Are Physical Capacity Constraints Relevant?: Applying Finance-Economics Theory to a Management Accounting Misconception

A view presented consistently in the management accounting literature is that firms usually operate at full capacity. Because firms are therefore subjected to physical capacity constraints, they frequently have to choose which of their profitable products to produce and in what quantities. The choice is made, according to the literature, by the application of a choice algorithm, and the application of this algorithm results in the loss of profitable sales. A contrary view presented by finance-economics theory is that managers maximise the value of the firm by undertaking all profitable projects (production). With `profitable' defined in economic terms, finance-economics theory predicts that firms are subject to economic constraints which apply well before physical constraints become relevant. It predicts that in competitive markets, efficient production results in firms having spare capacity most of the time. The paper is structured as follows. Sections 2 and 3 present the divergent claims relating to capacity issues from the management accounting and finance-economics literature respectively. A derivative issue, that of special order pricing, is also discussed in these sections. Section 4 applies well-established finance-economics principles to explain why the management accounting view on capacity constraints is a misconception. Since the two views are diametrically opposed, only one can be an accurate descriptor of the real world. Ultimately the differences can only be resolved empirically. Section 5 reports the results of a survey of Australian manufacturing firms. Conclusions are drawn in section 6.