A.  Facts of the Case

1.  A public sector company has six manufacturing units spread all over India.  Every unit has many divisions.

2.  The cost of inventory is determined on the following basis:

(a)  Direct material based on actual issues determined on the basis of work orders/shop orders which are identifiable with products.

 

(b)  Direct labour hours booked based on the job cards.

 

(c)   All other expenses (excepting the exclusions in the accounting policy given below) are treated as shop overheads and are allocated to the product produced in those shops based on labour hours.

3. The manufacturing units have achieved the planned production on an overall basis though within the same manufacturing unit, in some divisions there has been higher production while in others there has been lower production. There are certain periods of idle capacities during the year due to delays in receipt of orders and/or the customer/production related issues.  The capacities created in the divisions are also to a certain extent interchangeable in-principle.

4. The accounting policy of the company regarding the manufactured items, stock-in-trade and work-in-progress is as below:

“Manufactured items in stock and stock-in-trade are valued at cost excluding interest charges, administration overheads and sales overheads, or at the realisable value whichever is less.”

 

“Work-in-process (production) is valued on the basis of physically verified quantities at cost excluding interest charges, administration overheads and sales overheads, or at the realisable value whichever is less.”

 

5.  The auditors have expressed a view that the total overhead cost to be allocated should be arrived at after deducting cost attributable to the idle capacity/idle labour from the total fixed cost.

6.   The company’s view, based on paragraph 9 of the Accounting Standard (AS) 2, ‘Valuation of Inventories’, is that unless the idle time is because of the abnormal situations/reasons like strike, etc., there is no need to deduct the cost attributable to the idle labour/capacity from the total overheads.  Paragraph 9 of AS 2 specifically provides for the cost of conversion being based on ‘normal capacity’ which has been described as “the production expected to be achieved on an average over a number of periods or seasons under normal circumstances”.  It also provides for actual level of production being used if it approximates normal capacity.  The company’s view is that since the total production has been increasing, as also the capacity utilisation, AS 2 does not contemplate any deduction towards the cost of idle capacity.

7.  The querist has stated that in certain cases particularly when new technologies are absorbed there could be an increase in idle hours due to the manpower being rendered surplus which cannot be absorbed in the short run, or, even in a comparatively long run by public sector undertakings (PSUs). Rigid interpretation of the term ‘capacity’ giving emphasis on the idle hours without reckoning the increased production would act as disincentive to the absorption of new technologies and may not be called for given that production has, in fact, increased.

B.  Queries

8.  The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a)   Whether ‘installed capacity’ should be treated as synonymous to ‘normal capacity’.

 

(b)   Whether the ‘capacity’ is to be determined only in terms of labour hours.

 

(c)   Suggest a method for quantification of the idle capacity in case the same is to be separated from the overhead expenses.

 

(d)   Any other point/methodology to be considered in view of the revised AS 2 that is mandatory.

C. Points Considered by the Committee

9.   The Committee restricts itself to the particular issues raised in the query and has not gone into the appropriateness or otherwise of any other accounting aspect such as the accounting policy followed by the company.

10. The Committee is of the view that the ‘capacity’ of production facilities is usually determined in terms of number of units of production or in terms of direct labour hours taking into consideration the number of direct labour hours required to produce each unit of production.

11. The Committee notes paragraph 9 of the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’, which states as below:

“9.  The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities.  Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.  The actual level of production may be used if it approximates normal capacity.  The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant.  Unallocated overheads are recognised as an expense in the period in which they are incurred.  In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost.  Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.”

12. As per paragraph 9 of AS 2, normal capacity is the level of production that an enterprise expects to achieve on an average over a number of periods under normal circumstances.  The Committee is of the view that the installed capacity or the actual capacity utilisation of the production facilities does not necessarily reflect the production that is expected to be achieved over a number of years, assuming normal circumstances.  The Committee is further of the view that normal capacity should be assessed taking into account, inter alia, normal level of efficiency that is expected to be achieved considering the actual working conditions (as distinct from efficiency level based on ideal conditions) in normal circumstances, and estimated loss of production due to planned maintenance.  Thus, the normal capacity, which might be determined in terms of direct labour hours, would take into account the normal idle time.  The idle time due to abnormal reasons such as due to delay in receipt of orders, etc., should not be considered in determination of normal idle time and the normal capacity should be determined accordingly.

13. In case where new technologies have been adopted, the normal capacity should be determined with reference to the period when the plant would reach the stage of stability.  The normal capacity so determined should form the basis of allocation of fixed production overheads even during the initial years of working of the plant when the actual capacity utilisation may be lower than the normal capacity.

14. For the purpose of calculating the extent of fixed production overheads to be included in the cost of production, a fixed production overhead absorption rate is computed by dividing the total fixed production overheads by the normal capacity as determined in accordance with paragraphs 12 and 13 above.  This rate should be applied to the actual units of production for absorption of the same in the cost of production.

15. The fixed production overheads that remain unabsorbed/unallocated represent the abnormal costs which should be expensed in the year in which they are incurred.

16. In terms of capacity, the abnormal idle capacity would be represented by the difference between the normal capacity and the actual capacity utilised.

D. Opinion

17.  On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8:

(a) The ‘installed capacity’ may not often represent the ‘normal capacity’. The normal capacity should be determined in accordance with the principles stated in paragraphs 12 and 13 above.

 

(b) The ‘capacity’ may not necessarily be determined in terms of labour hours.  It may be determined in terms of the units of production, etc.

 

(c) The idle capacity represents the difference between the normal capacity and the actual capacity utilised.  The idle time due to abnormal reasons such as due to delay in receipt of orders, etc., should not be considered in determination of normal idle time and the normal capacity should be determined accordingly.  The overhead expenses relating to idle capacity should be expensed in the period in which they are incurred.

(d) Apart from the above, there are no other points.

1Opinion finalised by the Committee on 25.9.2000.