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Administrative Studies
ADMS 3510
Jamison Aldcorn

CHAPTER 9. EFFECTS OF DENOMINATOR LEVEL ON INVENTORY VALUATION Capacity choice -> denominator level -> price and cost Denominator levels: a complex decision w/ complex effects - Supply level constraints: a. Theoretical capacity: no delays b. Practical capacity: w/ idle time - Demand level constraints: a. Normal capacity: over specified time satisfying average customer b. Master capacity: satisfy customer demand for budget cycle for tax purposes These affect balance sheet and income statement Note: DOL increases for mechanization and DOL decreases for labour intensive Manager’s decisions: a. acquire all capacity b. make acquisition 1. Choose the budge period 2. Compute the fixed overhead cost allocation rate(s) 3. Select benchmark, standard or budgeted cost allocation base quantities 4. Select homogenous inputs for other fixed cost allocation bases 5. Analyze and select homogenous cost pools 6. Analyze and select capacity alternative to use in production-volume cost allocation base: a. Capacity supply ( theoretical > practical) i. Capacity management ii. Inventory value iii. Product cost (COGM) iv. Product price ( full absorption) b. Capacity demand ( normal > = master budget) i. Performance evaluation ii. Internal variance ( fixed overhead) iii. External governance iv. Financial reporting The decision framework and denominator choice If actual production is less than theoretical capacity because there is no demand or production is interrupted, the production-volume variance will be high and indicated opportunity cost of idle productive capacity. This is a non-value added cost for which a customer will not pay. Practical capacity reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays, safety inspections and so on. This type of scheduled idle capacity is often called off-limits idle capacity. Practical capacity is not constant over the life of the equipment. Process redesign can improve labour efficiency, wait time for materials and scheduling which would increase practical capacity Note: often, the difference between theoretical and practical capacity is off-limits idle capacity. Downtime : setups – non productive idle capacity: this is not off limits because it can be minimized with excellent scheduling or used to accomplish other value-added activities. Note: excess non- productive capacity can be used in other revenue- generating ways until demand growth accelerates (designing new products to fill unused capacity or leasing out unused capacity to others). Increased demand by customers may not only be for the product but for the services customized to their needs. Difference between the two demand level: time period- long for normal and short for master Effects on reporting, costing, pricing and evaluation Production volume variance= (denominator level in output units – actual output units) x budgeted fixed manufacturing overhead rate per output unit Page 8 : income statement effects of alternative denominator levels Product costing: For internal cost and price control: Practical capacity is often used to calculate the budgeted fixed manufacturing cost, but not appropriate for marketing functions . Budgeted fixed manufacturing cost refers to cost of supplying the capacity Product pricing: the downward demand spiral Progressive reduction in capacity use, which leads to an increase in the fixed overhead rate- i.e. realized quanitity in the master- bu
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