The Predetermined Overhead Rate and Capacity Appendix 2B

Learning Objective 6 Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.

The Predetermined Overhead Rate and Capacity—Methods One method, that we have used, bases the denominator on volume for overhead rates on the estimated, or budgeted, amount of the allocation base for the upcoming period. A second method, often used for internal management purposes, bases the denominator volume for overhead rates on the estimated total amount of the allocation base at capacity. For the remainder of this Appendix, we will make two assumptions: all manufacturing overhead costs are fixed; and the estimated, or budgeted, fixed manufacturing overhead at the beginning of the period equals the actual fixed manufacturing overhead at the end of the period.

Traditional Absorption Costing There are two significant problems with using the traditional absorption approach from a managerial accounting position. First, if predetermined overhead rates are based on budgeted activity and overhead includes significant fixed costs, then the unit product costs will fluctuate depending on the budgeted level of activity for the period. The second limitation of the absorption approach is that it charges products for resources that they don’t use. When the fixed costs of capacity are spread over estimated activity, the units that are produced must shoulder the costs of any unused capacity.

Capacity-Based Overhead Rates The limitations of traditional absorption costing can be overcome by using “estimated total amount of the allocation base at capacity” in the denominator of the predetermined overhead rate calculation (rather than the “estimated total units in the allocation base” in the denominator).

Capacity-Based Overhead Rates –Calculations Maximum, Inc. leases a piece of equipment for $100,000 per year. If run at full capacity, the machine can produce 50,000 units per year. However, the company estimates that 40,000 units will be produced and sold next year. Predetermined Overhead Rate based on units produced and sold: $100,000 40,000 = $2.50 per unit Predetermined Overhead Rate, if based on capacity, is: $100,000 50,000 = $2.00 per unit

Cost of Unused Capacity Part 1 Maximum, Inc. leases a piece of equipment for $100,000 per year. If run at full capacity, the machine can produce 50,000 units per year. However, the company estimates that 40,000 units will be produced and sold next year. Predetermined Overhead Rate based on unit capacity: $100,000 50,000 = $2.00 per unit Let’s calculate the cost of unused capacity using the following equation: Cost of unused capacity = (50,000 – 40,000) ×$2.00 = $20,000

Cost of Unused Capacity Part 2 (50,000 - 40,000) × $2.00 = $20,000 Cost of unused capacity would be reported on the internal use income statement as an other expense, just like selling and administrative expenses.

Managing the Cost of Unused Capacity Rather than treating it as a product cost (as is done in the absorption approach), the capacity-based approach would treat this cost as a period expense that is reported below the gross margin. The need to effectively manage capacity is then highlighted for the company’s managers. Managers should respond by: Seeking new business opportunities that consume the capacity. Cutting costs and shrinking the amount of available capacity out to work in process, finished goods, and/or cost of goods sold.

End of Chapter 2B