Under-absorption, abnormal idle capacity and a below-cost export order
Vasanth Alloys Ltd runs a single blast furnace and rolling mill. For the year to 31 March 20X6 budgeted fixed production overhead was ₹1,200 lakh on a normal capacity of 60,000 machine hours, a recovery rate of ₹2,000 per machine hour. Actual fixed overhead was ₹1,245 lakh and actual machine hours were 48,000. The shortfall had two causes: the furnace lining failed in July and the relining contractor took five weeks (5,750 machine hours), and the state electricity board imposed a 20% power cut for eleven weeks (6,250 machine hours). The relining bill was ₹38 lakh: ₹22 lakh restored the lining to its original specification and ₹16 lakh bought a higher-grade lining that raises furnace output by 6% and stretches the relining interval from three years to five. Separately, the marketing manager has an export enquiry for 8,000 tonnes at ₹1,500 per tonne against a normal domestic price of ₹1,900; variable cost is ₹1,350 per tonne and new tooling costing ₹6 lakh would be needed. The CFO proposes to charge the entire under-absorption to inventory.
1. Compute the under-absorbed fixed overhead at 31 March 20X6 and recommend how each element should be treated in the cost records and the financial statements.
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Computation
- Recovery rate = ₹1,200 lakh ÷ 60,000 hours = ₹2,000 per machine hour.
- Absorbed = 48,000 × ₹2,000 = ₹960 lakh; under-absorbed = ₹1,245 − ₹960 = ₹285 lakh.
- Idle hours 12,000 = 5,750 relining + 6,250 power cut, i.e. ₹115 lakh + ₹125 lakh = ₹240 lakh.
- Residual = ₹285 − ₹240 = ₹45 lakh spending variance (actual ₹1,245 lakh vs budget ₹1,200 lakh).
Reasoning The 60,000-hour normal capacity already allows for planned maintenance and normal holidays. An unplanned lining failure and an external, uncontrollable power restriction are not normal operating conditions, so the 12,000 unutilised hours are abnormal idle capacity. Charging them to production would inflate inventory and unit cost, distort the cost sheet and mask the inefficiency from management.
Treatment
- ₹240 lakh - abnormal idle facility cost: exclude from cost of production, charge to the costing profit and loss account and disclose separately.
- ₹45 lakh - expenditure variance: analyse it; if uncontrollable or policy-driven, write it off rather than absorb it.
- If the 60,000-hour base had already assumed a relining shutdown this year and the failure merely brought it forward, the ₹115 lakh becomes normal and is absorbed; only the ₹125 lakh stays abnormal. Document that determination.
The CFO's proposal overstates inventory by up to ₹240 lakh and is a likely cost-audit qualification.
2. Should Vasanth Alloys accept the export order at ₹1,500 per tonne? Support your answer with relevant-cost analysis and state the conditions attached to your advice.
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Relevant cost
- Variable cost: 8,000 × ₹1,350 = ₹108.00 lakh
- Incremental tooling: ₹6.00 lakh
- Total relevant cost = ₹114.00 lakh; relevant revenue = 8,000 × ₹1,500 = ₹120.00 lakh
- Net incremental benefit = ₹6.00 lakh; break-even price = ₹114 lakh ÷ 8,000 = ₹1,425 per tonne.
Reasoning Fixed overhead of ₹1,200 lakh is unchanged by the order and the plant has 12,000 idle machine hours, so fixed cost is irrelevant. Full absorption cost per tonne is far above ₹1,500, but a one-off order priced above relevant cost adds contribution that would otherwise be lost. The order is at ₹1,500, well above the ₹1,425 break-even.
Conditions
- The order must not displace domestic sales at ₹1,900 (each displaced tonne costs ₹550 of contribution at the normal price).
- No overtime premium, incremental power or freight; tooling must not be reusable/recoverable elsewhere.
- The customer must not become a reference price for domestic buyers, and the destination must not expose the company to anti-dumping or countervailing action.
- If the order consumes more than the available idle hours, recompute against the displaced contribution.
Accept subject to the above; the ₹6 lakh margin is thin, so protect it with a firm, non-cancellable order.
3. How should the ₹38 lakh relining expenditure be accounted for, and what is the correct treatment of the lost production during the relining?
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Split the bill by the nature of the benefit
- ₹22 lakh restored the lining to its original specification. It creates no additional future economic benefit beyond the original standard of performance, so it is a repair and is expensed. Where the replaced lining was recognised as a separate component, derecognise its carrying amount; where it was never separately identified (common for refractory linings), expensing is the practical and acceptable outcome.
- ₹16 lakh purchased a higher-grade lining that raises output by 6% and stretches the relining cycle from three to five years. That is an enhancement meeting the recognition criteria, so capitalise it and depreciate over the shorter of the new five-year relining interval and the furnace's remaining useful life.
What not to do Do not carry the ₹38 lakh as 'deferred revenue expenditure'. Deferral of a cost that has no future benefit is not permitted, and creating an asset to smooth profit would also fail the cost-audit test of a consistent, defensible cost accounting policy.
Lost production The five weeks of lost output is not a cost of the asset: no cost was incurred to bring the furnace to working condition during that period. It is abnormal idle capacity, written off and disclosed as computed earlier. Borrowing cost, if any, can be capitalised only on the ₹16 lakh qualifying expenditure and only if the furnace is a qualifying asset under the company's policy.