Examining Fixed Manufacturing Costs and Production Capacity
Product cost consists of two distinct components: fixed manufacturing costs and variable manufacturing costs. The production capacity refers to the people and physical resources needed to manufacture products — these are fixed manufacturing costs.
In the image below, note that the company’s variable manufacturing costs are $410 per unit, and its fixed manufacturing costs are $350 per unit. Now, what if the business had manufactured ten more units? Its total variable manufacturing costs would have been $4,100 higher.
The actual number of units produced drives variable costs, so even one more unit would cause the variable costs to increase. But the company’s total fixed costs would be the same if it had produced ten more units, or 10,000 more units, for that matter. Variable manufacturing costs are bought on a per-unit basis, whereas fixed manufacturing costs are bought in bulk for the whole period.
Fixed manufacturing costs are needed to provide production capacity for the period. After the business has the production plant and people in place for the year, its fixed manufacturing costs cannot be easily scaled down. The business is stuck with these costs over the short run. It has to make the best use it can from its production capacity.
Production capacity is a critical concept for business managers to stay focused on. You need to plan your production capacity well ahead of time because you need plenty of lead-time to assemble the right people, equipment, land, and buildings. When you have the necessary production capacity in place, you want to make sure that you’re making optimal use of that capacity.
The burden rate
The fixed cost component of product cost is called the burden rate. In the manufacturing example, the burden rate is computed as follows:
$42,000,000 fixed manufacturing costs for period ÷ 120,000 units production output for period
= $350 burden rate
Note that the burden rate depends on the number divided into total fixed manufacturing costs for the period — that is, the production output for the period.
The production capacity of the business example in the figure is 150,000 units for the year. However, this business produced only 120,000 units during the year, which is 30,000 units fewer than it could have. In other words, it operated at 80 percent of production capacity, which is 20 percent idle capacity:
120,000 units output ÷ 150,000 units capacity
= 80% utilization, or 20% idle capacity
This rate of idle capacity isn’t unusual — the average U.S. manufacturing plant normally operates at 80 to 85 percent of its production capacity.
The effects of increasing inventory
Looking back at the numbers shown in the figure, the company’s cost of goods sold benefited from the fact that it produced 10,000 more units than it sold during the year. These 10,000 units absorbed $3.5 million of its total fixed manufacturing costs for the year, and until the units are sold, this $3.5 million stays in the inventory asset account (along with the variable manufacturing costs).
It’s entirely possible that the higher production level was justified — to have more units on hand for sales growth next year. But production output can get out of hand.
Managers (and investors as well) should understand the inventory increase effects caused by manufacturing more units than are sold during the year. In the example shown in the figure, the cost of goods sold expense escaped $3.5 million of fixed manufacturing costs because the company produced 10,000 more units than it sold during the year, thus pushing down the burden rate.
The company’s cost of goods sold expense would have been $3.5 million higher if it had produced just the number of units it sold during the year. The lower output level would have increased cost of goods sold expense and would have caused a $3.5 million drop in gross margin and earnings before income tax. Indeed, earnings before income tax would have been 27 percent lower ($3.5 million ÷ $13.2 million = 27 percent decrease).