Between Normal Capacity Utilization and Expected Actual Capacity Utilization which Activity Level to Be Used for Capacity Management? In calculating an overhead rate, a great deal depends on the activity level selected. The greater the assumed activity, the lower the fixed portion of the overhead rate, because fixed overhead be spread over a greater number of direct labor dollars hours etc.
Capacity Management: Normal Capacity Vs. Expected Actual Capacity–> The variable portion of the rate will tend to remain constant at various activity levels. Determination of estimates used in deriving a factory overhead rate depends on whether a long or short range viewpoint is adopted i.e. whether the activity level used is :
(1) normal capacity or
(2) expected actual capacity.
Normal Capacity Utilization : The long-range or long-term planning and control approach in capacity management or normal capacity concept advocates that an overhead rate in which expenses and production are based on average utilization of the physical plant over a time period long enough to level out the highs and lows that occur in every business venture. A rate based on normal capacity utilization will not change because of changes in actual production; therefore it results in a more useful unit cost. The rate will be changed when prices of certain expense items change or when fixed costs increase or decrease.
A normal capacity rate concept assumes that the rate should not be changed because existing plant facilities are used to a greater or lesser degree. A job or product should not cost more to produce in anyone accounting period just because production was lower and fixed charges were spread over a fewer number of units. The calculation of normal capacity rate follows procedures described earlier. Factory overhead and bases used are estimated in terms of normal production figures.
In most instances under capacity management, the use of a normal rate causes applied expense to differ from actual expenses incurred. The possibility of such a difference or variance must be recognized, but this should not serve to discourage the use of an overhead rate or encourage the change of this rate. In fact, when this variance, generally called over- or under-applied factory overhead, is further analyzed, it reveals much useful capacity management information.