Theoretical capacity
Theoretical capacity is the maximum output a plant could produce running flat out with zero downtime, holidays or maintenance — an unreachable ceiling used only as a reference point.
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A factory sets its overhead rate using theoretical capacity of 60,000 units against €600,000 of budgeted fixed overhead, giving €10 per unit. Actual output of only 40,000 units absorbs 40,000 times €10, or €400,000, leaving €600,000 minus €400,000, or €200,000, of overhead unrecovered — simply because no plant produces at the theoretical rate.
Where it fits
SubjectCost AccountingAdvancedTopicAbsorption & Variable CostingAdvancedTopicOverhead Allocation & ABCAdvanced
The formula
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Variables
- Overhead absorption rate (€ per unit)
- Budgeted fixed overhead (€)
- Capacity level used as the denominator (units)
The rate at which fixed overhead is spread over output; choosing theoretical capacity as K makes the rate look low but leaves most overhead under-absorbed in practice.