Reference no: EM13876846

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:

Plant maximum (theoretical) capacity	100,000 DLHs
Variable overhead costs	$3.00 per DLH
Fixed overhead costs:
Salaries	$ 80,000
Depreciation  and amortization	50,000
Other expenses	30,000
Total fixed factory overhead	$160,000

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.

	Variance Report
	Actual Costs	Applied*	Variance†
Total variable factory overhead	$120,220	$120,000	$   (220)
Fixed factory overhead:
Salaries	$39,000	$32,000	$ (7,000)
Depreciation  and amortization	25,000	20,000	(5,000)
Other expenses	15,300	12,000	(3,300)
Total fixed factory overhead	$ 79,300	$ 64,000	$(15,300)

* 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?