So let's apply and extend some of these concepts and we'll use our recurring settings that will take place all though out the course in terms of GnG Landscapes. GnG Landscape is a nursery and landscape supply company. They sell flowers, bushes, trees, vegetables, seeds, and products like that. They also sell landscape material such as mulch, stone, and pavers. And there's a service angle to this company as well. In that they design landscapes for residential and commercial customers. Now importantly, GnG Landscapes is privately owned. But it's complex enough that it requires multiple managers and employees working on behalf of those owners. And by the way, the situation is becoming even more complex as the owner have recently acquired multiple businesses So in this situation, GnG managers are pricing birch trees. They need to understand the cost of producing birch trees so that they can price the products appropriately. The tree product line managers make a number of decisions regarding the operations associated with growing, maintaining, and selling the trees. But importantly, the decisions regarding capacity investment are made by GnG's to owners. Now these last two facts are important for discussion later on. So let's keep that on the back burner and focus on the pricing decision. The GnG managers calculate annual capacity cost for birch tree land and other capacity features, and that amounts to $10,000 per year. The land reserved for birch trees allows for 200 sapling plantings. That sounds like theoretical capacity. Theoretically, we could plant 200 saplings and have them evolve into birch trees that could be sold. Birch tree sampling yield however is approximately 90% of those plantings. So, 10% just doesn't survive, so 90% of the 200 or 180 plantings yields practical capacity. Annual demand over the past few years has been a 150 birch trees. But managers expect low demand for the current year due to a drought. And amounts to a 20% decrease of the normal demand. So just like we did in our earlier example, we can calculate capacity cost per unit based on different perspectives, the Theoretical, Practical, Normal, and Budgeted measures of capacity. As we mentioned before, the capacity cost do not change across those different perspectives. It will always be $10,000 per year. What does change is the denominator or the measure of capacity given these different perspectives. 200 trees was represented our Theoretical capacity. 90% of that or 180, represented our Practical capacity. That took into account the saplings that didn't turn into trees. The demand base measures of normal and budgeted amounted to 150 on average, representing our normal perspective of capacity, and then 20% less for this particular year due to the drought amounts to 120 trees. So the cost per unit can be calculated by taking the capacity costs of $10,000 and dividing by the capacity measure. And as you can see, across the different perspectives, there is great fluctuation in the cost per unit. It ranges from $50 per unit, given the theoretical perspective, up to $83 per unit, given the budgeted perspective. Now, let's take our capacity costs on a per unit basis and add those to the other costs that it takes to produce birch trees. Those would include direct materials and direct labor associated with producing the birch trees. So the saplings might cost us $20 each and the direct labor over the year of tending to each individual sampling amounts to $90 per tree. The capacity costs of 50 that we captured via the theoretical perspective with some with the 20 and the 90 to yield the total cost per unit over the course of the year. This would include the direct materials, direct labor, and this trees share of capacity costs. Based on this information, managers might decide on a price. Let's assume that price is 25% higher than the total cost being reported. So from a theoretical perspective, the cost per unit are 160, the price would be 125% of that number or $200 per sapling. Given the Practical, Normal, and Budgeted perspectives, you can see that the direct materials and direct labor costs are the same regardless of whatever capacity measure we're using. That's because when I calculating thing about the capacity, when we're talking about direct materials and direct labor. To all of the actions that differ across the perspectives is in the third row, the capacity cost per unit. And that's what we calculated on the previous slide. Summing all these individual measures up, gives us the total cost per unit given these different perspectives. And applying the same pricing principle of 25% markup, we can see that the price would vary substantially across the different perspectives. Again, all of this is attributable to the different perspectives that managers can adapt using calculating the capacity costs per unit. Now, one thing to point out here is the substantial difference between practical and budgeted, or the planned usage measure of capacity. The Practical version said that we were going to have 180 trees be produced. And the Budgeted version of capacity noted 120 trees. The implications for the reported costs are significant, as we demonstrated earlier. The practical version calculated per unit capacity costs of approximately $56 per unit. And the budgeted version of capacity calculated per unit capacity cost of 83. Now let's look a bit closer at the implications of these calculations. Under the budgeted perspective, the entire $10,000 of capacity costs is being allocated to the 120 trees being demanded this accounting period. Even though the $10,000 of capacity costs bought us capacity that could provide us from a practical perspective of 180 trees. Using practical capacity as the basis of cost allocation, allows for the cost of used capacity to be separated from the cost of excess capacity. Let's explore that a little bit more. Let's assume that birch trees are planted as budgeted, and capacity cost are allocated based on practical capacity. That means that we have a 120 trees that were planted, and the rate that we calculated under the practical perspective of approximately $56, gets assign to each of those 120 trees. So, of the $10,000 of capacity costs, $6,667 are assigned to the trees that were planted. Now, we actually incurred $10,000 worth of capacity costs, and that difference between the 10,000 and the 6,667 that ended up being allocated to the trees that were planted, is referred to as excess capacity. That's essentially the practical rate assigned to each of the 60 trees that we could've planted but did not. That excess capacity that we had in our field but we didn't plant those 60 trees. In essence, by using the practical capacity rate, separated out the capacity used in the amount of $6, 667 from the capacity not used or $3,330 worth. In contrast, compare this to when budgeted capacity is used. In that case, the 120 trees each receive the rate of $83 per tree approximately. That means that the entire $10,000 ended up on the cost of that 120 trees that we ended up planting. That means that the excess capacity that we did not use gets assigned to the trees that were actually planted. If we were to use the practical capacity as our rate, and multiply that by each of the 120 trees that we actually planted, and account for excess capacity separately, what are we doing with this approach? And is it even valid? Well first off, going back to some of the given information, the tree product line managers did not choose the level of capacity. They had no decision rights over the $10,000 that was spent for the field. They basically only had decision rights over how to manage the trees and eventually solve them. So the $10,000 that was spent and the resulting excess capacity that was not used, was not a function of their choice. By separating out excess capacity, these managers are not assigned costs that they did not have control over. Another advantage of this, is that it allows for the quantification of excess capacity. And this can be quite informative in many circumstances. Imagine that over the years, the excess capacity measure gets smaller and smaller. That's informative to owners and managers that were running out of excess capacity and that future investments might be necessary. Conversely, imagine that the value of excess capacity over multiple time periods is increasing. Meaning that we are using less and less of our available capacity. That might signal that a different type of decision might be necessary. To divest in capacity or that to use capacity in different ways. There are disadvantages, however. In particular, not all of the product costs are included if we were to separate out excess capacity. And if not all product costs are included, then we might underprice our product and actually not be making as much money as we thought. Now let's have a checkpoint to make sure that we understand these issues.
