Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 62

Capacity Levels and Fixed Overhead Rates At its Sutter City plant, Yuba Machine Company manufactures nut shellers, which it sells to nut processors throughout the world. Since its inception, the family-owned business has used actual factory overhead costs in costing factory output. On December 1, 2010, Yuba began using a predetermined factory overhead application rate to determine manufacturing costs on a more timely basis. The following information is from the 2010-2011 budget for the Sutter City plant:

Plant maximum (theoretical) capacity	100,000 DLHs
Variable overhead costs	$3.00 per DLH
Fixed overhead costs:
Salaries	$ 80,000
Depreciation and amortization	50,000
Other expenses	30,000
Total fixed factory overhead	$160,000

Based on these data, the predetermined factory overhead application rate was established at $4.60 per DLH.

A variance report for the Sutter City plant for the six months ended May 31, 2011, follows. The plant incurred 40,000 DLHs, which represents one-half of the company’s practical capacity level.

Variance Report
	Actual Costs	Applied*	Variance†
Total variable factory overhead	$120,220	$120,000	$ (220)
Fixed factory overhead:
Salaries	$39,000	$32,000	$ (7,000)
Depreciation and amortization	25,000	20,000	(5,000)
Other expenses	15,300	12,000	(3,300)
Total fixed factory overhead	$ 79,300	$ 64,000	$(15,300)

* Based on 40,000 direct labor-hours (DLHs).

†Favorable (Unfavorable)

Yuba’s controller, Sid Thorpe, knows from the inventory records that one-quarter of this period’s applied fixed overhead costs remain in the work-in-process and finished goods inventory accounts. Based on this information, he has included $48,000 of fixed overhead (i.e., three-quarter’s of the period’s applied fixed overhead) as part of the cost of goods sold in the following interim income statement:

YUBA MACHINE COMPANY Interim Income Statement For Six Months Ended May 31, 2011
Sales	$625,000
Cost of goods sold	380,000
Gross profit	$245,000
Selling expense	44,000
Depreciation expense	58,000
Administrative expense	53,000
Operating income	$ 90,000

Required

1. Define the term maximum (theoretical) capacity and explain why it might not be a satisfactory basis for determining the fixed factory overhead application rate. What other capacity levels can be used to set the fixed overhead allocation rate? Explain.

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2. Prepare a revised variance report for Yuba Machine Company using practical capacity as the basis for determining the fixed overhead application rate.

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3. Determine the effect on Yuba’s reported operating income of $90,000 at May 31, 2011, if the fixed factory overhead rate was based on practical capacity rather than on maximum capacity.

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4. What capacity level should companies use to determine the factory overhead application rate? Why?

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