capacity-based approach would treat this cost as a period expense that is reported below the gross margin. By separately disclosing the Cost of unused capacity as a lump sum of $60,000 on the income statement, instead of burying it in Cost of Goods Sold, the need to effectively manage capacity is highlighted for the company’s managers. Gener- ally speaking, a company’s managers should respond to large unused capacity costs by either seeking new business opportunities that consume the capacity, or by cutting costs and shrinking the amount of available capacity.
Prahad Corporation Income Statement For the Year Ended December 31
Sales1 . . . $ 1,200,000 Cost of goods sold2 . . . 1,080,000 Gross margin . . . 120,000 Other expenses:
Cost of unused capacity . . . $ 60,000
Selling and administrative expenses3 . . . 90,000 150,000 Net operating loss . . . $ (30,000)
1 Assume sales of 600,000 CDs at $2 per CD.
2 Assume the unit product cost of the CDs is $1.80, including $0.20 for manufacturing overhead.
3 Assume selling and administrative expenses total $90,000.
E X H I B I T 2 B – 1 Prahad Corporation: An Income Statement That Recognizes the Cost of Unused Capacity
EXERCISE 2B–2 Overhead Rates and Capacity Issues LO2–1, LO2–2, LO2–6
Security Pension Services helps clients to set up and administer pension plans that are in compli- ance with tax laws and regulatory requirements. The firm uses a job-order costing system in which overhead is applied to clients’ accounts on the basis of professional staff hours charged to the accounts. Data concerning two recent years appear below:
Last Year This Year
Estimated professional staff hours
to be charged to clients’ accounts . . . . 4,600 4,500 Estimated overhead cost . . . . $310,500 $310,500 Professional staff hours available . . . . 6,000 6,000
“Professional staff hours available” is a measure of the capacity of the firm. Any hours available that are not charged to clients’ accounts represent unused capacity. All of the firm’s overhead is fixed.
Required:
1. Marta Brinksi is an established client whose pension plan was set up many years ago. In both this year and last year, only 2.5 hours of professional staff time were charged to Ms. Brinksi’s account. If the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients, how much overhead cost would have been applied to Ms. Brinksi’s account last year? This year?
2. Suppose that the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients as in (1) above. Also suppose that the actual professional staff hours charged to clients’ accounts and the actual overhead costs turn out to be exactly as estimated in both years. How much unused capacity cost would the company report last year? How about for this year?
3. Refer back to the data concerning Ms. Brinksi in (1) above. If the company bases its predeter- mined overhead rate on the professional staff hours available, how much overhead cost would have been applied to Ms. Brinksi’s account last year? This year?
4. Suppose that the company bases its predetermined overhead rate on the professional staff hours available as in (3) above. Also suppose that the actual professional staff hours charged to clients’
accounts and the actual overhead costs turn out to be exactly as estimated in both years. How much unused capacity cost would the company report last year? How about for this year?
PROBLEM 2B–3 Predetermined Overhead Rate and Capacity LO2–1, LO2–2, LO2–6
Platinum Tracks, Inc., is a small audio recording studio located in Los Angeles. The company handles work for advertising agencies—primarily for radio ads—and has a few singers and bands as clients. Platinum Tracks handles all aspects of recording from editing to making a digital master from which CDs can be copied. The competition in the audio recording industry in Los Angeles has always been tough, but it has been getting even tougher over the last several years. The studio has been losing customers to newer studios that are equipped with more up-to-date equipment and that are able to offer very attractive prices and excellent service. Summary data concerning the last two years of operations follow:
Last Year This Year Estimated hours of studio service . . . . 1,000 800 Estimated studio overhead cost . . . . $160,000 $160,000 Actual hours of studio service provided . . . . 750 500 Actual studio overhead cost incurred . . . . $160,000 $160,000 Hours of studio service at capacity . . . . 1,600 1,600 The company applies studio overhead to recording jobs on the basis of the hours of studio ser- vice provided. For example, 40 hours of studio time were required to record, edit, and master the Verde Baja music CD for a local Latino band. All of the studio overhead cost is fixed, and the actual overhead cost incurred was exactly as estimated at the beginning of the year in last year and this year.
Required:
1. Platinum Tracks computes its predetermined overhead rate at the beginning of each year based on the estimated studio overhead cost and the estimated hours of studio service for the year. Using this approach, how much overhead would have been applied to the Verde Baja job last year? How about this year?
2. The president of Platinum Tracks has heard that some companies in the industry have changed to a system of computing the predetermined overhead rate based on the hours of studio service that could be provided at capacity. He would like to know what effect this method would have on job costs. How much overhead would have been applied using this method to the Verde Baja job if it had been done last year? This year?
3. If Platinum Tracks computes its predetermined overhead rate based on the hours of studio ser- vice that could be provided at capacity as in (2) above, how much unused capacity cost would the company have incurred last year? This year?
4. What fundamental business problem is Platinum Tracks facing? Which method of computing the predetermined overhead rate is likely to be more helpful in facing this problem? Explain.
CASE 2B–4 Ethics; Predetermined Overhead Rate and Capacity LO2–2, LO2–6
Pat Miranda, the new controller of Vault Hard Drives, Inc., has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at first, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the produc- tion manager, J. Stevens, and the assistant production manager, Marvin Washington.
Pat: I ran across an idea that I wanted to check out with both of you. It’s about the way we compute predetermined overhead rates.
J.: We’re all ears.
Pat: We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year, which is all a fixed cost, by the estimated total units produced for the coming year.
Marvin: We’ve been doing that as long as I’ve been with the company.
J.: And it has been done that way at every other company I’ve worked at, except at most places they divide by direct labor-hours.
Pat: We use units because it is simpler and we basically make one product with minor variations. But, there’s another way to do it. Instead of basing the overhead rate on the estimated total units pro- duced for the coming year, we could base it on the total units produced at capacity.
Marvin: Oh, the Marketing Department will love that. It will drop the costs on all of our products.
They’ll go wild over there cutting prices.
Pat: That is a worry, but I wanted to talk to both of you first before going over to Marketing.
J.: Aren’t you always going to have a lot of unused capacity costs?
Pat: That’s correct, but let me show you how we would handle it. Here’s an example based on our budget for next year.
Budgeted (estimated) production . . . . 160,000 units Budgeted sales . . . . 160,000 units Capacity . . . . 200,000 units Selling price . . . . $60 per unit Variable manufacturing cost . . . . $15 per unit Total manufacturing overhead cost (all fixed) . . . . $4,000,000 Selling and administrative expenses (all fixed) . . . . $2,700,000 Beginning inventories . . . . $0
Traditional Approach to Computation of the Predetermined Overhead Rate Estimated total manufacturing overhead cost, $4,000,000
______________________________________________ Estimated total units produced, 160,000 = $25 per unit Budgeted Income Statement
Revenue (160,000 units × $60 per unit) . . . . $ 9,600,000 Cost of goods sold:
Variable manufacturing (160,000 units × $15 per unit) . . . . $ 2,400,000 Manufacturing overhead applied
(160,000 units × $25 per unit) . . . . 4,000,000 6,400,000 Gross margin . . . . 3,200,000 Selling and administrative expenses . . . . 2,700,000 Net operating income . . . . $ 500,000