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How Manufacturers Should Account for Excess Capacity

Feb 5, 2019

Just as consumers have to abide by the load capacity of their washers and dryers, manufacturers should set up their businesses to handle certain production capacities. Based on past and projected future sales levels, they invest in machines, buildings, materials, and laborers to meet anticipated needs. In spite of these investments, a manufacturer sometimes experiences low demand levels resulting in excess capacity. As a result, the manufacturer loses efficiencies and profits. Fortunately, there are ways that companies can mitigate the effects of excess capacity. Let’s discuss two in greater detail.

Estimating Standard Capacity

Excess capacity can be fleeting or a long-term situation. The reason for the excess capacity will often determine the length of the lowered demand. A manufacturer that has built its business around the demand created by peak popularity may find that it has locked itself into a position of consistent excess capacity that needlessly increases operating costs. Management at a manufacturing company should determine the company’s standard or normal capacity. This capacity is based on a percentage (typically 80% to 85%) of the maximum efficient production of a facility. The production capacity should take into consideration downtime for repairs, labor shortages, and other unforeseen events.

Account for Product Costs in Times of Reduced Capacity

The issue of accounting for product costing in times of diminished demand is that the manufacturer’s fixed overhead dollars allocated to each production unit should not increase because of unusually low production volumes. If a manufacturer dilutes its fixed product costs over a high capacity that is underutilized, it creates a higher than necessary cost per unit. The accounting rules answer the problem: the portion of the fixed production overhead costs that are attributable to the excess capacity are not considered a part of the cost of the produced inventory. Instead, those costs are considered a part of the cost of goods sold and reported in the period in which they are incurred. By following the accounting rules to accurately determine unit costs, a company can prevent wide variations in inventory costs and, in turn, bring more consistency to its financial statements.

CRI Can Help Your Manufacturing Company Account for Excess Capacity

CRI understands the accounting principles that affect your manufacturing business and is ready to help you account for excess capacity—unless it’s related to your laundry.

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