Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Capacity Related Main Page | Cost
Allocation Main Page | Overhead Related Main Page
This is one of Howard Greer's informative and amusing fables, based on an actual case. It's about a company with an idle widget-making machine whose owner disagrees with the consultant (Greer) about what to do with the idle capacity costs. It is applicable to questions related to choosing the basis for overhead rates, how to treat capacity costs and pricing decisions.
The Waxahatchie Widget Company rented a small building and installed two widget-making machines. Each machine has the capacity to produce 500 widgets per hour or 1 million widgets based on a forty hour week, fifty weeks per year. The two machines provide total capacity of 2 million widgets annually. Labor and materials costs are ten cents per unit. Other factory costs (assumed to be fixed) are expected to be $300,000 per year. The total costs of producing 2 million widgets would be $500,000, or 25 cents each. The first year the company produced 1 million widgets and sold 600,000 widgets for 40 cents per widget. A competitor sells a similar product for 35 cents.
The questions are related to how to value the 1 million widgets and how to determine the company's income or loss for the year? Should the idle capacity costs be charged to the inventory as product costs, expensed, or treated as a loss? The variable costs are $100,000 for material and labor (1,000,000 @ .10) and the overhead is $300,000. Selling and administrative expenses are $30,000. The owner (based on the advice of his auditors) wants to value the inventory at 40 cents per unit. This would leave $160,000 in the ending inventory and show a loss of $30,000. The consultant (Greer) argues that the ending inventory should be valued at only $100,000 because $60,000 represents idle capacity costs. The two views are presented below.
| Consultant's (Greer's) View |
Auditor's & Owner's View |
|||
| Sales | $240,000 | $240,000 | ||
| Material and Labor | 100,000 | 100,000 | ||
| Factory Overhead | 300,000 | 300,000 | ||
| Less Ending Inventory (400,000) | 100,000 | 300,000 | 160,000 | 240,000 |
| Gross profit | -60,000 | 0 | ||
| Less Selling & Adm Expenses | -30,000 | -30,000 | ||
| Net Loss | -90,000 | -30,000 | ||
The owner says he is planning to raise the price of widgets to 50 cents. Greer argues that there is a fallacy in the auditor's and owner's assumptions about inventory valuation and pricing.
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Related summaries:
Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).
Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).
Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).
McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).