By Dennis Caplan, University at Albany (State University of New York)


CHAPTER 16:  Fixed Manufacturing Overhead



Chapter Contents:

-                      Alternative denominator levels

-                      Production incentives

-                      The allocation of fixed overhead and management decision-making

-                      Annie’s Soup Company

-                      Exercises and problems



Recall the steps to product costing:


1.                  Identify the cost object;

2.                  Identify the direct costs associated with the cost object;

3.                  Identify overhead costs;

4.                  Select the cost allocation base for assigning overhead costs to the cost object;

5.                  Develop the overhead rate per unit for allocating overhead to the cost object.


This chapter focuses on steps #3 through #5 for fixed manufacturing overhead.



Alternative denominator levels:

It is possible to allocate overhead separately for fixed overhead and for variable overhead, and there are sometimes good reasons to do so. When fixed and variable manufacturing overhead are allocated separately, there are important issues related to how the denominator of the fixed overhead rate is calculated. Alternative denominator choices are:


Theoretical capacity: This measure of factory capacity assumes 100% efficiency 100% of the time. It is analogous to the EPA miles-per-gallon estimates that are determined for new automobiles; nobody actually achieves this gas mileage in day-to-day driving, but the EPA estimates are useful for comparison shopping.


Practical capacity: This measure of factory capacity reduces theoretical capacity for anticipated unavoidable operating interruptions, including routine maintenance.


Normal capacity: This denominator-level concept measures the level of factory activity that satisfies average customer demand over an intermediate period of time. It frequently averages over seasonal or cyclical fluctuations in demand. As discussed in the previous chapter, Generally Accepted Accounting Principles now require companies to allocate fixed production overhead based on the “normal capacity” of the production facilities for external financial reporting purposes. The definition of normal capacity provided here is similar in concept to the definition provided in SFAS No. 151, although the definition in the pronouncement provides some latitude and encompasses a range of production levels.


Budgeted production: This denominator-level concept has been introduced previously. It is the level of factory activity budgeted for the upcoming period.


Because fixed costs, by definition, do not depend on the level of output, the numerator in the fixed overhead rate is not expected to differ across these four denominator choices. Since there is no cause-and-effect relationship in the short run between the estimation of the numerator and the quantity of the allocation base in the denominator, the larger the denominator, the smaller the amount of fixed overhead costs that are allocated to each unit of product.


This situation contrasts with variable overhead. In fact, for variable overhead, the numerator cannot be estimated until the denominator is estimated. For example, an apparel factory cannot accurately estimate electricity expense for the coming year until it predicts the amount of time the machines will run, and this estimate depends on the projected level of production. Hence, for variable overhead, the allocation base is chosen, then the quantity of the allocation base is estimated, and then variable overhead costs are estimated.



Production Incentives:

Many accounting writers have emphasized the effect that the allocation of fixed overhead can have on managerial incentives to overproduce. When fixed overhead is allocated to product, the greater the production level, the lower the fixed cost per unit. The lower fixed cost per unit might increase perceived profitability, but is the company really more profitable?


The answer to this question depends on what happens to the additional inventory. If the company is producing more inventory than it can sell, and is consequently stockpiling finished goods inventory, then clearly the company is not more profitable. This situation arises in Eliyahu Goldratt’s business novel The Goal (coauthored with Jeff Cox). Factory management in the novel is so committed to maximizing output and minimizing per-unit production cost, that they rent a warehouse to store large quantities of excess inventory.


On the other hand, if the factory can sell all of the goods that it produces, then as production increases, the factory really does become more profitable. Furthermore, when fixed costs are allocated to product, this increased profitability is reflected in the lower per-unit cost.


The key question, then, is whether managers, companies, or factories with incentives to overproduce can stockpile inventory without negative repercussions. It would seem that in the business environment of the past several decades, this risk has been overrated. Excess inventory is highly visible, physically and on the balance sheet, both for managerial accounting and financial reporting purposes. Hence, while it is important for managers and management accountants to be aware that the allocation of fixed overhead can provide incentives to overproduce, the risk posed by these incentives probably need not dictate the decision of whether to allocate fixed overhead for management accounting purposes. (Recall from Chapter 15 that for financial accounting purposes, companies must allocate fixed manufacturing overhead.)


The Allocation of Fixed Overhead and Management Decision-Making:

A more difficult question than perverse production incentives is whether the allocation of fixed overhead assists or hinders sourcing, marketing and pricing decisions. This question, which can be characterized as a debate of the merits of absorption costing versus contribution margin analysis, has probably generated more controversy than any other issue in management accounting. Following are three views from prominent accounting faculty.


In the second edition of his textbook Managerial Accounting (copyright 2004), James Jiambalvo, Dean of the Business School at the University of Washington, states that the major limitation of activity-based costing is that most companies use ABC to develop the full cost of products (Chapter 6, p. 208). Jiambalvo also offers only one answer to the question of why GAAP requires absorption costing: that “company managers may be concerned that variable cost information will prove helpful to competitors” (Chapter 5, p. 169). It is clear from these statements and others in his textbook that Professor Jiambalvo perceives little benefit from absorption costing for managerial decision-making.


Robert Kaplan, Professor at Harvard University, participated in a Panel Discussion on contribution margin analysis at the Annual Meeting of the American Accounting Association. Professor Kaplan, who was one of the most persuasive early advocates of activity-based costing and one of the originators of the Balanced Scorecard (discussed in Chapter 24), commented:


Interestingly, many companies have resisted for the most part the attempts by academic accountants to convince them to ignore their fixed costs. … Most companies persist in performing full cost allocations.

- Journal of Management Accounting Research, 1990 (Fall), p. 4


In fact, surveys suggest that for internal reporting purposes, approximately 50% of companies use variable costing and 50% use absorption costing.


In 1989, John Shank participated in the same panel discussion as Bob Kaplan. Professor Shank’s comments included the following:


I now believe at the broadest possible level that my [former] support for the contribution margin concept was misplaced and short-sighted. … I have been looking for some big successes from contribution margin analysis for 25 years, and I have come up empty. … In fact, it almost seems to be axiomatic, and let me call it Shank’s Axiom.


                     If the problem is small enough so that contribution margin analysis is relevant then it can’t have a very big impact on a company.

                     And if the possible impact in a decision setting is major, if it can really affect a company in a major way, then it’s silly to consider most of the factors to be fixed.


… Not only can I find no notable big successes from contribution margin concepts in the real world, I can point to many examples of what I consider to be notable failures from the application of the contribution margin mind-set. … I believe that more than one entire industry has competed itself to the brink of insolvency using contribution-based pricing.

- Journal of Management Accounting Research, 1990 (Fall), p. 17


Professor Shank refers to the trucking and airline industries in the years following their deregulation as two examples to illustrate his point. If an airplane is about to leave the gate with empty seats, the marginal cost of adding additional passengers to fill those seats is almost zero (a small increase in fuel consumption, and a few bags of pretzels, perhaps). Hence, an airline applying contribution margin analysis will make every effort to try to fill the plane to capacity, including offering deeply-discounted, last-minute fares. However, it is an open question as to whether the numerous bankruptcies and near-bankruptcies that have occurred in the airline industry in the years following deregulation resulted from a “contribution margin mind-set,” as Professor Shank suggests, or rather from the underlying economic characteristics of the industry. Given overcapacity in the industry, the fact that airlines have high fixed costs and low variable costs, and the fact that airlines have difficulty differentiating the services that they offer from their competitors, it is not clear that any one airline would have improved its situation using a full costing approach to pricing.



Annie’s Soup Company:

The following fictional example illustrates the general nature of the debate between contribution margin analysis and absorption costing.


Annie’s Soup Company manufactures twelve types of soup in its facility in Eureka, California. Each soup is produced on its own equipment, in a portion of the facility dedicated exclusively to it. The facility is running at 70% of capacity.


Annie’s Soup Company has traditionally reported the full cost of products for internal performance evaluation purposes, allocating facility-level costs to each product based on machine hours. Annie’s philosophy is to encourage product managers to set sales prices that will support the company’s overall profit targets, and she believes that full costing supports this objective. If facility-level costs were not allocated, then each product might show a profit, yet the company as a whole could show a loss.


The product manager of the cream soup line has proposed a new product: a cream spinach soup that would be called Annie’s Ultimate Spinach soup. The product manager admits that initial demand for this product probably would not support a sales price that would cover the full cost of the product including an allocation of facility-level costs. However, the product manager convinces Annie that because the facility has excess capacity, the new soup should be required to meet only its marginal costs (unit-level, batch-level and product-level costs in the cost hierarchy, but not facility-level costs). At a sales price of $1.75 per can to retailers, without an allocation of facility-level costs the profit margin would be $0.25 per can, but with facility-level costs allocated to Ultimate Spinach soup, it would be projected to show a loss of $0.25 per can.


The product manager’s argument persuades Annie to approve the production of Ultimate Spinach soup, and to evaluate it, at least initially, based on a cost that excludes facility-level costs.


The following year, the product manager of the tomato-based soups proposes a new tomato bisque soup. She asserts that since the latest soup introduced by the cream soup manager does not have facility-level costs allocated to it, neither should her new tomato bisque. Annie agrees.


Three years pass. The situation is now as follows. The company has 14 soups. Twelve soups have facility-level costs allocated to them, two do not. Is this situation acceptable, and if not, what should be done about it?


The current situation seems problematic. Annie cannot directly compare profitability across all 14 soups. As time passes, and as the date each soup was introduced becomes less salient, it is increasingly difficult to view Annie’s Ultimate Spinach Soup and the Tomato Bisque as the “marginal products.” In any case, as discussed in Caplan, Melumad and Ziv (The Denim Finishing Company, Issues in Accounting Education, 2005), it is not at all clear that contribution margin analysis can be effectively applied by always treating the newest product as the marginal product.


Should Annie start allocating facility-level overhead to all 14 products? If so, there is no obvious point in time at which to initiate this allocation to the two new products. Furthermore, if one of the new products shows a loss when facility-level costs are allocated to it, and if the factory still has excess capacity, it is not clear that the unprofitable product should be dropped. Marginal cost analysis applied to the decision of whether to drop a product is as relevant now as the initial marginal cost analysis that supported introducing the product in the first place.


Should Annie stop allocating facility-level overhead to all 14 products, and convert to a variable costing approach to product profitability analysis? The disadvantage of this approach is that without an allocation of facility-level costs, each of the 14 products could generate a positive contribution margin, which might be viewed positively by each of the product managers, yet the company as a whole could still be unprofitable. Rather, full costing helps ensure that product managers attempt to set sales prices that support the company’s overall profitability goals.



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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010


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