Idle capacity and abnormal costs

Idle capacity and abnormal costs: an example year

A plant has fixed production overheads of 2,400,000 a year and a normal capacity of 120,000 units, so overheads are absorbed at 20 a unit. A six-week strike cuts output to 100,000 units. Separately, a contaminated delivery of resin ruins a batch of 3,000 units, whose materials cost 15 each. The plant's normal scrap rate of 2% is built into its standard costs.

If the manufacturer had spread the full 2,400,000 over the 100,000 units made, each unit would carry 24 of overhead instead of 20, and closing stock would include part of the cost of the strike. IAS 2 prevents that: inventory carries only the cost of producing under normal conditions.

Which costs are abnormal?

• Abnormal waste: batches scrapped after a contamination, a machine failure or an operator error, beyond the normal scrap rate.
• Idle time: labour paid while lines stand still because of a breakdown, power cut or missing materials.
• Unabsorbed fixed overheads: when output falls below normal capacity, for example during a strike or a fall in demand.
• Rework of defective output beyond normal levels.

Normal levels of scrap, set-up time and planned maintenance shutdowns are part of making the product, so they stay in inventory cost. The line between normal and abnormal should be set in advance from the plant's history, not decided after the event.

What other costs does a strike cause?

Costs of extra security, temporary staff or penalties for late deliveries to customers are period costs, expensed as incurred. Penalties payable to customers under supply contracts may also be variable consideration that reduces revenue under IFRS 15, depending on the contract terms. Insurance recoveries for business interruption are recognised only when they are virtually certain, as a separate asset.

What about a new plant ramping up?

IAS 16 does not allow initial operating losses, or the costs of running a plant below full capacity while demand builds up, to be added to the cost of the plant. Once the plant is available for use, depreciation starts and output is costed at normal capacity: if a new line runs at 40% of normal capacity in its first months, the overheads not absorbed are expensed. Some manufacturers set a separate normal capacity for the ramp-up period; that is acceptable only where the ramp-up profile is planned and normal for that kind of plant, and it should be disclosed.

What happens when a line is mothballed?

A line taken out of use until demand returns stays in property, plant and equipment, and depreciation continues unless the line is fully depreciated, classified as held for sale or depreciated on a units of production basis. The costs of keeping it safe, such as security, insurance and maintenance to prevent deterioration, are expensed. Mothballing is an impairment indicator; see manufacturing plant impairment.

How are these costs treated in interim reports?

As at the year end. A strike in the first quarter is expensed in that quarter; deferring unabsorbed overheads in the hope that higher output later in the year will absorb them is not appropriate under IFRS. US GAAP differs here: under ASC 270, planned volume variances expected to be absorbed by the year end are often deferred at interim dates.

Where do abnormal costs appear in the income statement?

Usually in cost of sales, and disclosed separately when material, for example as costs of the strike or of the incident. Under IFRS 18, from 2027, they remain in the operating category; a manufacturer that excludes them from an adjusted operating profit shown in its results announcement would disclose that measure as a management-defined performance measure. See overhead absorption and normal capacity, standard costing and variances and manufacturing accounting.

This guide is general information. It is not tax or legal advice for your situation.