. Khursheedomer.1995. Applications of Fuzzy Sets and theTheory of Evidence to Accounting. Greenwich,CT: JAI Press.

35


Measuring the cost of capacity

Economy & Finance

Transcript of Measuring the cost of capacity