Determination and Impact of Normal Capacity on Stock Valuation

CA Bharat Sonkhiya, CA Nitin Sharma & Keshav Agarwal – [2023] 157 taxmann.com 511 (Article)

To begin with, Let’s take an example involving three employees, Neel, Nitin and Mukesh, working at a Law Firm in three different divisions. The firm has an outstation task that requires all three divisions to participate. Let us assume the total task has an installed capacity of 100%, which should be divided between the three as 33.33% each. The fixed cost of each division is Rs. 1,00,000. The workload allocation is as follows: Neel handles 60% of the work, Nitin manages 30%, and the remaining tasks fall to Mukesh. This distribution is not appropriate as Mukesh is working at below-normal capacity, so the fixed cost allocation will be severely imbalanced if we do not account for the concept of normal capacity. Neel is working at the above-normal capacity so costing will be much lower in the case of Neel. Muskesh’s divisions will not be competitive because of this inappropriate allocation of cost due to lesser work. To make the allocaiton of fixed cost meaningful let’s move on to the concept of normal capacity.

The concept of normal capacity often gets overlooked due to its subjectivity, making it challenging to establish a definitive standard. It has been seen that entities usually do not follow this concept because of a lack of clarity and tricky calculations. However, its significance cannot be overlooked. Normal capacity greatly influences the cost per unit of a product, its competitive edge and the basis of determination of selling price of the product.

When not factored into fixed overhead allocation, it can distort the true and fair view in the entity’s Books of Account, impacting stakeholders’ perception of its performance. Therefore, understanding and accurately applying normal capacity is pivotal for presenting a true and fair view of the entity’s accounts.

Let us understand the following terms as per Cost Accounting Standard 2 (CAS-2):

(a) “Installed capacity” refers to the maximum level of output or production that a business or facility can sustain under normal operating conditions. It represents the highest achievable level of production based on the company’s machinery, technology, and infrastructure.

(b) “Achievable Capacity” is the maximum productive capacity of a plant reduced by the predictable and unavoidable factors of interruption about internal causes. Thus, achievable capacity is the installed capacity minus the inevitable interruptions due to time lost for preventive maintenance, repairs, set-ups, normal delays, weekly off-days and holidays etc.

(c) “Normal Capacity” is the production achieved or achievable on an average over a period or season under normal circumstances. It takes into account the loss of capacity resulting from planned maintenance. Normal capacity is achievable capacity minus the loss of productive capacity due to external factors.

(d) ‘Actual Capacity Utilization’ is the volume of production achieved about installed capacity.

(e) “Fixed cost” is referred to as the cost that does not register a change with an increase or decrease in the quantity of goods produced by the entity.

Relevant extracts of AS-2

As per para 13 of AS-2, in determining the cost of inventories it is appropriate to exclude the abnormal amounts of wasted material and labour and recognize them as expenses in the period in which they are incurred.

Costs that are incurred in the normal course of business in bringing such inventories to their location are allocated according to a normal level of activity. In case actual production is abnormally lower as compared to a normal level, the expenditure of a fixed nature is reduced in proportion to the shortfall and not allocated to inventories and considered as expenses.

As per para 9 of AS-2, The actual level of production may be used if it approximates normal capacity. The amount of fixed production overhead allocated to each unit of production is not increased as a result of low production or idle plant.

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