When implementing a standard cost system,one of the system-design choices that management must make is choice of the denominator volume level for the purpose of calculating the fixed overhead application rate,which is used to determine product costs.Various alternatives exist for the denominator volume.
Required: 1.List and briefly describe the various alternatives that exist for defining the denominator activity level for product-costing purposes.
2.What provisions of generally accepted accounting principles (GAAP)and current income tax requirements affect the decision as to choice of the denominator volume level when developing the standard fixed overhead application rate? Provide an overview of the requirements in this regard.
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Feedback: 1.As indicated in the text,there are basically two "supply-based" alternatives and two "demand-based" alternatives for defining the denominator volume for the allocation of fixed overhead costs to products.On the supply side,one can use either theoretical capacity or practical capacity as the denominator activity level.Theoretical capacity,as the name implies,represents maximum possible activity (or output),with no interruptions or inefficiencies.Practical capacity is maximum capacity reduced by normal/expected lost production due to personal time,normal maintenance,etc.Note that practical capacity is not rigidly defined,but it is normally expressed as some percentage (e.g. ,85%)of theoretical capacity.On the demand side,one could use either budgeted capacity utilization or normal capacity as the denominator volume in setting fixed overhead application rates.The former,as the name implies,represents planned (or forecasted)capacity utilization for the upcoming year,while the latter represents a measure of average expected capacity utilization over an intermediate time period,e.g. ,the upcoming three- to five-year period.
2.For external reporting purposes,accountants need to follow the provisions of generally accepted accounting principles (FASB ASC 330-10-30-6 and -7,previously,Statement of Financial Standards No.151: Inventory Costs-An Amendment of ARB No.43,Chapter 4,available at HYPERLINK "http://www.fasb.org/" )regarding the setting of overhead allocation rates and the end-of- period disposition of any volume (idle capacity)variances.These generally accepted accounting principles specify that normal capacity be used for allocating fixed manufacturing costs to production and that abnormal amounts of idle facility expense should be recognized as current-period charges and not capitalized as part of inventory cost.(Note: "normal capacity" is defined as range of production levels-that is,production expected over a number of periods (or seasons)under normal circumstances. )There seem to be two major implications of the above reporting requirement: 1.The amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or an idle plant.2.Another implication (not stated explicitly,but implied in FASB ASC 330)is that when normal capacity is used,any unallocated fixed overhead is viewed as "abnormal," and therefore should be treated as a period cost.That is,unallocated overhead is recognized as an expense in the period in which this cost is incurred.General income tax provisions regarding inventory costing are contained in IRC 263: Uniform Capitalization Rules.This Code Section specifies only that an "allocable" share of costs,including indirect manufacturing costs,be included in inventory.Treasury Regulation §1.263A specifies that "indirect costs should be allocated .... using either a specific identification ("tracing")method,the standard cost method,or a method using burden rates,such as ratios based on direct costs,hours,or other items,or similar formulas,so long as the method employed reasonably allocates indirect costs among production .... activities." Finally,Treasury Regulation §1.471-11: Inventories of Manufactures specifies that companies must prorate variances,unless minor,in which case these variances can be charged as a period cost (but only if done for financial reporting purposes).Also,this Regulation goes on to state that when practical capacity is used to set fixed overhead allocation rates,"allocated cost" = ratio of actual output to practical capacity.Any resulting fixed overhead cost variance can then be written off as a period cost.

When Implementing a Standard Cost System,one of the System-Design Choices