Developing and Using a Predetermined Overhead Rate: High-Low Cost Estimation

For years, Mattoon Components Company has used an actual plantwide overhead rate and based its prices on cost plus a markup of 30%. Recently the marketing manager, Holly Adams, and the production manager, Sue Walsh, confronted the controller with a common problem. The marketing manager expressed a concern that Mattoon's prices seem to vary widely throughout the year. According to Adams, "It seems irrational to charge higher prices when business is bad and lower prices when business is good. While we get a lot of business during high-volume months because we charge less than our competitors, it is a waste of time to even call on customers during low-volume months because we are raising prices while our competitors are lowering them. Walsh also believed that it was "folly to be so pushed that We have to pay overtime in some months and then lay employees off in others. She commented, "While there are natural variations in customer demand, the accounting system seems to amplify this variation.

Required

a. Evaluate the arguments presented by Adams and Walsh. What suggestions do you have for improving the accounting and pricing procedures?

b. Assume that the Mattoon Components Company had the following total manufacturing overhead costs and direct labor hours in the last two years.

	Year 1	Year 2
Total manufacturing overhead	$325,000	$380,000
Direct labor hours	34,000	40,000

Use the high-low method (see Module 15) to develop a cost-estimating equation for total manufacturing overhead.

c. Develop a predetermined rate for next year, assuming 35,000 direct labor hours are budgeted for next year.

d. Assume that the actual level of activity next year was 36,000 direct labor hours and that manufacturing overhead was $341,550. Determine the underapplied or overapplied manufacturing overhead at the end of the year.

e. Describe two ways of handling any underapplied or overapplied manufacturing overhead at the end of the year.