Capacity Levels and Fixed Overhead Rates At its Sutter City plant, Yuba Machine Company manufactures 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, 2019, Yuba began using a predetermined factory overhead application rate to determine manufacturing costs on a more timely basis. The following information is from the 2019– 2020 budget for the Sutter City plant:
Based on these data, the predetermined factory overhead application rate was established at $4.60 per direct labor hour (DLH). A variance report for the Sutter City plant for the six months ended May 31, 2020, follows. The plant incurred 40,000 DLHs, which represents one-half of the company’s practical capacity level.
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 Inventory and Finished Goods Inventory accounts. Based on this information, he has included $48,000 of fixed overhead (i.e., three-quarters 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 factory overhead allocation rate? Provide a short definition of each of these alternative capacity levels. 2. Prepare a revised variance report for Yuba Machine Company using practical capacity as the basis for determining the fixed factory overhead application rate. Round each applied overhead cost and each overhead cost variance to the nearest whole dollar. Indicate whether each of the five overhead cost variances in the revised Variance Report is favorable (F) or unfavorable (U). 3. What would Yuba’s reported (a) cost of goods sold (CGS), and (b) operating income be for the 6 months ending May 31, 2020 if the fixed factory overhead rate is based on practical capacity rather than on maximum capacity? Round each answer to the nearest whole dollar. 4. What capacity level should companies use to determine the factory overhead application rate? Why?