Characteristics of Normal Volume

        Many accountants reject the normal-volume notion and maintain that each year must .stand by itself; that is, each year's overhead must be applied to each year's production, written off as a loss, or both. This attitude arises from (a) the widespread conviction that the year is the key time period, and (b) adherence to the idea that overhead costs for a given year generally must cling or attach to the units produced during that year regardless of the relationship of that year's activity to average long-run activity.
     A more convincing reason for using master-budget volume as a denominator is the overwhelming forecasting problem that accompanies the determination of normal volume'. Sales not only fluctuate cyclically but have trends over the long run. In effect, the use ol normal volume implies an unusual talent for accurate long-run forecasting. Many accountants and executives who reject the normal volume as a denorninator ciaim that the nature of their company's business precludes accurate forecasts beyond one year.
Where companies use normal volume, the objective is to choose a period long enough to average out sizable fluctuations in volume and to allow for trends in sales. The uniform rate for applying fixed overhead supposedly provides for "recovery" of fixed costs over the ions run. Companies expect that overapplications in some years will be offset by underapplications in other years.
       Conceptually, when normal volume is the denominator, the yearly overapplied or underapplied overhead should be carried forward on the balance sheet. Practically, however, year-end balances are closed directiy to Income Summary, because the accounting profession (and the Internal Revenue Service) generally views the year as being the terminal time span for allocation olunderapplied or overapplied overhead.

      Many managements want to keep running at full capacity, which really means practical capacitv. Their "normal volume" for applying fixed costs is "practical capacity"; anything less reduces profits and is undesirable. Where product costs are used as guides lor pricing, some managers say that this policy results in more competitive pricing, which maximizes truth volume and profits in good times and bad. Of course, profits also depend on lactors other than physical volume-for example, the elasticity of demand. The accounting effects of such a policy are lower unit costs for inventory purposes and the almost perpetual appearance of an unfavorable production volurne variance, sometimes described on the income statements as loss from idle capacity.
     Using practical capacity as a denominator volume has become increasingly popular with American businesses. As indicated earlier, over 21 percent of the surveved companies prefer to use practical capacity. A major reason is probably the position of the internal Revenue Service, which forbids variable costing but per- mits using practical capacitv as a denominator volume in conjunction rvith absorption costing. As compared with normal volume or master-budget volume, the practical- capacity denominator volume results in the faster write-offs of fixed factory overhead as a tax deduction.
     There is no requirement that American companies use the same denominator volumes for internal managernent purposes and for income-tax purposes. Nevertheless, the economies of recordkeeping often lead to the same accountiug for management and tax purposes.

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Characteristics of Capacity

The choice of a capacity size is usually the result of capital-budgeting decisions, which are reached after studying the expected impact of these capital outlays on operations over a number of years. The choice may be influenced by a combination of two major factors, each involving trade-off decisions and each heavily depending on long-range forecasts of demand, material costs, and labor costs:

1. Provision for seasonal and cyclical fuctuations in demand. The trade-off is between (a) additional costs of physical capacity and (b) the costs of inventory stockouts and/or the carrying costs of inventory safety stocks of such magnitude to compensate for seasonal and cyclical variations, the costs of overtime premium, sirbcontracting, and
2. Provision for upward trends in demand. The trade-off is between (a) the costs of con- structing too much capacity for initial needs and (b) the later extra costs of satisfying demand by alternative means. For example, should a factory designed to make color television tubes have an area of 100,000. 150,000, or 200,000 square feet?

Although it can be defined and measured in a particular situation, capacity is an illusive concept. Consider, for example, the following:

Capacity planning requires definition and measurement of capacity in a manner relevant to questions which arise in the planning process. This problem has two aspects. First, it is necessary to specify capacity in terms of how much the company should be prepared to make and to sell. Second, the capacity ofspecific facilities available or to be acquired must be determined... A variety of altemative combinations of capacity and operating patterns is usually possible

There is much fluidity in the quotation above. To most people, the term capacity 'implies a constraint, an upper limit. We sometimes hear, I'm working at capacity now. I simply can't do more.This same notion of capacity as a constraint is commonly held in industry.

Although the term capacity is usually applied to plant and equipment, it is equally applicable to other resources, such as people and materials. A shortage of direct labor, executive time, or materials may be critical in limiting company Production or sales.

The upper limit of capacity is seldom absolutely rigid, at least from an engineering viewpoint. That is, ways-such as overtime, subcontracting, or paying premium prices for additional materials-can usually be found to expand production. But these ways may be totally unattractive from an economic viewpoint. Hence, the upper limit of capacity is specified by management for current planning and control purposes after considering engineeting and economic factors. In this way, the upper limit is usually imposed by management' not by external forces'

Measurement of capacity usually begins with theoretical capacity (also-called maximum or ideal capacitv) that assumes the production of output 100 percent of the time. Then deductions are made for sundays, holidays, downtime, changeover time' and similar iterns to attain a measure of practical Capacity. The latter is defined as the maximum level at which the plant or department can operate efficiently. Practical capacity often allows for unavoidable operating interruptions such as repair time or waiting time (downtime).

Two other commonly used levels of capacity utilization are

1. NOrmal volume, which is the level of capacity utilization (which is less than 100 percent of practical capacity) that will satisfy average consumer.demand over as pan of time (often five years) that includes seasonal, cyilical, and trend factors; and
2. Master-budget Volume, which is usually the anticipated level of capacity utilization for the coming Year. There are apt to be differences in terms used between companies so be sure to obtain their exact meaning in a given situation. For example, master-budget volume is often called expected annual volume or expected annual capacity or expected annual activity or master-budget activity.

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