Fixed overheads do not fall when output falls. If they are spread over actual output, unit cost rises in a weak year and falls in a strong one, and product costs stop being comparable. CAS-2 fixes this by tying overhead absorption to a stable measure of capacity.
Capacity measures
| Measure | Meaning |
|---|---|
| Installed capacity | Maximum output of a facility under ideal conditions, as per the manufacturer’s specification or a technical assessment |
| Normal capacity | Output expected on average over several periods under normal circumstances, after allowing for planned maintenance and normal stoppages |
| Actual capacity utilisation | Output actually achieved in the period |
| Idle capacity | Normal capacity less actual capacity utilisation |
| Abnormal idle capacity | Idle capacity arising from abnormal causes, such as a strike, breakdown or lack of orders beyond normal levels |
Capacity is expressed in units of output, machine hours or another measure suited to the process.
Absorption of fixed overheads
Fixed production overheads are absorbed on the basis of normal capacity. Where actual production exceeds normal capacity, absorption is on actual production, so that inventory is not valued above cost.
Example. A line has normal capacity of 1,00,000 units and fixed overheads of ₹30 lakh. Output this year is 75,000 units.
- Absorption rate = 30,00,000 ÷ 1,00,000 = ₹30 per unit
- Absorbed in product cost = 75,000 × 30 = ₹22,50,000
- Unabsorbed (idle capacity) cost = ₹7,50,000, charged to the costing profit and loss account
If the overheads were spread over actual output, unit overhead would be ₹40, overstating product cost by a third.
Why it matters
- Pricing and quotations use a cost that does not swing with temporary volume changes.
- Inventory valuation follows the same principle under AS 2 / Ind AS 2.
- Cost audit reports capacity and utilisation, and treats loading of idle capacity cost onto products as non-compliance.
- Cost of production certificates under CAS-4 rely on normal capacity absorption.
Disclosure
Cost statements should disclose installed and normal capacity, actual utilisation, the basis of determination and the cost of abnormal idle capacity.