MERGING TWO TRADITIONAL CAPACITY MEASUREMENT SYSTEMS INTO ONE THAT PRODUCES MORE ACCURATE COSTS.

Capacity Utilization: Using the CAM-I Capacity Model in a Multi-Hierarchical Manufacturing Environment B Y P ARVEZ R. SOPARIWALA, PH.D. BETTER DECISION MAKING IS FACILITATED BY MERGING TWO TRADITIONAL CAPACITY MEASUREMENT SYSTEMS INTO ONE THAT PRODUCES MORE ACCURATE COSTS. Effectively managing the cost of capacity is a key to unlocking the value-creating potential of a company s resources. The concept focuses on identifying improvement opportunities. Consisting of a set of action-based tools for making products and providing better, faster, and cheaper services to customers, the development of capacity management systems is synonymous with best management practice in management accounting. Reaching this goal is a journey, not a destination; there is no one, universally correct model, measure, or approach to capacity management and measurement in complex, modern organizations. 1 Not since the severe recession of the early 1980s has capacity use in manufacturing stayed so low for so long, government data show. Production as a percentage of total capacity fell precipitously in the aftermath of the last recession, which ended in 2001, and 23 months into the recovery, the upturn has still not come. On average, manufacturers are using less than 73% of their capacity. 2 Capacity underutilization is the norm in practically every business environment. That is why the role of capacity management has become more important in both short-term and long-term periods. In the short term, knowing the existing level of capacity utilization allows management to realign their product mix to take advantage of their existing underutilized capacity. In the long term, recognition of the amount of structural idle capacity allows management to make a strategic investment, prevent an unneeded acquisition of additional resource capacity, or provide a justification MANAGEMENT ACCOUNTING QUARTERLY 17 WINTER 2006, VOL. 7, NO. 2

for getting rid of idle capacity. The cost/management accounting literature, led by Robin Cooper and Robert Kaplan, 3 has revived the capacity management issue first raised in the 1920s, when it was believed that the cost of idle capacity should not be included in the cost of a product or service but had to be written off to the income statement. 4 As a result, two streams of literature have arisen to assist in the determination of the costs of used and idle capacities. One stream, spearheaded by Michael Ostrenga, considers a multi-hierarchical manufacturing environment and proposes that the cost of used and idle capacities should be determined at the machine, shift, and plant levels. 5 As a result, it separates fixed capacity costs into machine-, shift-, and plant-related costs and then divides these costs by the practical capacities of machines, shifts, and plant, respectively, in order to determine the unit fixed cost at each hierarchical level. The other stream, spearheaded by the Consortium for Advanced Manufacturing-International (CAM-I), is the CAM-I Capacity Model, which essentially examines how acquired capacity is used or why it is allowed to remain idle. Instead of merely separating acquired capacity into used and idle capacity, it goes further and separates used capacity into productive and nonproductive capacity and separates idle capacity into idle off-limits, idle marketable, and idle nonmarketable capacities. As a result, the CAM-I Capacity Model provides a deeper understanding as to how acquired capacity was used or why a part of acquired capacity was kept idle. I merge both streams of literature to create a capacity measurement system for a manufacturing environment where fixed capacity costs are separated into machine-, shift-, and plant-related costs and each level is further examined to determine how much of its costs represent the cost of productive, idle, or nonproductive capacities. My capacity measurement system determines the cost of productive, idle, or nonproductive capacities at the machine, shift, and plant levels. In addition, to make my proposed capacity measurement system richer and more realistic, I add the following complexities. First, two dissimilar machines are used, one of them for one shift and the other for two shifts. Second, fixed capacity costs are divided into people-based resources (e.g., machine operator compensation) and time-based resources (e.g., leased equipment). Third, the possibility that some fixed capacity costs could be the cost of committed resources (e.g., machine operator s salary) while others could be the cost of flexible resources (e.g., machine operator s hourly wages) is recognized. My proposed capacity measurement system provides the following advantages. First, it allows for the determination of more accurate product costs for short- and long-term decision making. Second, it permits the determination of a composite capacity utilization rate for time-based resources, such as plant and equipment, for a plant or the entire organization, thereby providing capacity utilization information necessary for operational, tactical, and strategic decision making at the manufacturing function. Finally, it allows for the determination of the cost of idle, nonproductive, and productive capacities for people-based resources. This development is significant because capacity measurement research, by and large, has dealt only with timebased resources like plant and equipment, and this recognition of people-based resources enables the application of these capacity management principles to manufacturing and service companies alike. W HAT I S THE STATE OF THE C URRENT L ITERATURE? The Ostrenga model was the first to provide guidance on how to isolate excess capacity costs in order to exclude them from product costs. He distinguished between fixed costs that are capacity costs and those that can be categorized as other fixed costs. He argued that fixed capacity costs, like property taxes and insurance on building and equipment, are truly fixed and do not vary regardless of the number of shifts the manufacturing facility runs. As a result, the fixed capacity cost rate was computed by dividing these fixed capacity costs by the practical capacity of the entire system based on an established product mix. 6 Finally, he argued that other fixed costs are semi-variable and that the other fixed cost rate should be computed by dividing these costs by the master budgeted capacity. 7 Marinus DeBruine and Parvez Sopariwala (hereafter, DS) extended Ostrenga in two ways. First, they replaced fixed capacity costs with fixed plant costs that MANAGEMENT ACCOUNTING QUARTERLY 18 WINTER 2006, VOL. 7, NO. 2

are incurred merely by having a manufacturing facility. 8 As a result, they argued that the fixed plant rate should be determined by dividing the fixed plant costs by the practical capacity of all existing cells and processes and not merely the practical capacity of cells and processes used to support the current product mix. Second, they replaced other fixed costs with fixed shift costs, which are all fixed costs that are not categorized as fixed plant costs. 9 Hence, the fixed shift rate was determined by dividing the fixed shift costs by the practical capacity for each shift instead of master budgeted capacity. Sopariwala extended Ostrenga and DS in two ways. 10 First, he pointed out that determining the fixed shift cost rate based on the shifts activated could cause the fixed shift cost rate to fluctuate because the cost to activate each shift could be different. Besides, because the number of shifts activated depended on expected production, such predetermined fixed shift cost rates would inevitably be influenced by production. To alleviate this concern, he suggested that the budgeted fixed shift cost rate be determined by dividing the total potential shift cost for all three shifts by the practical capacity of the three shifts. Second, Sopariwala recognized that fixed shift costs included costs that were not necessarily influenced by the number of shifts activated but were incurred when a work cell or machine was activated (e.g., machine operator s wages). As a result, he added another category, machine-related cost, to the already existing shift-related and plant-related costs to enable the determination of more accurate costs. In the other literature stream, the CAM-I Capacity Model was developed as a tool for communicating to management the state of capacity utilization of its facilities. In a break from Ostrenga, the CAM-I Capacity Model used rated capacity instead of practical capacity as its benchmark for representing maximum capacity utilization. According to Thomas Klammer, Rated capacity uses a time measure. It assumes 24 hours a day, every day, with each tool producing at benchmark rates. The cost of this capacity is 100% of the total cost assignable to the process. 11 Hence, rated capacity, which is similar to theoretical capacity, represents the maximum possible production and is further split into idle, nonproductive, and productive capacity. 12 Idle capacity represents unused capacity and is further split into idle off-limits, idle marketable, and idle nonmarketable capacity, which are defined as follows: Idle off-limits capacity is unavailable for use. Examples of this capacity include government regulations, management policy, and contractual arrangements. 13 Idle marketable capacity is where a market exists but our capacity is idle. Reasons may include competitors market share, the existence of product substitutes, distribution constraints, or price/cost constraints. 14 Idle nonmarketable capacity is where a market does not exist or management made a strategic decision to no longer participate in the market. Capacity classified as nonmarketable is a target for abandonment. 15 Hence, idle off-limits capacity is capacity deemed unavailable for use because management decides to keep it idle (e.g., not working Sundays in deference to religious conventions), governmental regulations require that the plant be idle (e.g., not working on certain national holidays), or contractual agreements require that the plant be idle (e.g., holidays determined by union contracts). Understandably, such capacity becomes available if management changes its policy or government regulations or union contracts change. Idle marketable capacity represents capacity that is idle even though a market for the product exists; i.e., it represents management s inability to exploit the existing market. For example, as Klammer points out, such capacity could be caused by a faulty or inefficient distribution system and highlighting it would allow management to take corrective action. 16 Finally, idle nonmarketable capacity represents capacity where a market does not exist (e.g., the manufacture of 78 r.p.m. records or 8-track tapes), or management makes a decision not to participate in a certain market (e.g., General Motors decision to discontinue the Oldsmobile product line). Nonproductive capacity, as defined below, represents capacity that is used, albeit unproductively. In other words, it represents used capacity that does not add value to the product or service. Nonproductive capacity is capacity that is neither in a productive state nor in one of the defined idle states. MANAGEMENT ACCOUNTING QUARTERLY 19 WINTER 2006, VOL. 7, NO. 2

Nonproductive capacity includes setups, maintenance, standby, scheduled downtime, unscheduled downtime, rework, and scrap. Variability is a primary cause of nonproductive capacity. 17 Nonproductive capacity includes time lost on activities such as setups, maintenance, yield losses (the difference between the actual hours used to manufacture a product and the standard hours that should have been used to manufacture that product), and standby capacity that represents buffer capacity necessary to deal with the expected variability of a manufacturing environment caused by late receipt of material supplies, customers insistence on quick deliveries, slowdowns due to machine age, and so forth. Finally, productive capacity, as defined below, represents the time (the standard hours) needed to produce and deliver the product or service to the customer: Productive capacity provides value to the customer. We use productive capacity to change a product or provide a service. Examples of productive use of capacity include these: cutting, molding, welding, painting, furnace time, and assembly. Productive capacity results in the delivery of good products or services. 18 T HE P ROPOSED CAPACITY M EASUREMENT SYSTEM In order to provide a richer and more realistic framework for determining the cost of unused or idle capacity and the capacity utilization ratio, I merged the Ostrenga and CAM-I literature to create a manufacturing environment with the following additional complexities: Two different machines are used for a different number of shifts. Instead of assuming that all machines in a factory are similar and used for the same number of shifts, my manufacturing environment will consider two different machines, one of which will effectively be used for one shift and the other one for two shifts. Cost of time vs. people-based resources. DS and Sopariwala include both people-based resources (e.g., shift supervisor s salary) and time-based resources (e.g., equipment lease cost) in the fixed capacity costs and divide them by one practical capacity level. As a result, they ignore the different capacity levels that these time- and people-based resources acquire. For example, substituting theoretical capacity for practical capacity, one could argue that the yearly theoretical capacity of leased equipment should be 8,760 hours [24 hours a day x 365 days a year]. Similarly, a shift supervisor s yearly theoretical capacity, representing the number of hours for which she is paid, should be 2,080 hours [8 hours a day x 5 days a week x 52 weeks a year], assuming the 365th day was a Sunday. Therefore, if these two costs are not separately divided by their appropriate theoretical capacities, spreading the shift supervisor s salary over the theoretical capacity of the leased equipment would result in undercharging each unit produced. In my manufacturing environment, the salary of the shift supervisor will be allocated using the theoretical or rated capacity of the supervisor, i.e., 2,080 hours, while the cost of the leased equipment is allocated using the theoretical or rated capacity of the leased equipment, i.e., 8,760 hours. Cost of flexible vs. committed resources. My manufacturing environment does not limit itself to considering machine operator remuneration as either the cost of a committed resource (i.e., a worker is paid a fixed weekly or monthly salary irrespective of the number of hours she works, thereby creating a potential for idle or unused capacity) or the cost of a flexible resource (i.e., machine operators are only paid for the hours they work). 19 My manufacturing environment allows for the possibility of both types of machine operator compensation. Table 1 provides the facts of a hypothetical company, Jonah Corporation, which manufactures 500 units of Product X using two machines, Machine A and Machine B, each of which can potentially be operated for three shifts during the year. Machine A operators are salaried employees, i.e., the cost of a committed resource, while Machine B operators are hourly employees, i.e., the cost of a flexible resource. The raw material is first processed by Machine A, and the standard quantity of machine hours needed to process one unit of Product X using Machine A is three hours. After the processing in Machine A is complete, the semi-complete product is further processed in Machine B, and the standard quantity of machine hours needed to complete one unit of Product X using Machine B is four hours. In addition, it is assumed that each machine operator operates one and only one machine per shift. As a result, MANAGEMENT ACCOUNTING QUARTERLY 20 WINTER 2006, VOL. 7, NO. 2

Table 1: Jonah Corporation The Facts Panel A: Theoretical capacities and budgeted costs of resources acquired Theoretical capacities: Machine A Machine B Shifts Plant Machines A and B per shift People-based resources (LHs) 2,080 Time-based resources (MHs) 2,920 2,920 Shifts People-based resources (LHs) 2,080 Plant People-based resources (LHs) 6,240 Time-based resources (MHs) 8,760 Budgeted costs of resources acquired: Machines A and B People-based resources: Machine operator yearly salary per shift $24,960 Machine operator wages per labor hour $15.00 Time-based resources: yearly scheduled maintenance per machine/shift $12,000 $15,000 Shifts People-based resources: shift supervisor's yearly salary over three shifts $195,000 Plant People-based resources: plant manager's yearly salary $180,000 Time-based resources: yearly property taxes $300,000 Panel B: Operations for the year Machine A Machine B Shift 1 Shift 1 Shift 2 Production of Product X (units) 500 400 100 Standard LHs/MHs needed for 1 unit of Product X 3 4 4 Standard LHs/MHs for production of 500 units of Product X 1,500 1,600 400 Yield losses (LHs/MHs) 200 90 50 Setups, etc. (LHs/MHs) 80 112 55 Repairs, etc. (LHs/MHs) 70 120 30 Defectives, waste, etc. (LHs/MHs) 42 70 85 Actual LHs/MHs used for production of 500 units of Product X 1,892 1,992 620 Panel C: Other details 1 The agreement between management and the labor union required the plant to remain closed on Sundays. The 365th day of the year is assumed to be a Sunday. 2 The plant did not operate on Saturdays due to inadequate demand. 3 The agreement between management and the labor union entitled salaried employees to 11 holidays. 4 Management decided not to operate the third shift. 5 All excess capacity, i.e., capacity not directly recognized as idle off-limits, idle-marketable, nonproductive, or productive, is assumed to be additional idle marketable. MANAGEMENT ACCOUNTING QUARTERLY 21 WINTER 2006, VOL. 7, NO. 2

there is a 1:1 relationship between each machine and its operator, i.e., the use of one machine hour for a certain task automatically involves the use of a labor hour. Using the facts outlined in Table 1, Tables 2 6 reveal how the costs of processing 500 units of Product X are first divided into machine-, shift-, and plant-related costs and subsequently allocated to the various capacity types defined by CAM-I. M ACHINE-RELATED COSTS Machine-related costs are either people-based costs or time-based costs. The main difference is that the rated capacity for people-based, committed costs for one shift is 2,080 hours while the rated capacity for time-based committed costs over one shift is 2,920 hours. In this example, people-based costs are represented by machine-operator remuneration while time-based costs represent the yearly scheduled maintenance per machine for each shift. Let s look at how Machine A- and B- related costs are allocated among idle off-limits, idle marketable, nonproductive, and productive capacities. People-based Machine A-related costs. As 1,892 labor hours are used to manufacture 500 units of Product X in the first shift, only one machine operator is needed to run Machine A. Panel A of Table 2 shows that the people-based hourly labor rate averages to $12.00 [$24,960 yearly salary/2,080 labor hours], and Panel B of Table 2 reveals that $18,000 [1,500 standard hours x $12.00 per labor hour] is the cost of productive capacity for manufacturing 500 units. Panel C of Table 2 reveals that $4,704, the cost of nonproductive capacity, is allocated among yield losses, setups, repairs, defectives, waste, and so forth. 20 Panel D of Table 2 determines the cost of idle capacity. Management and the union agreed to 11 holidays during the year, so the cost of $1,056 [11 holidays x 8 hours per shift x $12.00 per labor hour] represents the cost of idle off-limits capacity for the salaried machine operator who works the first shift. The balance of 100 machine hours and its cost of $1,200 [100 labor hours x $12.00 per labor hour] is attributable to additional idle marketable capacity. Time-based Machine A-related costs. Panel A of Table 2 determines the time-based overhead rate of $4.11 per machine hour for each shift. Similarly, Panel B of Table 2 reveals that $6,164 is the cost of productive capacity for the first shift. In addition, resulting from the 1:1 relationship between machine and machine operator, the hours lost by Machine A due to yield losses, etc., are the same as the hours lost by its machine operators. Hence, Panel C of Table 2 determines that $1,611 is the cost of nonproductive capacity for the first shift. Panel D of Table 2 determines the cost of idle capacities. First, the idle off-limits cost relating to the 11 holidays is determined in a manner similar to that for the people-based costs, i.e., $362 [11 holidays x 8 hours per shift x $4.11 per machine hour] for each of the three shifts. As management and the labor union agreed to the plant being shut on Sundays, $1,742 [53 Sundays x 8 hours per shift x $4.11 per machine hour] represents idleness of 424 hours and is an additional cost of idle off-limits capacity for all shifts. Management also decided that the plant would remain shut on Saturdays due to inadequate demand for Product X. As a result, $1,710 [52 Saturdays x 8 hours per shift x $4.11 per machine hour] represents idleness of 416 hours and is a cost of idle marketable capacity for all shifts. In addition, because management decided not to operate the third shift, $8,186 [1,992 machine hours x $4.11 per machine hour] represents the cost of idle off-limits capacity for the third shift. For a similar reason, $8,186 represents additional idle marketable capacity because Machine A was not used in the second shift. People-based Machine B-related costs. As 400 units of Product X are manufactured in the first shift and 100 units of Product X are manufactured in the second shift, Machine B is activated for two shifts. Therefore, a machine operator is needed to operate Machine B in each of the first two shifts and is paid $15 per labor hour. Panel B of Table 3 reveals that $24,000 and $6,000 are charged to the cost of productive capacity for manufacturing 400 and 100 units in the first and second shifts, respectively. Panel C of Table 3 reveals that $5,880 and $3,300 of machine operator remuneration are charged to the cost of nonproductive capacity in shifts 1 and 2, respectively. There is no cost of idle capacity because the machine operator is an hourly employee, that is, the cost of a flexible resource. Time-based Machine B-related costs. Panel A of Table 3 determines the time-based overhead rate of $5.14 per MANAGEMENT ACCOUNTING QUARTERLY 22 WINTER 2006, VOL. 7, NO. 2

Table 2: Determination of the cost of productive, nonproductive, and idle capacities for Machine A costs using CAM-I* PEOPLE-BASED TIME-BASED TOTAL COSTS FIRST SHIFT SECOND SHIFT TOTAL FIRST SHIFT SECOND SHIFT THIRD SHIFT TOTAL (LHs) $ (LHs) $ $ % (MHs) $ (MHs) $ (MHs) $ $ % $ % Panel A: The determination of applicable capacity-based labor and overhead rates Budgeted committed resources (Note 1) $24,960 $12,000 $12,000 $12,000 Theoretical capacity (LHs/MHs) (Note 1) 2,080 2,920 2,920 2,920 Budgeted people-based rate per LH $12 Budgeted time-based overhead rate per MH $4.11 $4.11 $4.11 Panel B: The cost of productive capacity Actual production (Note 2) 1,500 $18,000 $18,000 72.12% 1,500 $6,164 $6,164 17.12% $24,164 39.64% Panel C: The cost of nonproductive capacity Yield loss (Note 2) 200 $2,400 $2,400 9.62% 200 $822 $822 2.28% $3,222 5.29% Setups (Note 2) 80 $960 $960 3.85% 80 $329 $329 0.91% $1,289 2.11% Repairs, etc. (Note 2) 70 $840 $840 3.37% 70 $288 $288 0.80% $1,128 1.85% Defectives, waste, etc. (Note 2) 42 $504 $504 2.02% 42 $173 $173 0.48% $677 1.11% Total 392 $4,704 $4,704 18.85% 392 $1,611 $1,611 4.47% $6,315 10.36% Panel D: The cost of idle capacity Idle off-limits capacity Plant closed on Sundays (Note 3) 424 $1,742 424 $1,742 424 $1,742 $5,227 14.52% $5,227 8.58% Plant closed for holidays (Note 4) 88 $1,056 $1,056 4.23% 88 $362 88 $362 88 $362 $1,085 3.01% $2,141 3.51% Plant closed for third shift (Note 6) 1,992 $8,186 $8,186 22.74% $8,186 13.43% Total 88 $1,056 $1,056 4.23% 512 $2,104 512 $2,104 2,504 $10,290 $14,499 40.27% $15,555 25.52% Idle marketable capacity Plant closed on Saturdays (Note 5) 416 $1,710 416 $1,710 416 $1,710 $5,129 14.25% $5,129 8.41% Extra capacity First shift (Note 7) 100 $1,200 $1,200 4.81% 100 $411 $411 1.14% $1,611 2.64% Extra capacity Second shift (Note 8) 1,992 $8,186 $8,186 22.74% $8,186 13.43% Total 100 $1,200 $1,200 4.81% 516 $2,121 2,408 $9,896 416 $1,710 $13,726 38.13% $14,926 24.48% Panel E: The cost of acquired capacity Total costs 2,080 $24,960 $24,960 100% 2,920 $12,000 2,920 $12,000 2,920 $12,000 $36,000 100% $60,960 100% *Some totals have been rounded in the tables. Notes 1 Extracted from Panel A of Table 1. 2 Hours extracted from Panel B of Table 1. 3 [53 Sundays x 8 hours/shift] This is idle off-limits capacity due to management s agreement with labor not to work on Sundays. 4 [11 holidays x 8 hours/shift] This is idle off-limits capacity due to management s agreement with labor not to work on certain holidays. 5 [52 Saturdays x 8 hours/shift] This is idle marketable capacity because the plant did not operate on Saturdays due to inadequate demand. 6 [Acquired capacity (2,920 hours) idle off-limits capacity (424 + 88 hours) idle marketable capacity (416 hours)] This is idle off-limits capacity because management decided not to operate the third shift. 7 [Acquired capacity (2,080 hours) productive capacity (1,500 hours) nonproductive capacity (392 hours) idle off-limits capacity (88 hours)] This excess capacity is considered to be idle marketable. 8 [Acquired capacity (2,920 hours) idle off-limits capacity (424 hours + 88 hours) idle marketable capacity (416 hours)] This excess capacity is considered to be idle marketable. MANAGEMENT ACCOUNTING QUARTERLY 23 WINTER 2006, VOL. 7, NO. 2

machine hour for each shift. Panel B of Table 3 reveals that $8,219 and $2,055 are the cost of productive capacity for manufacturing 400 and 100 units during the first and second shifts, respectively. In addition, resulting from the 1:1 relationship between the machines and machine operators, the hours lost by Machine B due to yield losses, etc., are the same as the hours lost by its machine operators. Therefore, Panel C of Table 3 determines that $2,014 and $1,130 are the costs of nonproductive capacity for the first and second shifts, respectively. Panel D of Table 3 determines the cost allocated to idle off-limits capacity (i.e., plant closed on Sundays and holidays) and idle marketable capacity (i.e., plant closed on Saturdays) in a manner similar to that for Machine A in Panel D of Table 2. In addition, because Machine B was not used to its full capacity in the second shift, $7,048 [1,372 machine hours x $5.14 per machine hour] represents the cost of additional idle marketable capacity. Finally, because management decided not to operate the third shift, $10,233 [1,992 machine hours x $5.14 a machine hour] represents the cost of idle off-limits capacity for the third shift. 21 A brief evaluation. Tables 2 and 3 reveal that most of the people-based resources were used either productively or nonproductively. This is understandable because Machine A s operator accounted for all her time during the first shift and both Machine B operators were hourly workers. More than 70% of the time-based resources, however, were idle. This can be attributed to the fact that a large portion of the second shift and the entire third shift were idle. S HIFT-RELATED COSTS People-based shift-related costs, represented here by a shift supervisor s yearly salary, are incurred because a shift is activated. 22 Her rated capacity per shift is 2,080 hours. A shift is activated even if only one of the two machines is activated because a shift supervisor is hired to supervise both machines and, if one machine is idle, her salary attributable to that machine is idle capacity. As two machines can be activated each shift, the shift capacity for each activated shift is 4,160 labor hours [2,080 labor hours per shift x 2 machines]. The following discussion reveals that the allocation of these costs among idle off-limits, idle marketable, nonproductive, and productive capacities is dependent on the allocations of Machine A and B costs detailed earlier in Tables 2 and 3. People-based first-shift-related costs. As the total cost for three-shift shift supervisory salaries is $195,000 per year, or an average of $65,000 yearly, Panel A of Table 4 shows that the people-based overhead rate averages to $15.63 per labor hour. Production output equivalent to 3,100 standard labor hours (1,500 for Machine A and 1,600 for Machine B) is processed during the first shift, so Panel B of Table 4 reveals that $48,438 is charged to the cost of productive capacity. In addition, Panel C of Table 4 determines $12,250 as the cost of nonproductive capacity. Using Panel D of Tables 2 and 3, Panel D of Table 4 shows that $2,750 and $1,563 are the costs of idle off-limits and idle marketable capacities, respectively. People-based second-shift-related costs. The second shift processes 400 standard hours of production on Machine B, so Panel B of Table 4 reveals that $6,250 is charged to the cost of productive capacity. Panel C of Table 4 determines that $3,438 of the shift supervisor s salary is charged to the cost of nonproductive capacity. Panel D of Table 4 determines the cost of $2,750 representing the 11 holidays in the same manner as above. Next, because Machine B was idle for 1,372 hours in the second shift, $21,438 is charged to idle marketable capacity. Finally, because Machine A was not used during the second shift, 1,992 labor hours represent idle capacity, and $31,125 is charged to idle marketable capacity. A brief evaluation. Table 4 reveals that about 93% of the people-based resources in the first shift were used productively or nonproductively, while only about 15% of the people-based resources were so used in the second shift. This outcome is understandable because the first shift was used completely while only a small portion of the second shift was used. P LANT-RELATED COSTS Plant-related costs are usually a cost of committed resources and can be either people-based costs, represented here by the plant manager s salary of $180,000 per year, or time-based costs, represented here by yearly property taxes of $300,000. A plant would be considered activated even if one out of three shifts is activated because the plant manager, even though she is not MANAGEMENT ACCOUNTING QUARTERLY 24 WINTER 2006, VOL. 7, NO. 2

Table 3: Determination of the cost of productive, nonproductive, and idle capacities for Machine B costs using CAM-I PEOPLE-BASED TIME-BASED TOTAL COSTS FIRST SHIFT SECOND SHIFT TOTAL FIRST SHIFT SECOND SHIFT THIRD SHIFT TOTAL (LHs) $ (LHs) $ $ % (MHs) $ (MHs) $ (MHs) $ $ % $ % Panel A: The determination of applicable capacity-based labor and overhead rates Budgeted committed resources (Note 1) $15,000 $15,000 $15,000 Theoretical capacity (LHs/MHs) (Note 1) 2,920 2,920 2,920 Budgeted time-based overhead rate per MH $5.14 $5.14 $5.14 Budgeted people-based rate per LH (Note 1) $15 $15 Panel B: The cost of productive capacity Actual production (Note 2) 1,600 $24,000 400 $6,000 $30,000 76.57% 1,600 $8,219 400 $2,055 $10,274 22.83% $40,274 47.84% Panel C: The cost of nonproductive capacity Yield loss (Note 2) 90 $1,350 50 $750 $2,100 5.36% 90 $462 50 $257 $719 1.60% $2,819 3.35% Setups (Note 2) 112 $1,680 55 $825 $2,505 6.39% 112 $575 55 $283 $858 1.91% $3,363 3.99% Repairs, etc. (Note 2) 120 $1,800 30 $450 $2,250 5.74% 120 $616 30 $154 $771 1.71% $3,021 3.59% Defectives, waste, etc. (Note 2) 70 $1,050 85 $1,275 $2,235 5.93% 70 $360 85 $437 $796 1.77% $3,121 3.71% Total 392 $5,880 220 $3,300 $9,180 23.43% 392 $2,014 220 $1,130 $3,144 6.99% $12,324 14.64% Panel D: The cost of idle capacity Idle off-limits capacity Plant closed on Sundays (Note 3) 424 $2,178 424 $2,178 424 $2,178 $6,534 14.52% $6,534 7.76% Plant closed for holidays (Note 4) 88 $452 88 $452 88 $452 $1,356 3.01% $1,356 1.61% Plant closed for third shift (Note 6) 1,992 $10,233 $10,233 22.74% $10,233 12.16% Total 512 $2,630 512 $2,630 2,504 $12,863 $18,123 40.27% $18,123 21.53% Idle marketable capacity Plant closed on Saturdays (Note 5) 416 $2,137 416 $2,137 416 $2,137 $6,411 14.25% $6,411 7.62% Extra capacity Second shift (Note 7) 1,372 $7,048 $7,048 15.66% $7,048 8.37% Total 416 $2,137 1,788 $9,185 416 $2,137 $13,459 29.91% $13,459 15.99% Panel E: The cost of acquired capacity Total costs 1,992 $29,880 620 $9,300 $39,180 100% 2,920 $15,000 2,920 $15,000 2,920 $15,000 $45,000 100% $84,180 100% Notes 1 Extracted from Panel A of Table 1. 2 Hours extracted from Panel B of Table 1. 3 [53 Sundays X 8 hours/shift] This is idle off-limits capacity due to management s agreement with labor not to work on Sundays. 4 [11 holidays X 8 hours/shift] This is idle off-limits capacity due to management s agreement with labor not to work on certain holidays. There is no corresponding holiday time for the people-based resources because the machine operators are hourly employees. 5 [52 Saturdays X 8 hours/shift] This is idle marketable capacity since the plant did not operate on Saturdays due to inadequate demand. 6 [Acquired capacity (2,920 hours) idle off-limits capacity (424 hours + 88 hours) idle marketable capacity (416 hours)] This is idle off-limits capacity because management decided not to operate the third shift. 7 [Acquired capacity (2,920 hours) productive capacity (400 hours) nonproductive capacity (220 hours) idle off-limits capacity (424 hours + 88 hours) idle marketable capacity (416 hours)] This excess capacity is considered to be idle marketable. MANAGEMENT ACCOUNTING QUARTERLY 25 WINTER 2006, VOL. 7, NO. 2

physically present for all three shifts, is responsible for the operations in these three shifts, and, if a shift is idle, her salary relating to that shift is idle capacity. The following discussion reveals that the allocation of plantrelated people- and time-based costs among idle off-limits capacity, idle marketable capacity, nonproductive capacity, and productive capacity is dependent largely on the allocations of Machine A, Machine B, and shift-related costs detailed earlier in Tables 2 4. People-based plant-related costs. As there are two machines, Machines A and B, and at least one of them operates during the year, the plant capacity is 12,480 labor hours [2,080 hours per machine per shift x 3 shifts x 2 machines]. In consideration that the plant s three shifts are not used evenly, however, the yearly cost of $180,000 and the plant capacity of 12,480 labor hours are divided by three so that each shift can be treated separately. As a result, Panel A of Table 5 reveals the average hourly overhead rate of $14.42 per shift. The productive, nonproductive, and idle labor hours for the first two shifts are derived directly from Panels B through D of Tables 2 through 4. Based on the hourly overhead rate of $14.42, Panels B through D of Table 5 show costs of productive, nonproductive, and idle capacities for the first two shifts. The third shift is idle as a result of management s directive, so $60,000 of the plant manager s salary is charged to idle off-limits capacity as follows: $2,538 representing holidays and $57,462 representing the remaining 3,984 [(2,080 hours 88 holiday hours) x 2 machines] labor hours idled due to the plant being closed for the third shift. Time-based plant-related costs. As the plant operated at least one shift, the plant capacity is 17,520 machine hours [2,920 hours per machine per shift x 3 shifts x 2 machines]. Again, the yearly cost of $300,000 and the plant capacity of 17,520 machine hours are divided by three so that each shift can be treated separately, considering that the three shifts are not used evenly. Panel A of Table 5 reveals the average hourly overhead rate is $17.12 per shift. The productive, nonproductive, and idle labor hours for the first two shifts are derived directly from the time-based Panels B through D of Tables 2 4. As a result, using the hourly overhead rate of $17.12, Panels B through D of Table 5 show the costs of productive, nonproductive, and idle capacities for all shifts. A brief evaluation. Table 5 shows that about 36% of the people-based resources and about 26% of the timebased resources were used either productively or nonproductively. The low percentage usage for both resources is directly attributable to the fact that a large percentage of these resources were idled during the second shift and that the third shift was completely idled. S UMMARY Table 6 summarizes the results from Tables 2 5 and breaks up the total cost of $755,140 into people-based costs of $374,140 and time-based costs of $381,000. In addition, Table 6 also provides capacity utilization ratios for the people- and time-based costs, which reveal the following: People-based costs. Panels A through C of Table 6 reveal that about 53% of the acquired people-based capacity was put to productive or nonproductive use. Most of the idle capacity, however, is in the form of the shift supervisor or plant manager salary, which can only be reduced if the plant is utilized more. Time-based costs. Panels A through C of Table 6 also show that about 26% of the acquired time-based capacity was put to productive and nonproductive use; i.e., its capacity utilization ratio is 26%. The idle capacity here is caused primarily by the fact that the plant was essentially operating one shift and should be a reminder to management that the plant has quite a bit of idle capacity left and could use an infusion of new business to enhance its capacity utilization. T HE CAPACITY M EASUREMENT SYSTEM AS A D ECISION-MAKING A ID The proposed capacity measurement system also can be used as a decision-making aid, for example, to determine if a recently received new order should be accepted. Assume that the plant receives a one-time special order for 100 units of a Product X wannabe (hereafter Product XX) for which the prospective customer is willing to pay $40,000. Product XX, whose details are provided in Table 7, requires material costing $6,000 and extensive setups as evidenced by the 40 setup hours MANAGEMENT ACCOUNTING QUARTERLY 26 WINTER 2006, VOL. 7, NO. 2

Table 4: Determination of the cost of productive, nonproductive, and idle capacities for shift-related costs using CAM-I PEOPLE-BASED FIRST SHIFT SECOND SHIFT TOTAL (LHs) $ % (LHs) $ % $ % Panel A: The determination of applicable capacity-based labor and overhead rates Budgeted committed resources (Note 1) $65,000 $65,000 Theoretical capacity (LHs/MHs) (Note 2) 4,160 4,160 Budgeted people-based overhead rate per LH $15.63 $15.63 Panel B: The cost of productive capacity Actual production (Note 3) 3,100 $48,438 74.52% 400 $6,250 9.62% $54,688 42.07% Panel C: The cost of nonproductive capacity Yield loss (Note 3) 290 $4,531 6.97% 50 $781 1.20% $5,313 4.09% Setups (Note 3) 192 $3,000 4.62% 55 $859 1.32% $3,859 2.97% Repairs, etc. (Note 3) 190 $2,969 4.57% 30 $469 0.72% $3,438 2.64% Defectives, waste, etc. (Note 3) 112 $1,750 2.69% 85 $1,328 2.04% $3,078 2.37% Total 784 $12,250 18.85% 220 $3,438 5.29% $15,688 12.07% Panel D: The cost of idle capacity Idle off-limits capacity Plant closed on Sundays (Note 4) Plant closed for holidays (Note 5) 176 $2,750 4.23% 176 $2,750 4.23% $5,500 4.23% Plant closed for third shift (Note 6) Total 176 $2,750 4.23% 176 $2,750 4.23% $5,500 4.23% Idle marketable capacity Plant closed on Saturdays (Note 4) Extra capacity Machine A first shift (Note 7) 100 $1,563 2.40% $1,563 1.20% Extra capacity Machine A second shift (Note 8) 1,992 $31,125 47.88% $31,125 23.94% Extra capacity Machine B second shift (Note 9) 1,372 $21,438 32.98% $21,438 16.49% Total 100 $1,563 2.40% 3,364 $52,563 80.87% $54,125 41.63% Panel E: The cost of acquired capacity Total costs 4,160 $65,000 100% 4,160 $65,000 100% $130,000 100% Notes 1 Extracted from Panel A of Table 1. 2 Theoretical capacity for one machine operator per shift is 2,080 hours (Panel A of Table 1). Because the shift supervisor supervises two machine operators, the theoretical capacity per shift is 4,160 hours. 3 The sum of the people-based amounts relating to Machine A (Note 2 from Table 2) and Machine B (Note 2 from Table 3). 4 As supervisors are not paid to work on weekends, there is no idle capacity for Saturdays and Sundays. 5 As supervisors are entitled to 11 paid holidays, 88 hours for each shift (176 hours) represent idle off-limits capacity. 6 As management decided not to operate the third shift, there is no people-based idle off-limits capacity for this shift. 7 Please refer to Note 7 from Table 2. 8 [Acquired capacity (2,080 hours) idle off-limits capacity (88 hours)] This excess capacity is considered to be idle marketable. 9 [Acquired capacity (2,080 hours) productive capacity (400 hours) nonproductive capacity (220 hours) idle off-limits capacity (88 hours)] This excess capacity is considered to be idle marketable. MANAGEMENT ACCOUNTING QUARTERLY 27 WINTER 2006, VOL. 7, NO. 2

Table 5: Determination of the cost of productive, nonproductive, and idle capacities for plant-related costs using CAM-I* Panel A: The determination of applicable capacity-based overhead rates PEOPLE-BASED TIME-BASED TOTAL COSTS FIRST SHIFT SECOND SHIFT THIRD SHIFT TOTAL FIRST SHIFT SECOND SHIFT THIRD SHIFT TOTAL (LHs) $ (LHs) $ (LHs) $ $ % (MHs) $ (MHs) $ (MHs) $ $ % $ % Budgeted committed resources (Note 1) $60,000 $60,000 $60,000 $100,000 $100,000 $100,000 Theoretical capacity (LHs/MHs) (Note 2) 4,160 4,160 4,160 5,840 5,840 5,840 Budgeted people-based overhead rate per LH $14.42 $14.42 $14.42 Budgeted time-based rate per MH $17.12 $17.12 $17.12 Panel B: The cost of productive capacity Actual production (Note 2) 3,100 $44,712 400 $5,769 $50,481 28.04% 3,100 $53,082 400 $6,849 $59,932 19.98% $110,412 23.00% Panel C: The cost of nonproductive capacity Yield loss (Note 3) 290 $4,183 50 $721 $4,904 2.72% 290 $4,966 50 $856 $5,822 1.94% $10,726 2.23% Setups (Note 3) 192 $2,769 55 $793 $3,563 1.98% 192 $3,288 55 $942 $4,229 1.41% $7,792 1.62% Repairs, etc. (Note 3) 190 $2,740 30 $433 $3,173 1.76% 190 $3,253 30 $514 $3,767 1.26% $6,940 1.45% Defectives, waste, etc. (Note 3) 112 $1,615 85 $1,226 $2,841 1.58% 112 $1,918 85 $1,455 $3,373 1.12% $6,215 1.29% Total 784 $11,308 220 $3,173 $14,481 8.04% 784 $13,425 220 $3,767 $17,192 5.73% $31,673 6.60% Panel D: The cost of idle capacity Idle off-limits capacity Plant closed on Sundays (Note 4) 848 $14,521 848 $14,521 848 $14,521 $43,562 14.52% $43,562 9.08% Plant closed for holidays (Note 5) 176 $2,538 176 $2,538 176 $2,538 $7,615 4.23% 176 $3,014 176 $3,014 176 $3,014 $9,041 3.01% $16,656 3.47% Plant closed for third shift (Note 6) 3,984 $57,462 $57,462 31.92% 3,984 $68,219 $68,219 22.74% $125,681 26.18% Total 176 $2,538 176 $2,538 4,160 $60,000 $65,077 36.15% 1,024 $17,534 1,024 $17,534 5,008 $85,753 $120,822 40.27% $185,899 38.73% Idle marketable capacity Plant closed on Saturdays (Note 4) 832 $14,247 832 $14,247 832 $14,247 $42,740 14.25% $42,740 8.90% Extra capacity Machine A first shift (Note 7) 100 $1,442 $1,442 0.80% 100 $1,712 $1,712 0.57% $3,155 0.66% Extra capacity Machine A second shift (Note 8) 1,992 $28,731 $28,731 15.96% 1,992 $34,110 $34,110 $62,840 13.09% Extra capacity Machine B second shift (Note 9) 1,372 $19,788 $19,788 10.99% 1,372 $23,493 $23,493 7.83% $43,282 9.02% Total 100 $1,442 3,364 $48,519 $49,962 27.76% 932 $15,959 4,196 $71,849 832 $14,247 $102,055 34.02% $152,016 31.67% Panel E: The cost of acquired capacity Total costs 4,160 $60,000 4,160 $60,000 4,160 $60,000 $180,000 100% 5,840 $100,000 5,840 $100,000 5,840 $100,000 $300,000 100% $480,000 100% * Some totals have been rounded in the tables. Notes 1 Extracted from Panel A of Table 1. 2 For people-based resources, please refer to Note 1 from Table 4. Theoretical capacity for one machine per shift is 2,920 hours (Panel A of Table 1). For two machines, the theoretical capacity per shift is 5,840 hours. 3 The sum of the people-based and time-based hours relating to Machine A (Note 2 from Table 2) and Machine B (Note 2 from Table 3). 4 The sum of the people-based and time-based hours relating to Machines A and B (Notes 3 and 5 from Tables 2 and 3). 5 The sum of the people-based and time-based hours relating to Machines A and B (Note 4 from Tables 2 and 3). 6 The sum of the people-based and time-based hours relating to Machines A and B (Note 6 from Tables 2 and 3). 7 The sum of the people-based and time-based hours relating to Machine A (Note 7 from Table 2). 8 The sum of the people-based and time-based hours relating to Machine A (Note 8 from Table 2 and Note 8 from Table 4). 9 The sum of the people-based and time-based hours relating to Machine B (Note 7 from Table 3 and Note 9 from Table 4). MANAGEMENT ACCOUNTING QUARTERLY 28 WINTER 2006, VOL. 7, NO. 2

Table 6: Determination of the cost of productive, nonproductive, and idle capacities using CAM-I A summary for the production of 500 units of Product X Panel A: The cost of productive capacity Machine A-related Machine B-related Shift-related Plant-related Total costs Capacity utilization ratios Table 2 Table 3 Table 4 Table 5 (% of acquired capacity) People- Time- People- Time- People- People- Time- People- Time- People- Timebased based based based based based based based based Total based based Total Actual production $18,000 $6,164 $30,000 $10,274 $54,688 $50,481 $59,932 $153,168 $76,370 $229,538 40.94% 20.04% 30.40% Panel B: The cost of nonproductive capacity Yield loss $2,400 $822 $2,100 $719 $5,313 $4,904 $5,822 $14,716 $7,363 $22,079 3.93% 1.93% 2.92% Setups $960 $329 $2,505 $858 $3,859 $3,563 $4,229 $10,887 $5,416 $16,303 2.91% 1.42% 2.16% Repairs, etc. $840 $288 $2,250 $771 $3,438 $3,173 $3,767 $9,701 $4,825 $14,526 2.59% 1.27% 1.92% Defectives, waste, etc. $504 $173 $2,325 $796 $3,078 $2,841 $3,373 $8,748 $4,342 $13,091 2.34% 1.14% 1.73% Total $4,704 $1,611 $9,180 $3,144 $15,688 $14,481 $17,192 $44,052 $21,947 $65,999 11.77% 5.76% 8.74% Panel C: The cost of used capacity (productive + nonproductive capacity) Total costs $22,704 $7,775 $39,180 $13,418 $70,375 $64,962 $77,123 $197,221 $98,316 $295,537 52.71% 25.80% 39.14% Panel D: The cost of idle capacity Idle off-limits capacity Plant closed on Sundays $5,227 $6,534 $43,562 $55,323 $55,323 0.00% 14.52% 7.33% Plant closed for holidays $1,056 $1,085 $1,356 $5,500 $7,615 $9,041 $14,171 $11,482 $25,654 3.79% 3.01% 3.40% Plant closed for third shift $8,186 $10,233 $57,462 $68,219 $57,462 $86,638 $144,100 15.36% 22.74% 19.08% Total $1,056 $14,499 $18,123 $5,500 $65,077 $120,822 $71,633 $153,444 $225,077 19.15% 40.27% 29.81% Idle marketable capacity Plant closed on Saturdays $5,129 $6,411 $42,740 $54,279 $54,279 0.00% 14.25% 7.19% Extra capacity Machine A first shift $1,200 $411 $1,563 $1,442 $1,712 $4,205 $2,123 $6,328 1.12% 0.56% 0.84% Extra capacity Machine A second shift $8,186 $31,125 $28,731 $34,110 $59,856 $42,296 $102,152 16.00% 11.10% 13.53% Extra capacity Machine B second shift $7,048 $21,438 $19,788 $23,493 $41,226 $30,541 $71,767 11.02% 8.02% 9.50% Total $1,200 $13,726 $13,459 $54,125 $49,962 $102,055 $105,287 $129,240 $234,526 28.14% 33.92% 31.06% Total idle capacity $2,256 $28,225 $31,582 $59,625 $115,038 $222,877 $176,919 $282,684 $459,603 47.29% 74.20% 60.86% Panel E: The cost of acquired capacity Total costs $24,960 $36,000 $39,180 $45,000 $130,000 $180,000 $300,000 $374,140 $381,000 $755,140 100% 100% 100% MANAGEMENT ACCOUNTING QUARTERLY 29 WINTER 2006, VOL. 7, NO. 2

needed for Machines A and B. Incorporating the details from Table 7 into Tables 2 5 provides Table 8 (i.e., an updated Table 6), which reveals that the total costs for 500 units of Product X and 100 units of Product XX would amount to $786,895 (amount in bold) whereas the total costs for only 500 units of Product X amounted to $755,140 (Table 6). In other words, the additional 100 units of Product XX require an additional nondirect, material-related cost of $31,755. Panel A of Table 9 explains this difference of $31,755 in the context of changes in the cost of used (i.e., productive and nonproductive), idle, and acquired capacities. Panels B through E provide more detailed explanations depending on whether the order for 100 units of Product XX is a short-term or special order or a longerterm, three- to five-year contract. We first assume that this order for 100 units of Product XX is a short-term, special order. As a result, its feasibility is determined using the cash flow or the resources available or acquired approach: The order will be acceptable if the net cash inflow of $40,000 exceeds the net resources needed to be acquired to manufacture and ship 100 units of Product XX. Panel E of Table 9 provides the cash outflow implications of accepting this order. These cash outflows include the cost of hiring a second-shift machine operator for Machine A at a yearly salary of $24,960, the additional wages of $6,000 for Machine B s operator (representing the 400-hour productive capacity needed to manufacture 100 units of Product XX on Machine B in the second shift), and the additional wages of $795 for Machine B s operator (representing the 53-hour nonproductive capacity incidental to the manufacture of 100 units of Product XX on Machine B). 23 There are no cash flow implications for any other nondirect, materialrelated resources needed to manufacture and ship 100 units of Product XX. As a result, all things being equal, the short-term order for 100 units of Product XX would be approved because the expected cash inflow of $40,000 exceeds the expected total cash outflow of $37,755 [$6,000 direct material + $31,755 other costs]. Table 7: Facts relating to the new order of 100 units of Product XX Machine A Machine B Production of Product XX (units) 100 100 Standard LHs/MHs needed for 1 unit of Product XX 3 4 Standard LHs/MHs for production of 100 units of Product XX 300 400 Yield losses (LHs/MHs) 12 8 Setups, etc. (LHs/MHs) 40 40 Repairs, etc. (LHs/MHs) 5 5 Total expected nonproductive time (LHS/MHs) 57 53 Expected LHs/MHs needed to produce 100 units of Product XX 357 453 On the other hand, assume that the customer wants to arrange for a five-year commitment to supply 100 units of Product XX each year. As this is a long-term order, its feasibility is determined using the accrual or the resources used approach: The order will be acceptable if the yearly revenue of $40,000 over five years exceeds the expected cost of resources needed to manufacture and ship 100 units of Product XX over the same five years. As a result, Panels B and C provide details regarding the long-term cost of manufacturing 100 units of Product XX. For example, using the labor and overhead rates determined in Panels A of Tables 2 5, Panel B reveals the cost of productive capacity (i.e., at standard cost) that would be used in the manufacture of 100 units of Product XX, and Panel C reveals the cost of nonproductive capacity that is expected to be incidental to the manufacture of 100 units of Product XX. As a result, all things being equal, the long-term order for 100 units of Product XX would not be approved because the expected yearly revenues of $40,000 fall short of the yearly cost of resources expected to be used of $59,082 [$6,000 direct material + $53,082 other costs]. The divergence in results is caused by the difference in the assumptions used for determining the feasibility of short- vs. long-term contracts. For a short-term contract, only those resources that need to be acquired to complete the order are acquired. As a result, no addi- MANAGEMENT ACCOUNTING QUARTERLY 30 WINTER 2006, VOL. 7, NO. 2