A key challenge in providing useful managerial accounting information is understand- ing and correctly analyzing an organization’s value-creating capacity and the costs of
providing that capacity. By capacity we mean the amount of resources a company applies to its value chain and the upper limit on the amount of goods or services that an organiza- tion can produce in a specified period of time using those resources. For example, how many iPhones can Apple’s suppliers manufacture in a month? Or how many people can Disney’s Magic Kingdom effectively accommodate in a day? Or how many cell phone calls or text messages can Verizon process in an hour?
Managers at Whole Foods Market must make many decisions about the amount of resources to provide. Each activity in their value chain brings capacity challenges, from how many supplier development managers to hire, to the size of the next store to be opened, to the staffing levels in each existing store.
For example, the company must spend money to train and employ cashiers. Every dollar spent on cashiers is a dollar of profit that will not be earned, so Whole Foods Market does not want to schedule more of cashier time than it has to. But if shoppers find checkout lines that are too long because there are not enough cashiers available to work, they will not find the shopping environment to be convenient and reliable and might go elsewhere to shop for groceries. But how should they balance the lost profit on grocer- ies against the cost of providing cashiers, especially when hiring and orienting a new employee and then training that employee as a cashier is such a significant investment?
This is the capacity dilemma faced by Whole Foods Market’s managers and accountants.
Let’s consider a very simple example of how to think about the costs of capacity.
There are various concepts of an organization’s capacity. Theoretical capacity refers to the upper limit on production of goods or services, for the amount of resources pro- vided, if everything works perfectly. This means that no cashiers miss time for illness, no cash registers break down, there are no unexpected interruptions such as power outages or severe storms, and so forth. Because such perfection is rarely achieved, most manag- ers believe that a more useful measure of capacity is practical capacity, which allows for normal occurrences such as equipment (cash register) downtime and worker (cashier) fatigue or illness.
Important questions for the managerial accounting system to address are (1) What is an organization’s practical capacity? (2) What are the costs of the resources supplied to provide that capacity? and (3) How have those resources been used in creating value?
To explore these issues, let’s focus on a familiar scenario, the pizza business. Some of Whole Foods Market’s bigger stores include a “pizza bar,” where pizzas can be pur- chased whole or by the slice. Let’s suppose you have taken a part-time job there making pizzas. You work the 6:00 to 8:00 p.m. shift three evenings a week, Monday, Wednesday, and Friday. In addition to the great fringe benefit of getting to eat the occasional free slice of pizza with your favorite toppings, you receive a wage of $11 an hour. So each evening that you work, you make $22.
After some training and a little experience, you can make a pizza in about six min- utes. This includes picking up a premeasured lump of pizza dough, patting it out, twirl- ing it ostentatiously over your head a few times, putting it down, covering it with pizza sauce, applying the cheese and other toppings, and tossing it in the oven. Making a pizza with “the works” takes longer than a plain cheese pizza, but for the typical combination of pizzas made on a typical evening, it averages out to six minutes. Also, the six-minute average time required per pizza allows for occasional mistakes, retrieving more toppings from the deli when they run out, taking short cell-phone calls, and other normal disrup- tions. You have no scheduled break during your short two-hour shift, so on a busy eve- ning you could make as many as 20 pies (120 minutes available ÷ the average 6 minutes per pizza).
So, using the terminology discussed above, the cost of the labor resources sup- plied for your two-hour shift is $22, and the practical capacity of that two-hour shift is 20 pizzas made.
Now suppose that during the first week of October, you experience very different levels of demand on your three evening shifts. Monday night football causes a steady demand for pizzas, and you make all the pizzas you can make, 20 of them, that evening.
Wednesday evening is pretty slow, and you make just 10 pizzas. Friday evening, which is
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“One of the problems today is that we rely on all these computer reports—we know what customers buy, and how rapid the sell- through is on any given item—but no report will tell you how much they would have bought if things had been different.” (1k)
Macy’s Learning Objective 1-8 Explain how investments in capacity affect managerial decision making.
normally very busy, is unusually slow because of a traffic jam that keeps many customers from reaching the store. You make just one pizza.
Now we can calculate the cost of your labor for a pizza during each of your three shifts. One fairly simple answer is to divide your labor cost per shift by the number of pizzas you made in each shift, as follows:
Let’s stop and think about this. Does this analysis make any sense? Most accountants and managers would argue that it does not make much sense to say that Monday’s pizzas cost $1.10 each for your labor, Wednesday’s cost $2.20 each, and the labor for the one pizza you made on Friday cost $22.00! This result highlights the problem of confusing the cost of a resource supplied with the cost of a resource used. The cost of your labor resource supplied during each shift was $22.00, but the cost of your labor resource used varied from shift to shift due to widely different demand levels.
The cost of your labor resource used should be computed as shown in column (c) of the following table. Moreover, the cost of your labor resource used per pizza is a constant
$1.10 per pizza, regardless of demand, as calculated in column (d). Finally, the cost of your labor resource unused (i.e., the cost of unused capacity) is calculated in column (e).
To best understand the table, start with column (a) and work across.
Think of it this way. On Monday, you produced 20 pizzas. On Friday, you produced one pizza—and a whole lot of wasted time! What did that wasted time cost Whole Foods Market? The $22 they paid you less the $1.10 that actually produced value that someone would pay for, or $20.90. (Also, 19 unmade pizzas × $1.10 = $20.90.) That’s the cost of unused capacity, not the cost of pizzas.
Unfortunately, it is not uncommon for managers to mistakenly act like all the money spent on production should be divided up over the products or services produced, without considering whether some of that spending was for resources supplied but unused.
The moral of the story is that it is very important to distinguish among the cost of resources supplied [column (b) above], the cost of resources used [column (c) above], and the cost of resources unused [column (e) above], which is the same as the cost of unused capacity. An important task for any management team, including the one at Whole Foods Market, is to understand and manage the cost of capacity. Providing them data about the costs of unused capacity gives them an important tool.12
12This is, of course, a very simple illustration, because it focuses on a single resource, i.e., the cost of one employee’s labor. Even an operation as simple as making pizzas involves many resources, such as pizza ingredients, possibly multiple employees, buildings and equipment, and advertising. Imagine how much more complicated capacity issues are for a major airline or a large manufacturer. Nevertheless, by studying the concepts of capacity and the cost of capacity in a very simple scenario, you should develop a basic understanding of this very important concept. For another example, see David Welch and Ian Rowley, “Risky Business at Nissan,” BusinessWeek, November 2, 2009.
(b) 2 hours × $11.00 per hour
(c) $22.00 × (pizzas made ÷ pizzas in practical capacity) (d) cost of labor resource used ÷ pizzas made (e) $22.00 − cost of labor resource used
(a) Shift
(b) Cost of Labor
Resource Supplied
(c) Cost of Labor Resource Used
(d) Cost of Labor Resource Used
per Pizza
(e) Cost of Labor Resource Unused (i.e., cost of unused
capacity)
Monday $22.00 $22.00[$22 × (20 ÷ 20)] $1.10($22.00 ÷ 20) $ 0.00
Wednesday 22.00 11.00[$22 × (10 ÷ 20)] 1.10($11.00 ÷ 10) 11.00
Friday 22.00 1.10[$22 × (1 ÷ 20)] 1.10($1.10 ÷ 1) 20.90
Shift Labor Cost Pizzas Made Cost per Pizza
Monday $22.00 20 $ 1.10
Wednesday 22.00 10 2.20
Friday 22.00 1 22.00