ACCT 215 Problems Solutions, Fall 2011

Chapter 03A The Predetermined Overhead Rate and Capacity Appendix 3A The Predetermined Overhead Rate and Capacity Exercise 3A-1 (30 minutes) 1. The overhead applied to Ms. Miyami’s account would be computed as follows: 2010 2011 Estimated overhead cost (a)............................... $144,000 $144,000 Estimated professional staff hours (b).............. 2,400 2,250 Predetermined overhead rate (a) ÷ (b).............. $60 $64 Professional staff hours charged to Ms. Miyami’s account........................................ × 5 × 5 Overhead applied to Ms. Miyami’s account...... $300 $320 2. If the actual overhead cost and the actual professional hours charged turn out to be exactly as estimated there would be no underapplied or overapplied overhead. 2010 2011 Predetermined overhead rate (see above)....... $60 $64 Actual professional staff hours charged to clients’ accounts (by assumption)................... × 2,400 × 2,250 Overhead applied................................................ $144,000 $144,000 Actual overhead cost incurred (by assumption)....................................................... 144,000 144,000 Under- or overapplied overhead....................... $                   0 $                   0 3. If the predetermined overhead rate is based on the professional staff hours available, the computations would be: 2010 2011 Estimated overhead cost (a)................................. $144,000 $144,000 Professional staff hours available (b).................. 3,000 3,000 Predetermined overhead rate (a) ÷ (b)............... $48 $48 Professional staff hours charged to Ms. × 5 × 5 3A-1 Chapter 03A The Predetermined Overhead Rate and Capacity Miyami’s account................................................ 3A-2 Chapter 03A The Predetermined Overhead Rate and Capacity Overhead applied to Ms. Miyami’s account....... $240 $240 Problem 3A-1 (continued) 4. If the actual overhead cost and the actual professional staff hours charged to clients’ accounts turn out to be exactly as estimated overhead would be underapplied as shown below. 2010 2011 Predetermined overhead rate (see 3 above) (a).......................................................................... $48 $48 Actual professional staff hours charged to clients’ accounts (by assumption) (b)............... × 2,250 × 2,400 Overhead applied (a) × (b).................................... $108,000 $115,200 Actual overhead cost incurred (by assumption)......................................................... 144,000 144,000 Underapplied overhead........................................ $   36,000 $   28,800 The underapplied overhead is best interpreted in this situation as the cost of idle capacity. Proponents of this method of computing predetermined overhead rates suggest that the underapplied overhead be treated as a period expense that would be separately disclosed on the income statement as Cost of Unused Capacity. Problem 3A-3 (60 minutes) 1. The overhead applied to the Slug Fest job would be computed as follows: 2010 2011 Estimated studio overhead cost (a)................... $90,000 $90,000 Estimated hours of studio service (b)................ 1,000 750 Predetermined overhead rate (a) ÷ (b).............. $90 $120 Slug Fest job’s studio hours ............................... × 30 × 30 Overhead applied to the Slug Fest job ............. $2,700 $3,600 3A-3 Chapter 03A The Predetermined Overhead Rate and Capacity Overhead is underapplied for both years as computed below: 2010 2011 Predetermined overhead rate (see above) (a) $90 $120 Actual hours of studio service provided (b)...... × 900 × 600 Overhead applied (a) × (b)................................... $81,000 $72,000 Actual studio cost incurred.................................   90,000 90,000 Underapplied overhead...................................... $   9,000 $18,000 2. If the predetermined overhead rate is based on the hours of studio service at capacity, the computations would be: 2010 2011 Estimated studio overhead cost (a)................... $90,000 $90,000 Hours of studio service at capacity (b).............. 1,800 1,800 Predetermined overhead rate (a) ÷ (b).............. $50 $50 Slug Fest job’s studio hours ............................... × 30 × 30 Overhead applied to the Slug Fest job ............. $1,500 $1,500 Overhead is underapplied for both years under this method as well: 2010 2011 Predetermined overhead rate (see above) (a)..... $50 $50 Actual hours of studio service provided (b)......... × 900 × 600 Overhead applied (a) × (b)...................................... $45,000 $30,000 Actual studio cost incurred....................................   90,000 90,000 Underapplied overhead......................................... $45,000 $60,000 Problem 3A-3 (continued) 3. When the predetermined overhead rate is based on capacity, underapplied overhead is interpreted as the cost of idle capacity. Indeed, proponents of this method suggest that underapplied overhead be treated as a period expense that would be separately disclosed on the income statement as Cost of Unused Capacity. 4. Skid Road Recording’s fundamental problem is the competition that is drawing customers away. The competition 3A-4 Chapter 03A The Predetermined Overhead Rate and Capacity is able to offer the latest equipment, excellent service, and attractive prices. The company must do something to counter this threat or it will ultimately face failure. Under the conventional approach in which the predetermined overhead rate is based on the estimated studio hours, the apparent cost of the Slug Fest job has increased between 2010 and 2011. That happens because the company is losing business to competitors and therefore the company’s fixed overhead costs are being spread over a smaller base. This results in costs that seem to increase as the volume declines. Skid Road Recording’s managers may be misled into thinking that the problem is rising costs and they may be tempted to raise prices to recover their apparently increasing costs. This would almost surely accelerate the company’s decline. Under the alternative approach, the overhead cost of the Slug Fest job is stable at $1,500 and lower than the costs reported under the conventional method. Under the conventional method, managers may be misled into thinking that they are actually losing money on the Slug Fest job and they might refuse such jobs in the future—another sure road to disaster. This is much less likely to happen if the lower cost of $1,500 is reported. It is true that the underapplied overhead under the alternative approach is much larger than under the conventional approach and is growing. However, if it is properly labeled as the cost of idle capacity, management is much more likely to draw the appropriate conclusion that the real problem is the loss of business (and therefore more idle capacity) rather than an increase in costs. While basing the predetermined rate on capacity rather than on estimated activity will not solve the company’s basic problems, at least this method will be less likely to send managers misleading signals. 3A-5