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ery and equipment and property taxes on the production plant
should be classified as manufacturing overhead costs.
To illustrate the effects of misclassifying manufacturing
costs, suppose that $480,000 of the company™s manufacturing
fixed overhead costs had been recorded in fixed operating
expenses instead of in fixed manufacturing overhead costs.
Otherwise, everything else remains the same as shown before
in the company example. Figure 18.2 shows the effects of this
misclassification error. Pay particular attention to the operat-
ing profit line, which is taxable income before the interest
expense deduction.
In Figure 18.2 fixed operating expenses are inflated by
$480,000 (from $2,300,000 to $2,780,000). This amount is
shifted from fixed manufacturing overhead costs, which
decreases from $2,100,000 to $1,620,000. Thus, $480,000 in
manufacturing fixed overhead escapes being charged to the
12,000 units produced, which decreases unit product cost by
$40, from $685 to $645.
Remember that 1,000 of the 12,000 units manufactured
during the year go into ending inventory, not out the door to
customers. Each of the 1,000 units carries $40 less in fixed
overhead cost, for a total of $40,000 less in ending inventory.
Operating profit, or taxable income before interest, is $40,000
less as the result of the misclassification error, so income tax
for the year would be less. In one sense, we have cooked the
books to record $40,000 less in operating profit simply by
reclassifying some costs away from manufacturing.*

*Although it would be rather unusual, a manufacturer could start and end
the period with no inventory, in which case profit would be the same no
matter how costs were classified”although for internal management
reports the proper classification of costs is always important.


Management Profit Report for Year
Sales Volume = 11,000 Units
Per Unit Total
Sales revenue $1,400 $15,400,000
Cost-of-goods-sold expense ($ 645) ($ 7,095,000)
Gross margin $ 755 $ 8,305,000
Variable operating expenses ($ 305) ($ 3,355,000)
Contribution margin $ 450 $ 4,950,000
Fixed operating expenses ($ 2,780,000)
Operating profit (earnings before
interest and income tax) $ 2,170,000

Manufacturing Costs for Year
Annual Production Capacity = 12,000 Units
Actual Output = 12,000 Units
Basic Cost Components Per Unit Total
Raw materials $ 215 $ 2,580,000
Direct labor $ 260 $ 3,120,000
Variable overhead $ 35 $ 420,000
Fixed overhead $ 135 $ 1,620,000
Total manufacturing costs $ 645 $ 7,740,000

Distribution of Manufacturing Costs
11,000 units sold (see above) $ 645 $ 7,095,000
1,000 units inventory increase $ 645 $ 645,000
Total manufacturing costs $ 7,740,000
FIGURE 18.2 Misclassification of manufacturing costs.

Target sales prices may be determined by marking up unit
product cost a certain percent. Thus, managers should be very
clear regarding whether all manufacturing overhead costs are
included in the calculation of unit product cost. If not, the
markup percent should be adjusted since it would be based on
an understated unit product cost. The better course of action
would seem to be to properly classify all manufacturing over-
head costs in the first place.


Most manufacturers have fairly large fixed manufac-
turing overhead costs”depreciation of plant and equipment,
salaries of a wide range of employees (from the vice president
of production to janitors), fire insurance costs, property taxes,
and literally hundreds of other costs. Fixed manufacturing
overhead costs provide production capacity. Managers should
measure or at least make their best estimate of the production
capacity provided by their fixed manufacturing overhead
costs. Capacity is the maximum potential production output
for a period of time provided by the manufacturing facilities
that are in place and ready for use.
Suppose the company™s annual production capacity were
15,000 units instead of the 12,000 units assumed in the pre-
ceding example. The business has correctly classified costs
between manufacturing and other operating costs. All other
profit and production factors are the same as before. The com-
pany manufactured only 12,000 units during the year. The
3,000-unit gap between actual output and production capacity
is called idle capacity. In short, the company operated at 80
percent of its capacity (12,000 units actual output · 15,000
units capacity = 80%). I should mention that 20 percent idle
capacity is not unusual.
Producing below capacity in any one year does not neces-
sarily mean that management should downsize its production
facilities. Production capacity has a long-run planning hori-
zon. Most manufacturers have some capacity in reserve to
provide for growth and for unexpected surges in demands for
its products. Our concern focuses on how to determine unit
product cost given the 20 percent idle capacity.
In most situations, 20 percent idle capacity would be con-
sidered within the range of normal production output levels.
So the company would compute unit product cost the same as
shown earlier. The 12,000-unit actual output is divided into
the $2.1 million total fixed manufacturing overhead costs to
get the fixed overhead cost burden rate, which is $175. This is
the burden rate included in unit product cost in Figure 18.1.
The theory is that the actual number of units produced
should absorb all fixed manufacturing overhead costs for the
year even though a fraction of the total fixed manufacturing
costs were wasted, as it were, because the company did not


produce up to its full capacity. In this way, the cost of idle
capacity is buried in the unit product cost, which would have
been lower if the company had produced at its full capacity
and thus spread its fixed manufacturing costs over 15,000
The main alternative is to divide total fixed manufacturing
overhead costs by capacity. This would give a fixed overhead
cost burden rate of $140 ($2.1 million total fixed manufactur-
ing overhead costs · 15,000 units annual capacity = $140 bur-
den rate). In terms of total dollars, the company had 20
percent idle capacity during the year, so 20 percent of its $2.1
million total fixed overhead costs, or $420,000, would be
charged to an idle capacity expense for the year. This amount
would bypass the unit product cost computation and go
directly to expense for the year.*
Managers may not like treating idle capacity cost as a sepa-
rate expense because this draws attention to it. In the manu-
facturing costs summary, anyone could easily see that the
business produced at only 80 percent of its capacity and so
would be aware that the unit product cost is higher than if it
were based on capacity.

If, on the other hand, actual output were substantially less
than production capacity, the fixed overhead burden rate

should not be based on actual output. The idle capacity cost
definitely should be reported as a separate expense in the
internal management profit report. (External financial reports
seldom report the cost of idle capacity as a separate expense.)
The generally accepted accounting rule is that the fixed
manufacturing overhead burden rate included in the calcula-
tion of unit product cost should be based on a normal output
level”not necessarily equal to 100 percent of production
capacity, but typically in the 75 to 90 percent range. However,
it must be admitted that there are no hard-and-fast guidelines
on this. In short, some amount of normal idle capacity cost is

*Cost-of-goods-sold expense would be $7,150,000 (11,000 units sold — $650
unit product cost = $7,150,000); idle capacity expense would be $420,000.
The total of these two would be $7,570,000, which is $35,000 more than
the $7,535,000 cost-of-goods-sold expense shown in Figure 18.1. In short,
operating profit would be $35,000 less and ending inventory would be
$35,000 less.


loaded into the unit product cost because the fixed overhead
burden rate is based on an output level less than full capacity.

The ideal manufacturing scenario is one of maximum produc-
tion efficiency”no wasted materials, no wasted labor, no
excessive reworking of products that don™t pass inspection the
first time through, no unnecessary power usage, and so on.
The goal is optimum efficiency and maximum productivity for
all variable costs of manufacturing. The current buzz word is
TQM, or total quality management, as the means to achieve
these efficiencies and to maximize quality.

Management control reports should clearly highlight produc-
tivity ratios for each factor of the production process”each
raw material item, each labor step, and each variable cost fac-
tor. One key productivity ratio, for instance, is direct labor
hours per unit. Ten to fifteen years ago it took 10 hours to
make a ton of steel, but today it takes only about 4 hours; a
recent article in the New York Times commented that the rela-
tively low number of workers on the production floor of the
modern steel plant is remarkable.
The computation of unit product cost is based on the
essential premise that the manufacturing process is reason-
ably efficient, which means that productivity ratios for every
cost factor are fairly close to what they should be. Managers
should watch productivity ratios in their production control
reports, and they should take quick action to deal with the
problems. Occasionally, however, things spin out of control,
and this causes an accounting problem regarding how to deal
with gross inefficiencies.
To explain, suppose the company in the example had wasted
raw materials during the year. Assume the $2,580,000 total
cost of raw materials in the original scenario (see Figure 18.1)
includes $660,000 of wastage. These materials were scrapped
and not used in the final products. Inexperienced or untrained
employees may have caused this. Or perhaps inferior-quality
materials not up to the company™s normal quality control stan-
dards were used as a cost-cutting measure.
This problem should have been stopped before it


amounted to so much; quicker action should have been
taken. In any case, assume the problem persisted and the
result was that raw materials costing $660,000 had to be
thrown away and not used in the production process. The
preferred approach is to remove the $660,000 from the
computation of unit product cost, which would lower the
unit product cost by $55 ($660,000 wasted raw materials
cost · 12,000 units output = $55). The $660,000 excess raw
materials cost would be deducted as a onetime extraordinary
expense, or loss, in the profit report.
The wasted raw materials costs could be included in unit
product cost, but this could result in a seriously misleading
cost figure. Nevertheless, exposing excess raw materials cost
in a management profit report is a touchy issue. Would you
want the blame for this laid at your doorstep? It might be bet-
ter to bury the cost in unit product cost and let it flow against
profit that way rather than as a naked item for other top-level
managers to see in a report.

Standard Costs
Many manufacturing businesses use a standard cost system.
Perhaps the term system here is too broad. What is meant is
that certain procedures are adopted by the business to estab-
lish performance benchmarks, then actual costs are compared
against these standards to help managers carry out their con-
trol function.
Quantity and price standards for raw materials, direct
labor, and variable overhead costs are established as yard-
sticks of performance, and any variances (deviations) from the
standards are reported. Despite the clear advantages of stan-
dard cost systems, many manufacturers do not use any formal
standard cost system. It takes a fair amount of time and cost
to develop and to update standards.


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