Optimizing Your Business’ Performance with Capacity Management

what is Capacity ManagementWhen it comes to business operations and measuring performance, the optimal production scale a company can sustain is an important metric to measure. If a business’ capacity can’t be realized and sustained – or the bottlenecks can’t be identified and addressed in a timely manner – a business will likely stagnate and fail. Understanding more about capacity management can help businesses reduce the chances of dealing with sub-optimal performance.

Capacity Defined

A business’ capacity is defined as its highest level of production on a consistent basis. By measuring the capacity of a business, we can calculate its ongoing revenue projections. This type of evaluation also can help a company determine how to manage production snarls and identify ways to increase capacity reserves to help it manage abnormally high production demands. 

Capacity Utilization Rate Defined

This ratio is the percentage of a business’ production capacity that’s currently utilized. If an organization has a capacity utilization rate of 60 percent, the firm is currently operating at 60 percent of its theoretical capacity. When it comes to analyzing a business, this percentage can determine how much capacity may be available for spikes in demand.

This is calculated by taking the actual output and dividing it by theoretical output, with the result multiplied by 100, or as follows:

(actual output/theoretical output) x 100 = capacity utilization rate

Activity Capacity Overview

Activity capacity assesses the scale of production of a particular task over a given time frame (a quarter, six months, or a 12-month fiscal year) while accounting for regular production factors. Common facets of production that affect output include worker rest periods, equipment upkeep, crew swaps, etc. This investigation allows a business to determine if it can accomplish projected production in the near term with existing equipment or if the business needs to analyze bottlenecks before reassessing.

Budgeted Capacity

This method is used to approximate the manufacturing quantity scheduled for subsequent time frames. Criteria that’s analyzed for the plan hinges on forecasted market demand, resource availability and production capabilities. It’s an imperative consideration that impacts sales forecasts, indirect operational budgets, and the direct production budget.

Depending on the type of business, budgeted capacity can be represented in either hours or units. For example, a company would evaluate industry and economic demand trends, along with the time frame it’s trying to forecast and what resources the business has available for production. The following steps are commonplace during this process:

Step 1:

  • The business plans to produce 480,000 widgets for the projected time frame.

Step 2:

  • The business looks at how many shifts will be run, how much each shift can produce, how many days the company will operate, and the number of hours available for production for each shift. This will help the company determine production and resource availability for the projected time frame.  

Step 3:

  • The business will look at what it’s able to produce based on its full capacity:
  • Potential per shift = 100 widgets per hour x 8 hours a shift x 1 shift = 800 widgets
  • Potential per day = 800 widgets per shift x 3 shifts per day = 2,400 widgets
  • Annual production = 2,400 widgets per day x 275 working days per year = 660,000 widgets

Conclusion

The budgeted production of 480,000 widgets annually is approximately 73 percent of the business’s total production capacity. This leaves the business with ample room to respond to new clients and/or increased demand from existing clients for unexpected orders.

While each business is unique, taking steps to analyze and make more educated projections is one way to increase a company’s efficiency.

Defining Materiality in Accounting

Materiality in AccountingIn the world of accounting and auditing, there is a concept called materiality. The term materiality essentially means an amount that, if erroneously omitted or included, impacts the financials of a company to the point where they don’t tell the truth. One very basic example would be if a $1 million revenue small business made a mistake recording their accounts payable, and as a result, the business has $100,000 of expenses missing from their results. This would be material. If the same exact mistake happened in a multi-billion multinational company, it would not.

When it comes to materiality in accounting, there are many nuances that need to be considered when evaluating and determining what’s material and what’s not. One way to look at materiality from an accountant’s perspective is to determine how much a particular transaction (such as a purchase) or event (such as a lawsuit) will have on a company’s financial performance. Whether it’s an omission or a mistake in calculating and reporting such an event, the way an accountant evaluates and decides how to proceed with reporting the information (or not) can make a big difference in whether or not such information is material or immaterial.

Another way to look at whether information is material or immaterial is to determine if omitting (or through an accounting mistake) such information would mislead or change a person’s actions regarding the company (investing in, providing a loan to the company, etc.). If omitting the information would influence an outside party’s decision, it would be material. If including the mistake would not change an outside party’s decision regarding the company, it would be immaterial.

One consideration is the benchmark a company uses to determine if a transaction or event would trigger a materiality classification. For example, net profit, operating income, total assets/shareholder’s equity, gross profit, or gross revenue are commonly used. However, it’s important to keep in mind that operating income might not be the best metric if the business loses money, breaks even, or is modestly profitable.

When it comes to looking at net income and a loss, what matters is how big of a percentage the loss represents against the net income. If there’s a $10,000 loss of inventory (for example, due to a termite infestation of a special type of wood) at a furniture manufacturer that has annual sales of $100 million, it would be immaterial and not necessary to report it on the income statement. However, if this occurred at a start-up furniture factory with a net income of $50,000, it would be a 20 percent loss and would certainly make a material impact to investors, lenders, etc.

Documenting Decisions

The next step is for accountants to document their judgments and the reasons why they made each type of documentation. It’s a way for the internal financial managers or the auditor to determine what was done and why. One example looks at whether or not to depreciate or expense an item – for which the materiality depends on the item’s cost.

If an office desk costs $125, depreciating the office desk seems impractical and would likely be classified as a business expense during a company’s tax year. However, depending on the size of a business’ net income, a start-up may consider it material, but an established, publicly traded consumer staple corporation buying the same item would likely consider it immaterial.

Determining (im)materiality is often a judgment call by the financial experts within a company and the auditors who evaluate companies’ financial statements. With a consistent approach, businesses can make measured decisions for their internal and external audiences.

How the 2022 Consolidated Appropriations Act Impacted Accounting in 2023

2022 Consolidated Appropriations ActAccording to the Centers for Medicare & Medicaid Services’ report “Advancing Rural Health Equity,” the 2022 Consolidated Appropriations Act (CAA) maintained telehealth options due to the COVID-19 Public Health Emergency (PHE) order for 151 more days beyond the original expiration of the Covid-19 PHE. Medicare recipients will benefit from the extension of telehealth services. This legislation will also permit Medicare to pay for telehealth services provided by Federally Qualified Health Centers and Rural Health Clinics.

The 2023 Consolidated Appropriations Act extends, through 12/31/2024, the following telehealth flexibilities authorized during the COVID-19 public health emergency. Healthcare providers are permitted to bill Medicare for telehealth services regardless of Medicare patients’ residence. Examples of providers include audiologists, speech-language pathologists, physical therapists, and occupational therapists. Telehealth coverage will also remain available for mental health services through 2024.

During March 2020, the U.S. Centers for Medicare & Medicaid Services (CMS) lengthened the Covid-19 Accelerated and Advance Payments (CAAP) Program to more medical suppliers under Part A and Part B. Such accelerated and advanced payments are remittances to both Part A and Part B providers in the case of interruptions to submissions and processing of claims. This can happen during man-made or natural disasters as a means to speed up cash flow to healthcare suppliers and providers. The CARES Act (P.L. 116-136) offers greater flexibility via increased time lines and payment sums through the expanded CAAP program for providers.

Based on the Continuing Appropriations Act, 2021, and Other Extensions Act, while the CMS no longer accepts accelerated or advance payments, permitted providers will have repayment begin 12 months after each provider or supplier’s accelerated or advance payment is issued.

One important consideration when it comes to accounting for these types of transactions is party consideration. Primarily, these transactions involve more than simply the purchaser and merchant. When it comes to medical services, and especially Medicare and Medicaid, there’s the patient, the direct service provider (doctor, nurse, admin staff, etc.), the facility (in or out of network consideration), and the private or government-based administered entity. The point here is that when it comes to revenue recognition, there needs to be explicit delineation for which party delivers services to the patient (and when) and how each party recognizes revenue based on their arrangement(s) with the patient.  

As for recognizing revenue, the relationships between the patient and the different providers are important due to when the entities are able to recognize revenue — generally when the material/service/product is delivered/satisfied. This is where records are important to keep and analyze on the accounting end so there can be proper reconciliation as to when the product/service has been fulfilled and when it’s recognized by the appropriate entity for revenue recognition procedures.

While there’s no cut-and-dried method to account for the evolving way payments are made, it’s important to keep up with state and federal legislation. Always check with your accountant to stay current with the latest updates to these laws.

Understanding Operating and Capital Leases

What is Operating Capital and Capital LeasesThe first thing to define is what a lease itself is. It’s an agreement or contract where one party, the lessor, allows another individual or business, the lessee, to use their asset in return for payments or different assets. The next step is to define the following types of leases. The two types covered in this article are operating and finance (or capital) leases.

International Financial Reporting Standards (IFRS)

IFRS does not differentiate between operating and capital leases. However, depending on if the loan has certain characteristics of transferring generally accepted rewards and risks, it would resemble what’s otherwise considered a finance lease. When it comes to Canadian Accounting Standards for Private Enterprises (ASPE) and Generally Accepted Accounting Principles (GAAP), the terms capital lease and finance lease can be used interchangeably.

Operating Leases

Operating leases are used when the client wants to rent and not purchase. During and once the lease is up, the lessor is always in possession.

It can be cheaper to rent – and sometimes renting is the only option for small or medium-sized businesses that are unable to purchase assets. Another advantage for businesses is that they can stay competitive by being able to upgrade their assets since they don’t own it. Along with lessees generally only having to pay for asset maintenance costs, operating expenses for the leased assets are likely tax-deductible because they’re considered business costs. Agreements normally last three-quarters of an asset’s estimated economic life, and the present value of lease payments is usually less than 90 percent of an asset’s fair market value.

Finance (Capital) Leases

Once this agreement’s term is up, the lessee owns the formerly leased asset. Unlike an operating lease, it provides the lessee an opportunity to purchase the asset below fair market value through a bargain purchase option. It also differs in that the contract’s term spans a minimum of three-quarters of the asset’s estimated useful life. If the present value of the lease payments is at least 90 percent of the asset’s original cost, it qualifies as this type of loan.

Determining the Loan Type

Looking through the lens of IFRS, one way to decide what type of a lease to enter is to calculate the present value of the smallest lease financial obligations. Taking the following loan terms, we can determine what percentage of the minimum lease payments are of the asset’s fair value when the lease is signed. Here’s an example.

On the first day of the year, a business signed a lease agreement for five years for equipment that has a fair value of $150,000 and has an interest rate of 8.75 percent. A single installment of $33,750 will be paid at the start of each year. The equipment will be returned to the lessor at the end of the lease. The asset’s useful life is five years, with no residual value. The company chooses the straight-line depreciation method.

Since the equipment will be returned to the lessor, the bargain purchase option doesn’t apply. Also, since the economic life is five years and the lease term are the same length, it’s 100 percent, rendering the asset to have no alternative use once the lease is completed. Therefore, we can determine the present value as follows:

Number of Periods (NPER) = 5 annual payments over the loan’s life

Rate = 8.75 annual interest rate

FV = 0 (future value)

PMT = $33,750 (single payment per 12-month period)

Type 1 = (payment is made at the beginning of the year)

Calculated using Excel, the present value is $143,693. This present value divided by the initial cost means that the asset’s fair value when leased is 95.8% ($143,693/$150,000)

Based on this calculation, with the least lease payments’ net present value well above the 90 percent minimum threshold, it would be considered a finance or capital lease.