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, 2010, Yuba began using a predetermined factory overhead application rate to determine 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.

 

Predetermined overhead application rate =		$4.60	per DLH
Actual DLHs worked during the period =		40,000
% of practical capacity Level used during the period =		50%
	Variance Report
	Actual Costs	Applied *	Variance †
Total variable factory overhead	$120,220	$120,000	($220)
Fixed factory overhead			$0
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 DLHs (Direct Labor Hours)
† Favorable (Unfavorable)
% of the current period's applied fixed overhead costs in ending WIP and Finished Goods Inventory =					25%
Amount of the current period's applied fixed overhead cost included in CGS =					$48,000

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-quarters of the period’s applied fixed overhead) as part of the cost of goods sold in the following interim income statement:
YUBA MACHINE COMPANY
Interim Income Statement
For Six Months Ended May 31, 2011
Sales .............$625,000
Cost of goods sold ........ 380,000
Gross profit ..........$245,000
Selling expense .......... 44,000
Depreciation expense ...... 58,000
Administrative expense ..... 53,000
Operating income ........ $ 90,000

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 factory 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?

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At this point, the instructor has an opportunity to provi de an expanded discussion of this issue by referencing appropriate financial reporting and income-tax consi derations concerning the setting of predetermined overhead rates, parti cularly fixed overhead rates As indicated in the chapter, generally accepted accounting principles (GAAP) (FASB ASC 330-30-10-3, previously SFAS No. 151, and available at www.fasb.org) deal specifically with the issue of establishing overhead allocation rates and the disposition of any resulting overhead variances at the end of the period GAAP requires the use of norm al capacity for allocating fixed overhead costs to production. Further, "normal capacity refers to a range of production levels (i.e., the amount of) production expected over a number of periods under normal circumstances." By this specification, "normal capacity" refers to a range of production levels within which ordinary variations in production levels are expected. Further, GAAP requires that any unallocated overheads be recognized as an expense in the period in which they are incurred" (FASB ASC 330-10-30-7, previously SFAS No. 151) For U.S. income tax purposes, the issue regarding choice of the denominator level for establishing fixed overhead allocation rates and the end-of -period treatment of overhead cost variances is provided in the Regulations. Two, in particular, bear on the subject at hand: Reg. §1 263A and Reg. § 1.471-11 Reg. §1.263A specifies that "indirect production) costs be allocated using either the standard cost method or a method using burden rates, such as ratios based on direct costs, hours, or other items, or similar formulas, so long as the method employed reasonably allocates indirect costs among production...activities." (emphasis added) Reg. § 1.471-11 ( Inventories of Manufacturers ) extends the guidance provided in Regulation 1.263A by specifying the following: Unless minor in amount, end-of-period overhead cost variances must be prorated; if minor in amount, and treated this way for financial -reporting purposes, such variances can be written off as period costs » When "practical capacity" is used to set fixed overhead allocati on rates, allocated cost to inventory is equal to the ratio of actual output to practical capacity-any fixed overhead variance for the period can be written off as a period cost