Before looking at how to calculate the production volume, capacity utilisation and efficiency ratios, it is useful to consider the concept of standard hours.
The standard hour
The standard hour is a useful concept in performance measurement. The definition of a standard hour is the amount of work achievable, at the expected level of efficiency, in an hour.
A company manufactures three products (A, B and C) in one of its production cost centres. It is expected that 10 units of product A can be manufactured per direct labour hour, 25 units of product B and 20 units of product C.
The standard hour and standard time of the products are therefore:
Standard time (the time required to make one unit)
0.1 hours or 6 minutes
0.04 hours or 2.4 minutes
0.05 hours or 3 minutes
The standard hour is especially useful as a common measure for combining heterogeneous (dissimilar) products so that manufacturing performance as a whole can be assessed.
The budgeted production of the three products (A, B and C) in period 1 is:
- Product A - 12,400 units
- Product B - 10,000 units
- Product C - 18,500 units
The total budgeted direct labour hours for period 1, based on the standard hour data above, is:
- Product A - 1,240 hours (12,400 units ÷ 10 units per hour)
- Product B - 400 hours (10,000 units ÷ 25 units per hour)
- Product C - 925 hours (18,500 units ÷ 20 units per hour)
Total budgeted direct labour hours: 2,565
It can be seen that the budgeted production of the three different products can be combined into an overall labour activity measure, and this also can be applied to the actual production volumes, using the same data about the standard hours of each product. This enables the effect of changes in the production mix to be measured.
In period 1 a total of 2,430 direct labour hours were worked and the actual production output of the three products was as follows:
- Product A - 13,300 units
- Product B - 9,600 units
- Product C - 18,000 units
Taking these actual results into account and the data concerning the standard hours of each product, the total expected direct labour hours for the actual production output in period 1 can be calculated as follows:
- Product A - 1,330 hours (13,300 units ÷ 10 units per hour)
- Product B - 384 hours (9,600 units ÷ 25 units per hour)
- Product C - 900 hours (18,000 units ÷ 20 units per hour)
Total expected direct labour hours for actual production: 2,614
This figure can also be called standard hours of actual production, standard hours produced or equivalent standard hours.
Using the above data about the budgeted direct labour hours, the actual direct labour hours and the standard direct labour hours of actual production, a series of ratios can be calculated to help measure and understand the performance of the cost centre as a whole in period 1. The ratios are:
- Production volume ratio
- Capacity utilisation ratio
- Efficiency ratio
Production volume ratio
The production volume ratio measures how the actual production output for a period, measured in standard direct labour hours, compares with the budgeted hours for a production cost centre. It is calculated as:
(Standard direct labour hours of actual production ÷ budgeted direct labour hours) × 100%.
2,614÷ 2,565 × 100% = 101.9%
A ratio of > 100% indicates above budget production volume and vice versa.
The production volume ratio can be further analysed by:
- The actual number of hours worked compared with budget (measured by the capacity utilisation ratio).
- The efficiency with which the output is produced (measured by the efficiency ratio).
Capacity utilisation ratio
The capacity utilisation ratio measures whether the total direct labour hours worked in a production cost centre in a period was greater or less than what was budgeted. It is calculated as:
(Actual direct labour hours worked ÷ budgeted direct labour hours) × 100%.
2,430 ÷ 2,565 × 100% = 94.7%
A ratio of > 100% indicates that more direct labour hours were worked than budget and vice versa.
The efficiency ratio measures whether the production output for a period in a production cost centre took more or less direct labour time than expected. It is calculated as:
(Standard direct labour hours of actual production ÷ actual direct labour hours worked) × 100%.
2,614 ÷ 2,430 × 100% = 107.6%
A ratio of > 100% indicates greater labour efficiency than budgeted and vice versa.
It can be seen, from the above ratios, that the actual output in the production cost centre in the period, measured in standard direct labour hours, was 1.9% higher than budget (it may be noted that the total number of product units manufactured was the same as budget, but the units of one product are not comparable, in terms of production effort, with another).
The over-budget production activity occurred despite the fact that utilisation of capacity was only 94.7% of the budgeted utilisation. This was because direct labour efficiency was 7.6% better than expected – ie fewer hours than expected were required to produce the actual output.
The relationship between the three ratios can be demonstrated as follows:
Production volume = [(Capacity utilisation × Efficiency) ÷ 100]
Written by a member of the Management Accounting examining team