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Alternative measures of capacity

One primary cause of underapplied or overapplied overhead is a difference in budgeted and actual costs. Another cause is a difference in the level of activity or capacity chosen to compute the predetermined overhead and the actual activity incurred. Capacity refers to a measure of production volume or some other activity base. Alternative measures of activity include theoretical, practical, normal, and expected capacity. 

The estimated maximum potential activity for a specified time is the theoretical capacity. This measure assumes that all factors are operating in a technically and humanly perfect manner. Theoretical capacity disregards realities such as machinery breakdowns and reduced or stopped plant operations on holidays. Choice of this level of activity provides a probable outcome of a material amount of underapplied overhead cost.

Reducing theoretical capacity by ongoing, regular operating interruptions (such as holidays, downtime, and start-up time) provides the practical capacity that could be achieved during regular working hours. Consideration of historical and estimated future production levels and the cyclical fluctuations provides a normal capacity measure that encompasses the long run (5 to 10 years) average activity of the firm. This measure represents a reasonably attainable level of activity, but will not provide costs that are most similar to actual historical costs. Thus, many firms use expected annual capacity as the selected measure of activity. Expected capacity is a short-run concept that represents the anticipated activity level of the firm for the upcoming period, based on projected product demand. It is determined during the budgeting process conducted in preparation of the master budget for that period.

If actual results are close to budgeted results (in both dollars and volume), this measure should result in product costs that most closely reflect actual costs and, thus, an immaterial amount of underapplied or overapplied overhead.
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