A to Z Costing Knowledge Glossary — Letter E
Investopedia-style costing concepts explained with formulas, practical examples, comparisons, and exam-focused teaching tips.
1 Economic Order Quantity (EOQ)
| Category | Material Cost Management |
|---|---|
| Best Used In | Optimizing inventory ordering |
| Key Formula | EOQ = √(2 × Annual Demand × Ordering Cost / Holding Cost per unit) |
| Exam Importance | High |
Economic Order Quantity (EOQ) is the optimal order size that minimizes the total cost of ordering and holding inventory.
It balances the trade-off between ordering cost (which decreases with larger orders) and carrying cost (which increases with larger orders).
- Inventory procurement planning
- Reducing total material costs
- Just-in-time and lean management
A company with annual demand of 10,000 units, ordering cost ₹500 per order, and holding cost ₹20 per unit per year uses EOQ to find the optimal order size that minimizes total inventory costs.
Annual demand (D) = 12,000 units, ordering cost (S) = ₹200 per order, holding cost (H) = ₹30 per unit per year. EOQ = √(2 × 12,000 × 200 / 30) = √(1,60,000) = 400 units. Total minimum cost = (12,000/400)×200 + (400/2)×30 = ₹6,000 + ₹6,000 = ₹12,000.
Where: D = Annual demand, S = Ordering cost per order, H = Holding cost per unit per year
- Determine annual demand for the material.
- Identify ordering cost per order.
- Identify holding cost per unit per year.
- Substitute into EOQ formula.
- Use EOQ as optimal order size to minimize total cost.
| EOQ vs. Re-order Level | EOQ is order quantity; re-order level is the inventory level at which new order is placed. |
|---|---|
| EOQ vs. Just-in-Time | JIT aims for minimal inventory and frequent small orders; EOQ calculates the least-cost order size. |
2 Efficiency Variance
| Category | Standard Costing / Variance Analysis |
|---|---|
| Best Used In | Measuring resource utilisation efficiency |
| Key Formula | (Standard Quantity for Actual Output − Actual Quantity) × Standard Rate |
| Exam Importance | High |
Efficiency Variance is a general term for variances that measure the difference between the actual input used and the standard input that should have been used for actual output, valued at standard cost.
It focuses on the quantity or hours of resources (materials, labour, overhead) consumed compared to standard. It is often called usage variance for materials or labour efficiency variance for labour.
- Material usage variance analysis
- Labour efficiency variance analysis
- Overhead efficiency variance analysis
Standard material for 100 units = 500 kg; actual used 520 kg. Standard price ₹10/kg. Efficiency variance = (500-520)×10 = ₹200 adverse.
Standard labour hours for actual production 1000 hours; actual hours 950. Standard rate ₹80. Efficiency variance = (1000-950)×80 = ₹4,000 favourable.
- Compute standard quantity allowed for actual output.
- Record actual quantity used.
- Find the difference.
- Multiply by standard rate.
- Interpret favourable/adverse.
| Efficiency Variance vs. Rate Variance | Rate variance is price effect; efficiency variance is quantity effect. |
|---|---|
| Material Efficiency vs. Labour Efficiency | Same concept but applied to materials or labour respectively. |
3 Elements of Cost
| Category | Fundamental Cost Classification |
|---|---|
| Best Used In | Cost sheet, cost analysis |
| Key Formula | Total Cost = Material + Labour + Expenses + Overheads |
| Exam Importance | Very High |
Elements of Cost are the basic categories into which costs are classified, namely material, labour, and expenses, each further divided into direct and indirect.
These elements form the building blocks of cost accounting, enabling systematic cost collection and control.
- Preparation of cost sheets
- Classification of costs in ledgers
- Cost control and reduction
In a cost sheet, materials are split into direct material and indirect material; labour into direct labour and indirect labour; expenses into direct expenses and overheads. This helps in computing prime cost and total cost.
Direct material ₹50,000, direct labour ₹30,000, direct expenses ₹5,000 = Prime cost ₹85,000. Add factory overhead ₹20,000 = Works cost ₹1,05,000. Add admin overhead ₹10,000 = Cost of production ₹1,15,000. Add selling overhead ₹5,000 = Total cost ₹1,20,000.
- Identify all material costs and separate direct/indirect.
- Identify labour costs, separate direct/indirect.
- Identify expenses, separate direct/indirect.
- Sum direct elements to get prime cost.
- Add overheads to get total cost.
| Direct vs. Indirect Elements | Direct elements are traceable; indirect are overheads. |
|---|---|
| Elements of Cost vs. Cost Behaviour | Elements are by nature; behaviour is by variability. |
4 Engineered Costs
| Category | Cost Behaviour / Cost Estimation |
|---|---|
| Best Used In | Manufacturing with clear input-output relationships |
| Key Formula | Engineered Cost = Quantity of Inputs × Standard Price |
| Exam Importance | Low |
Engineered Costs are costs that have a direct, predictable relationship with output, based on engineering studies or technical specifications.
These are costs that can be precisely determined by the physical relationship between inputs and outputs, such as direct material usage per unit.
- Setting standard material and labour quantities
- Budgeting in manufacturing
- Cost control in repetitive production
A car manufacturer knows from engineering that each car requires 4 tyres. The engineered cost of tyres per car is 4 × price per tyre. This is used as a standard.
Standard: each widget requires 2 kg of steel and 0.5 labour hours. If steel costs ₹100/kg and labour ₹200/hour, engineered cost = (2×100) + (0.5×200) = ₹300 per widget.
- Determine the physical input-output relationship (e.g., kg per unit, hours per unit).
- Determine standard price or rate for each input.
- Compute engineered cost per unit.
- Use as standard for variance analysis.
- Update periodically based on engineering changes.
| Engineered vs. Discretionary Costs | Discretionary costs have no fixed input-output relationship (e.g., advertising); engineered costs do. |
|---|---|
| Engineered vs. Committed Costs | Committed costs are fixed and based on long-term commitments; engineered costs are variable and activity-based. |
5 Environmental Costing
| Category | Contemporary Costing |
|---|---|
| Best Used In | Sustainability accounting, environmental management |
| Key Formula | Total Environmental Cost = Prevention + Detection + Internal Failure + External Failure |
| Exam Importance | Low |
Environmental Costing is the identification, measurement, and allocation of costs related to environmental impact, including pollution prevention, waste management, and compliance.
It extends traditional costing to include environmental costs, helping businesses understand the financial impact of their environmental activities and improve sustainability.
- Environmental management accounting
- Cost of compliance with regulations
- Sustainable product costing
A company calculates the cost of waste treatment, emissions control equipment, and environmental fines separately, then allocates to products to understand true cost and identify reduction opportunities.
Total environmental costs: waste disposal ₹2,00,000, pollution control equipment ₹3,00,000, environmental training ₹50,000. Total ₹5,50,000 allocated to 10,000 units = ₹55 per unit.
- Identify all environmental-related costs (waste, emissions, compliance).
- Categorize as prevention, appraisal, internal/external failure.
- Allocate or apportion to cost objects.
- Compute environmental cost per unit.
- Use for decision making and sustainability reporting.
| Environmental Costing vs. Traditional Costing | Traditional costing ignores environmental impacts; environmental costing includes them. |
|---|---|
| Environmental Costing vs. Life-cycle Costing | Life-cycle costing covers all stages from cradle to grave; environmental costing focuses on environmental impacts. |
6 Equivalent Units
| Category | Process Costing |
|---|---|
| Best Used In | Valuation of work-in-process |
| Key Formula | Equivalent Units = Physical Units × Percentage of Completion |
| Exam Importance | Very High |
Equivalent Units is a process costing technique that converts partially completed units into the equivalent number of fully completed units.
It allows for the allocation of costs between completed units and ending work-in-process by expressing work-in-process in terms of equivalent completed units.
- Process costing with ending WIP
- Valuation of inventory
- Cost per unit calculation
At month-end, a process has 100 units of WIP that are 50% complete. These 100 units are equivalent to 50 fully completed units for cost allocation.
Completed units 1000, ending WIP 200 units 60% complete. Equivalent units = 1000 + (200 × 0.60) = 1120. Total cost ₹1,12,000. Cost per equivalent unit = ₹100. WIP value = 200 × 0.60 × 100 = ₹12,000.
- Identify completed units and ending WIP.
- Determine percentage of completion for WIP (usually separately for materials and conversion).
- Compute equivalent units for each cost component.
- Divide total costs by equivalent units to get cost per equivalent unit.
- Allocate costs to completed units and WIP.
| Equivalent Units vs. Physical Units | Physical units are actual count; equivalent units adjust for completion stage. |
|---|---|
| Weighted Average vs. FIFO Method | Both use equivalent units but differ in how they treat beginning WIP costs. |
7 Escalation Clause
| Category | Contract Costing |
|---|---|
| Best Used In | Long-term contracts affected by price fluctuations |
| Key Formula | Adjusted Price = Base Price × (Current Index / Base Index) |
| Exam Importance | Medium |
An Escalation Clause is a provision in a contract that allows for adjustment of the contract price based on changes in specified cost indices (e.g., material, labour) during the contract period.
It protects both contractor and client from unforeseen price increases or decreases, ensuring fair compensation over long-term projects.
- Construction contracts
- Long-term manufacturing supply agreements
- Projects with volatile input costs
A construction contract worth ₹10 crore includes an escalation clause tied to steel price index. If steel prices rise 10%, the contract price increases proportionately for the steel component.
Contract price ₹5,00,000 with escalation clause: 60% material, 20% labour, 20% fixed. Material price index rises from 200 to 220 (10% increase). Escalation for material = 60% × 10% = 6%. New price = 5,00,000 × (1 + 0.06) = ₹5,30,000 (plus labour if indexed).
- Identify components subject to escalation and their weights.
- Determine base index value at contract signing.
- Determine current index value at review date.
- Calculate percentage change for each component.
- Apply weights to compute total escalation and adjusted price.
| Escalation Clause vs. De-escalation Clause | Escalation allows increase; de-escalation allows decrease when indices fall. |
|---|---|
| Escalation Clause vs. Fixed Price Contract | Fixed price has no adjustment; escalation allows price changes based on indices. |
8 Estimated Cost
| Category | Cost Prediction |
|---|---|
| Best Used In | Quotations, bidding, budgeting |
| Key Formula | Estimated Cost = Estimated Quantities × Estimated Prices/Rates |
| Exam Importance | High |
Estimated Cost is a forecast of the expected cost of a product, job, or service, based on past experience, engineering estimates, or market data, before actual production.
It is a pre-determined cost used for planning, quotation, and decision making; it may not be as precise as standard cost but serves as a guide.
- Preparing quotations for customers
- Bidding for tenders
- Budget preparation
A contractor estimates that a project will cost ₹50,00,000 based on expected material, labour, and overhead. This estimate is used to submit a bid with a markup.
Estimated material ₹2,00,000, labour ₹1,50,000, overhead ₹50,000. Total estimated cost = ₹4,00,000. Quotation with 10% profit = ₹4,40,000.
- Identify the cost object and its specifications.
- Estimate quantities and rates for each cost element.
- Sum to get total estimated cost.
- Add profit margin to determine quotation.
- Use for planning and comparison with actual costs later.
| Estimated Cost vs. Standard Cost | Standard cost is scientifically predetermined; estimated cost may be based on rough judgement. |
|---|---|
| Estimated Cost vs. Actual Cost | Actual cost is incurred; estimated is predicted before incurrence. |
9 Exception Reporting
| Category | Management Reporting |
|---|---|
| Best Used In | Focusing management attention on significant variances |
| Key Formula | Exception threshold = Materiality limit (e.g., ±5% or absolute amount) |
| Exam Importance | Medium |
Exception Reporting is a management technique that focuses on reporting only significant deviations from plan or budget, allowing managers to concentrate on areas requiring attention.
It is based on the principle of “management by exception” — only variances that exceed a pre-determined threshold are reported in detail; everything else is assumed to be running smoothly.
- Budgetary control
- Standard costing variance reports
- KPI dashboards with alerts
A company sets tolerance of ±5% on departmental expenses. In a month, only two departments exceed this threshold; those two are highlighted in the exception report for management action, while other departments are not discussed.
Budgeted sales ₹5,00,000; actual ₹5,40,000 (8% favourable). Exception report flags this for investigation into cause (e.g., unexpected large order).
- Set tolerance limits for each metric.
- Compare actual performance with budget/standard.
- Identify variances exceeding limits.
- Prepare exception report listing only those variances.
- Management investigates and acts on exceptions.
| Exception Reporting vs. Routine Reporting | Routine reporting includes all data; exception reporting highlights only outliers. |
|---|---|
| Exception Reporting vs. Management by Exception | Management by exception is the principle; exception reporting is the tool. |
10 Exchange Rate Variance
| Category | Financial Costing / Variance Analysis |
|---|---|
| Best Used In | International transactions, import/export |
| Key Formula | (Actual Exchange Rate − Budgeted/Standard Exchange Rate) × Foreign Currency Amount |
| Exam Importance | Low |
Exchange Rate Variance is the difference in cost or revenue arising from fluctuations in foreign exchange rates between the time a transaction is budgeted and the time it is settled.
For companies dealing in foreign currencies, exchange rate movements can cause actual costs to differ from standard or budgeted costs.
- Import/export cost accounting
- Budgeting for foreign currency transactions
- Performance evaluation of international operations
A company budgets an import at $1 = ₹80, but actual rate at payment is $1 = ₹85. For a $10,000 purchase, exchange variance = (85-80) × 10,000 = ₹50,000 adverse.
Budgeted exchange rate 1 USD = ₹82, actual 1 USD = ₹79. For $5,000 payable, variance = (79-82) × 5,000 = -₹15,000 favourable (paying less).
- Determine standard/budgeted exchange rate.
- Determine actual exchange rate at transaction date.
- Identify foreign currency amount.
- Compute difference in rate and multiply by amount.
- Classify as favourable/adverse and analyze cause.
| Exchange Rate Variance vs. Price Variance | Price variance is due to supplier price change; exchange variance is due to currency fluctuation. |
|---|---|
| Exchange Rate Variance vs. Translation Difference | Transaction variance is on actual flows; translation is on financial statement consolidation. |
11 Ex-factory Price
| Category | Pricing / Incoterms |
|---|---|
| Best Used In | Setting base price excluding delivery and taxes |
| Key Formula | Ex-factory Price = Cost of Production + Profit Margin |
| Exam Importance | Low |
Ex-factory Price is the selling price of goods at the factory gate, excluding any transportation, insurance, loading, or other delivery charges.
It is the base price that the buyer pays for goods collected from the seller’s premises; all subsequent costs are borne by the buyer.
- Quoting prices for domestic sales
- Costing for products sold ex-works
- Comparison of factory prices across companies
A manufacturer quotes ₹500 per unit ex-factory. The buyer arranges and pays for transport, insurance, and other charges separately.
Cost of production ₹400, profit margin 25% = ₹100. Ex-factory price = ₹500. Buyer pays additional ₹50 for transport; total landed cost ₹550.
- Compute total cost of production per unit.
- Determine desired profit margin.
- Add profit to cost to get ex-factory price.
- Quote this price; buyer pays additional delivery costs.
- Use for comparison with other incoterms (FOB, CIF).
| Ex-factory vs. Ex-works | Both are essentially the same; Ex-works is the broader incoterm including all costs up to factory gate. |
|---|---|
| Ex-factory vs. FOB | FOB includes loading and transport to port; ex-factory excludes all delivery. |
12 Ex-works Price
| Category | Pricing / Incoterms |
|---|---|
| Best Used In | International trade, cost allocation |
| Key Formula | Ex-works Price = Total Cost to Make Goods Available at Factory |
| Exam Importance | Low |
Ex-works Price is the price of goods at the seller’s premises, where the buyer assumes responsibility for all transportation, insurance, and export formalities.
Under Incoterms, Ex-works (EXW) represents the minimum obligation for the seller; the buyer bears all costs and risks from the seller’s door onwards.
- International sales quotations
- Costing for domestic sales where buyer arranges pickup
- Simplifying seller’s responsibility
A seller quotes “Ex-works ₹1,000 per unit.” The buyer pays ₹1,000 and arranges for pickup, freight, insurance, and customs clearance.
Ex-works price ₹800/unit. Buyer pays freight ₹100, insurance ₹20, customs ₹50. Total landed cost ₹970, but seller only receives ₹800.
- Determine all costs to produce and make goods ready at factory.
- Add profit margin.
- Quote ex-works price.
- Buyer handles all subsequent logistics.
- Compare with other incoterms for decision making.
| Ex-works vs. Ex-factory | Essentially identical; ex-works is the official Incoterm, ex-factory is informal. |
|---|---|
| Ex-works vs. CIF | CIF includes cost, insurance, and freight to destination; ex-works includes none. |
13 Expense
| Category | Fundamental Accounting Concept |
|---|---|
| Best Used In | Period cost recognition |
| Key Formula | Expense = Cost that has expired or been matched to revenue |
| Exam Importance | High |
An Expense is a cost that has been used up or expired in the process of generating revenue during the current accounting period.
Expenses are reductions in economic benefits during the period, arising from outflows or depletions of assets (e.g., cost of goods sold, salaries, rent).
- Income statement preparation
- Period cost classification
- Matching principle application
When raw material is consumed in production, its cost becomes an expense (part of COGS) when the finished product is sold. Until then, it is an asset (inventory).
Salary paid for current month ₹50,000 is an expense. But purchase of machinery ₹5,00,000 is not an expense; it is capitalized and depreciated over time.
- Identify costs incurred during period.
- Determine which costs have expired (benefit consumed).
- Match those costs with revenues generated in same period.
- Record as expenses in income statement.
- Carry forward unexpired costs as assets (e.g., inventory, prepaid).
| Expense vs. Cost | Cost is the total sacrifice; expense is the portion used up in current period. |
|---|---|
| Expense vs. Expenditure | Expenditure is cash outlay; expense is recognised cost for the period, may be non-cash (depreciation). |
14 Explicit Costs
| Category | Cost Classification (Economic Cost) |
|---|---|
| Best Used In | Profit computation, economic analysis |
| Key Formula | Explicit Costs = Actual cash payments for inputs |
| Exam Importance | Low |
Explicit Costs are actual out-of-pocket payments made by a firm to purchase or hire resources from external parties, such as wages, rent, materials, and utilities.
These are the visible, recorded costs that appear in the accounting books and involve actual cash outflow.
- Accounting profit calculation
- Cash flow analysis
- Cost control
A business pays ₹1,00,000 for raw materials, ₹50,000 for wages, ₹20,000 for rent. These are explicit costs, recorded in accounts and used to compute accounting profit.
Explicit costs of a firm for a year: materials ₹5,00,000, labour ₹3,00,000, rent ₹2,00,000, utilities ₹50,000. Total explicit costs = ₹10,50,000. Accounting profit = Revenue − Explicit costs.
- Identify all cash transactions for inputs.
- Sum them to get total explicit costs.
- Deduct from revenue to get accounting profit.
- Compare with economic profit (which also considers implicit costs).
- Use for financial reporting.
| Explicit vs. Implicit Costs | Implicit costs are opportunity costs of owner’s resources; explicit are actual cash outlays. |
|---|---|
| Explicit vs. Sunk Costs | Sunk costs are already incurred and irreversible; explicit costs are current cash outlays. |
15 External Failure Costs
| Category | Cost of Quality |
|---|---|
| Best Used In | Quality management, customer satisfaction |
| Key Formula | External Failure Costs = Warranty + Returns + Complaints + Liability |
| Exam Importance | Medium |
External Failure Costs are costs incurred when a defective product or service reaches the customer, including warranty claims, returns, product liability, and lost sales.
These are the most expensive category of quality costs because they damage reputation and incur additional costs after delivery.
- Quality cost reporting
- Identifying need for better prevention
- Customer satisfaction improvement
A company tracks warranty claims, product returns, and customer complaint handling costs. These are external failure costs that indicate quality problems not caught earlier.
Warranty claims ₹2,00,000, returns ₹50,000, complaint handling ₹30,000, product liability ₹1,00,000. Total external failure costs = ₹3,80,000.
- Identify all costs arising after product delivery due to defects.
- Categorize into warranty, returns, complaints, liability.
- Sum to get total external failure costs.
- Analyze trends to justify investment in prevention.
- Use in COQ reporting.
| External vs. Internal Failure Costs | Internal failure costs are found before delivery (scrap, rework); external are after delivery. |
|---|---|
| External Failure vs. Appraisal Costs | Appraisal costs detect defects before delivery; external failure occurs when appraisal misses defects. |
16 Efficiency Ratio
| Category | Performance Measurement |
|---|---|
| Best Used In | Evaluating operational productivity |
| Key Formula | Efficiency Ratio = (Standard Hours for Actual Output / Actual Hours Worked) × 100 |
| Exam Importance | Low |
Efficiency Ratio is a measure of how effectively a company or department uses its resources, typically expressed as the ratio of standard hours allowed for actual output to actual hours worked.
It indicates productivity: a ratio above 100% means better than expected efficiency; below 100% indicates inefficiency.
- Labour productivity measurement
- Departmental performance evaluation
- Identifying areas for improvement
Standard hours for actual production = 2000; actual hours worked = 1800. Efficiency ratio = (2000/1800)×100 = 111.11%, indicating high efficiency.
Standard hours for output 1500, actual hours 1600. Efficiency ratio = (1500/1600)×100 = 93.75%, showing inefficiency of 6.25%.
- Compute standard hours allowed for actual output.
- Record actual hours worked.
- Divide standard by actual and multiply by 100.
- Interpret ratio relative to 100%.
- Use for performance reports.
| Efficiency Ratio vs. Capacity Ratio | Capacity ratio = actual hours / budgeted hours; efficiency ratio = standard hours / actual hours. |
|---|---|
| Efficiency Ratio vs. Activity Ratio | Activity ratio = standard hours / budgeted hours; efficiency ratio is more specific to labour. |
17 Extra Shift Allowance
| Category | Labour Cost Element |
|---|---|
| Best Used In | Overtime and multiple shift operations |
| Key Formula | Extra Shift Allowance = Additional rate × Hours worked in extra shift |
| Exam Importance | Low |
Extra Shift Allowance is the additional compensation paid to workers for working in shifts beyond the normal shift, such as a second or third shift, or on holidays.
It is a labour cost component that includes shift differentials, overtime premiums, and other allowances for unusual working hours.
- Manufacturing operations running multiple shifts
- Labour cost budgeting for overtime
- Costing products made during extra shifts
A factory runs a night shift with a 10% shift premium. Workers’ normal rate ₹100/hour, extra shift rate ₹110/hour. The additional ₹10 is the extra shift allowance.
Worker works 8 hours in second shift at premium of 20% over base ₹120/hour. Extra shift allowance = (120 × 0.20) × 8 = ₹24 × 8 = ₹192 per worker.
- Determine normal wage rate.
- Determine shift premium percentage or amount.
- Identify hours worked in extra shift.
- Multiply premium by hours to get allowance.
- Include in labour cost for costing products.
| Extra Shift Allowance vs. Overtime Premium | Overtime premium is for hours beyond normal workday; extra shift allowance may apply to any non-standard shift. |
|---|---|
| Extra Shift Allowance vs. Night Shift Allowance | Night shift allowance is a specific type of extra shift allowance for working at night. |
18 Ending Inventory
| Category | Inventory Valuation |
|---|---|
| Best Used In | Cost of goods sold, balance sheet valuation |
| Key Formula | Ending Inventory = Beginning Inventory + Purchases − Cost of Goods Sold |
| Exam Importance | High |
Ending Inventory is the value of goods remaining unsold at the end of an accounting period, representing the closing stock that becomes the next period’s beginning inventory.
It includes raw materials, work-in-process, and finished goods on hand at period end, valued using an inventory costing method (FIFO, weighted average, etc.).
- Cost of goods sold calculation
- Balance sheet presentation
- Inventory management and control
A retailer starts year with stock ₹1,00,000, purchases ₹5,00,000, and sells goods costing ₹4,00,000. Ending inventory = 1,00,000 + 5,00,000 − 4,00,000 = ₹2,00,000.
Beginning inventory ₹2,00,000, purchases ₹8,00,000, COGS ₹7,50,000. Ending inventory = 2,00,000 + 8,00,000 − 7,50,000 = ₹2,50,000.
- Determine beginning inventory value.
- Add net purchases or cost of goods manufactured.
- Subtract cost of goods sold during period.
- Result is ending inventory value.
- Use for balance sheet and as next period’s opening stock.
| Ending Inventory vs. Closing Stock | Same concept; closing stock is another term for ending inventory. |
|---|---|
| Ending Inventory vs. Cost of Goods Sold | Ending inventory is what remains; COGS is what was sold. |
19 Excess Capacity
| Category | Capacity Planning |
|---|---|
| Best Used In | Costing for idle capacity, special orders |
| Key Formula | Excess Capacity = Total Capacity − Utilized Capacity |
| Exam Importance | Low |
Excess Capacity refers to the unused production capacity available, where actual output is below the maximum possible output.
It is the gap between what a facility can produce at full capacity and what it actually produces, often due to low demand, inefficiency, or seasonal fluctuations.
- Special order pricing decisions
- Cost control for idle capacity
- Capital budgeting for expansion
A factory has capacity of 10,000 units per month but is producing only 7,000 units. The excess capacity of 3,000 units can be used to accept a special order at lower price without affecting regular sales.
Machine capacity 20,000 hours/year; currently used 15,000 hours. Excess capacity = 5,000 hours. A special order uses 1,000 of these excess hours; the cost considered includes only variable costs, not fixed (since fixed already covered).
- Determine maximum production capacity (in units or hours).
- Determine actual utilization.
- Subtract to find excess capacity.
- Use excess capacity for accepting special orders or deciding on new product lines.
- Cost of using excess capacity often excludes fixed costs already incurred.
| Excess Capacity vs. Idle Capacity | Idle capacity is similar but may refer to temporary downtime; excess capacity is broader. |
|---|---|
| Excess Capacity vs. Bottleneck | Bottleneck is a constraint; excess capacity is unused capacity, opposite of a bottleneck. |
20 Economic Value Added (EVA)
| Category | Performance Measurement |
|---|---|
| Best Used In | Shareholder value creation, incentive compensation |
| Key Formula | EVA = Net Operating Profit After Tax − (Capital Employed × WACC) |
| Exam Importance | Medium |
Economic Value Added (EVA) is a financial performance measure that calculates the true economic profit of a company by deducting the cost of capital from operating profit.
EVA indicates whether a company is generating returns above its cost of capital, thereby creating value for shareholders. Positive EVA means value creation; negative EVA means value destruction.
- Corporate performance evaluation
- Executive compensation
- Investment decision making
A company has NOPAT of ₹10 crore, capital employed ₹50 crore, and WACC 12%. EVA = 10 − (50 × 0.12) = 10 − 6 = ₹4 crore, indicating value creation.
NOPAT ₹5,00,000, capital employed ₹20,00,000, WACC 10%. EVA = 5,00,000 − (20,00,000 × 0.10) = 5,00,000 − 2,00,000 = ₹3,00,000 positive.
- Compute NOPAT from income statement.
- Determine total capital employed.
- Compute weighted average cost of capital (WACC).
- Multiply capital by WACC to get capital charge.
- Subtract capital charge from NOPAT to get EVA.
| EVA vs. Accounting Profit | Accounting profit ignores cost of equity; EVA deducts full cost of capital. |
|---|---|
| EVA vs. ROI | ROI is a ratio; EVA is an absolute value measure. |
