Capacity Levels and Fixed Overhead Rates At its Sutter City plant, Yuba Machine Company manu- factures 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 deter- mine manufacturing costs on a more timely basis. The following information is from the 2010-2011 budget for the Sutter City plant:
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Plant maximum (theoretical) capacity
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100,000 DLHs
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Variable overhead costs
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$3.00 per DLH
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Fixed overhead costs:
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Salaries
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$ 80,000
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Depreciation and amortization
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50,000
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Other expenses
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30,000
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Total fixed factory overhead
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$160,000
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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.
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Variance Report
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Actual Costs
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Applied*
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Variance†
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Total variable factory overhead
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$120,220
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$120,000
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$ (220)
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Fixed factory overhead:
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Salaries
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$39,000
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$32,000
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$ (7,000)
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Depreciation and amortization
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25,000
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20,000
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(5,000)
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Other expenses
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15,300
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12,000
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(3,300)
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Total fixed factory overhead
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$ 79,300
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$ 64,000
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$(15,300)
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* 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:
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.
2. Prepare a revised variance report for Yuba Machine Company using practical capacity as the basis for determining the fixed overhead application rate.
3. Determine the effect on Yuba's reported operating income of $90,000 at May 31, 2011, if the fixed fac- tory overhead rate was based on practical capacity rather than on maximum capacity.
4. What capacity level should companies use to determine the factory overhead application rate? Why?