18: D.4. Capacity Level and Management Decisions Flashcards
(10 cards)
A company incurs $1,500,000 in fixed overhead. It applies overhead using practical capacity of 18,000 units, but produces only 12,000 units. What is the under-applied overhead?
OH rate = $1,500,000 ÷ 18,000 = $83.33
Applied OH = 12,000 × $83.33 = $1,000,000
Under-applied OH = $1,500,000 – $1,000,000 = $500,000
This amount must be prorated or closed to COGS.
Why might master budget capacity distort product cost when used during a period of sharp demand decline?
Master budget reflects expected demand, not actual capacity. If demand falls sharply, fewer units are produced. The fixed OH rate remains high → leads to overcosting units, which may result in uncompetitive pricing and downward demand spiral.
A company using normal capacity applies $950,000 of overhead to production but actually incurs $1,000,000. Variance is prorated. How does this affect ending inventory and income?
Prorating means variance is spread to WIP, FG, and COGS. Ending inventory reflects a share of the $50,000 under-applied overhead.
✅ Final inventory and income will match what they would have been under actual cost allocation.
Why does theoretical capacity result in the lowest cost per unit but also the largest variance?
The denominator is largest (e.g., 25,000 units) → OH rate is lowest. But since actual production is lower, very little overhead is applied to products, causing a large under-applied variance.
✅ Makes theoretical capacity inappropriate for pricing or income reporting.
How can unused capacity be leveraged instead of being treated as a sunk cost?
Outsource manufacturing for other firms
Launch a low-cost product line to utilize spare capacity
Lease or sell part of the facility
✅ Strategic use of unused capacity improves ROA and reduces overhead burden.
Why does closing overhead variance 100% to COGS make operating income dependent on the chosen capacity level?
Different capacities apply different amounts of OH → when variance is closed to COGS directly, inventory values are not adjusted.
⚠️ That means more or less OH is expensed depending on the denominator used → distorts income.
If variances are prorated, what is the effect of capacity level choice on final financial statements?
✅ None. Prorating ensures total OH allocated = actual OH incurred.
No matter which denominator was used to apply overhead, the final inventory and COGS balances match actual cost.
Why is practical capacity the preferred denominator for pricing decisions, even if it results in under-applied overhead?
Because it reflects full, realistic utilization. It avoids passing costs of idle capacity to customers (which would lead to higher prices and lower sales).
✅ It supports stable pricing, protects competitiveness, and isolates idle cost for management review.
A firm used normal capacity and over-applied $200,000 in overhead. If the variance is closed to COGS, what is the effect on operating income?
Closing over-applied OH to COGS reduces COGS by $200,000, increasing operating income.
⚠️ Income would appear higher than actual efficiency justifies.
Why is using practical capacity aligned with lean and Just-In-Time (JIT) principles?
Practical capacity excludes idle time due to poor planning or waste.
✅ Aligns with lean focus on eliminating non-value-added activity and maximizing asset utilization.
