JSI’s controller believes that the company’s traditional costing system may be providing mis- leading cost information. To determine whether or not this is correct, the controller has prepared an analysis of the year’s expected manufacturing overhead costs, as shown in the following table:
Kenya Dark Viet Select
Expected sales . . . . 80,000 pounds 4,000 pounds Batch size . . . . 5,000 pounds 500 pounds Setups . . . . 2 per batch 2 per batch Purchase order size . . . . 20,000 pounds 500 pounds Roasting time per 100 pounds . . . . 1.5 roasting hours 1.5 roasting hours Blending time per 100 pounds . . . . 0.5 blending hours 0.5 blending hours Packaging time per 100 pounds . . . . 0.3 packaging hours 0.3 packaging hours
Activity Cost Pool Activity Measure
Expected Activity for the Year
Expected Cost for the Year Purchasing . . . . Purchase orders 2,000 orders $ 560,000 Material handling . . . . Number of setups 1,000 setups 193,000 Quality control . . . . Number of batches 500 batches 90,000 Roasting . . . . Roasting hours 95,000 roasting hours 1,045,000 Blending . . . . Blending hours 32,000 blending hours 192,000 Packaging . . . . Packaging hours 24,000 packaging hours 120,000 Total manufacturing
overhead cost . . . . $ 2,200,000
Data regarding the expected production of Kenya Dark and Viet Select coffee are presented below.
Required:
1. Using direct labor-hours as the manufacturing overhead cost allocation base, do the following:
a. Determine the plantwide predetermined overhead rate that will be used during the year.
b. Determine the unit product cost of one pound of Kenya Dark coffee and one pound of Viet Select coffee.
2. Using the activity-based absorption costing approach, do the following:
a. Determine the total amount of manufacturing overhead cost assigned to Kenya Dark cof- fee and to Viet Select coffee for the year.
b. Using the data developed in (2a) above, compute the amount of manufacturing overhead cost per pound of Kenya Dark coffee and Viet Select coffee.
c. Determine the unit product cost of one pound of Kenya Dark coffee and one pound of Viet Select coffee.
3. Write a brief memo to the president of JSI that explains what you found in (1) and (2) above and that discusses the implications of using direct labor-hours as the only manufacturing over- head cost allocation base.
(CMA, adapted)
volume for overhead rates on the estimated, or budgeted, amount of the allocation base for the upcoming period. The second method, often used for internal management purposes, bases the denominator volume for overhead rates on the estimated total amount of the allo- cation base at capacity. To simplify our forthcoming comparison of these two methods, we make two important assumptions that will hold true throughout the entire appendix: (1) all manufacturing overhead costs are fixed; and (2) the estimated, or budgeted, fixed manufac- turing overhead at the beginning of the period equals the actual fixed manufacturing over- head at the end of the period.
Let’s assume that Prahad Corporation manufactures DVDs for local production stu- dios. The company’s DVD duplicating machine is capable of producing a new DVD every 10 seconds from a master DVD. The company leases the DVD duplicating machine for a fixed cost of $180,000 per year, and this is the company’s only estimated (and actual) manufacturing overhead cost. With allowances for setups and maintenance, the machine is theoretically capable of producing up to 900,000 DVDs per year. However, due to a business downturn, Prahad’s customers are unlikely to order more than 600,000 DVDs next year. The company uses machine time as the allocation base for applying manufac- turing overhead to DVDs. These data are summarized below:
Prahad Corporation Data
Total estimated and actual manufacturing overhead cost . . . $180,000 per year Allocation base—machine time per DVD . . . 10 seconds per DVD Capacity . . . 900,000 DVDs per year Budgeted output for next year . . . 600,000 DVDs
If Prahad uses the first method mentioned above, which computes predetermined overhead rates using the estimated or budgeted activity for the period, then its predeter- mined overhead rate for next year would be $0.03 per second of machine time computed as follows:
Predetermined overhead rate
= Estimated total manufacturing overhead cost _____________________________________ Estimated total amount of the allocation base = _________________________________________$180,000 600,000 DVDs × 10 seconds per DVD
= $0.03 per second
Because each DVD requires 10 seconds of machine time, each DVD will be charged for $0.30 of overhead cost.
While this absorption approach is commonly used for external reporting purposes, it has two important limitations from a managerial accounting standpoint. 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 bud- geted level of activity for the period. For example, if Prahad’s budgeted output for the year was only 300,000 DVDs (instead of 600,000 DVDs), its predetermined overhead rate would be $0.06 per second of machine time or $0.60 per DVD rather than $0.30 per DVD. Notice that as the company’s budgeted output falls, its overhead cost per unit increases. This in turn makes it appear as though the cost of producing DVDs has increased, which may tempt managers to raise prices at the worst possible time—just as demand is falling.
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. If the level of activity falls, a company’s shrinking output of products must absorb a growing share of idle capacity cost that is above and beyond their actual production cost.
Basing the predetermined overhead rate on the estimated total amount of the alloca- tion base at capacity overcomes the two limitations just discussed. It is computed as follows4:
4 Ordinarily, because of variable overhead costs, the estimated total manufacturing overhead cost at capacity will be larger than the estimated total manufacturing overhead cost at the estimated level of activity. However, for simplicity we assume in this appendix that all overhead costs are fixed. Then the total manufacturing overhead cost will be the same regardless of the level of activity.
Predetermined overhead rate based on capacity
= Estimated total manufacturing overhead cost at capacity ______________________________________________ Estimated total amount of the allocation base at capacity = _________________________________________$180,000 900,000 DVDs × 10 seconds per DVD
= $0.02 per second
When Prahad bases its predetermined overhead rate on activity at capacity, its over- head rate is $0.02 per second instead of $0.03 per second as computed under the absorp- tion approach. Consequently, the overhead cost that Prahad will apply to each DVD using the capacity-based approach would be $0.20 (= $0.02 × 10 seconds) per unit instead of
$0.30 per unit under the absorption method. Notice that the capacity-based amounts per second and per unit are lower than the absorption-based amounts. This occurs because the capacity-based approach uses a higher denominator volume that reflects Prahad’s capacity to produce DVDs—9,000,000 seconds.
Prahad’s capacity-based rate of $0.02 per second will remain constant even if its budgeted level of activity fluctuates from one period to another. So, if the company’s estimated level of activity drops from 600,000 DVDs to 300,000 DVDs, its capacity- based rate would stay at $0.02 per second. The company’s unused capacity cost would increase in this situation, but its unit cost to make DVD’s would stay constant at $0.20 per unit.
Whenever a company operates at less than full capacity and allocates fixed overhead costs using a capacity-based denominator volume it will report some amount of unused capacity cost that is computed as follows:
Cost of unused capacity =
(
Amount of the allocation base at capacity – Actual amount of the allocation base)
× Predetermined overhead rate For example, let’s assume that Prahad Company actually used 6,000,000 seconds on the DVD duplicating machine to produce 600,000 DVDs. At this level of output, the company would compute its cost of unused capacity as follows:Cost of unused capacity =
(
Amount of the allocation base at capacity – Actual amount of the allocation base)
× Predetermined overhead rate Cost of unused capacity = ( 9,000,000 seconds – 6,000,000 seconds ) × $0.02 per second Cost of unused capacity = 3,000,000 seconds × $0.02 per secondCost of unused capacity = $60,000
Exhibit 2B–1 illustrates how Prahad would disclose this cost of unused capac- ity ($60,000) within an income statement prepared for internal management purposes.
Rather than treating it as a product cost (as is done in the absorption approach), Prahad’s
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