Ethics Predetermined Overhead Rate and Capacity Pat Miranda
Ethics; Predetermined Overhead Rate and Capacity Pat Miranda, the new controller of Vault Hard Drives, Inc., has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at first, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, J. Stevens, and the assistant production manager, Marvin Washington.
Pat:
I ran across an idea that I wanted to check out with both of you. It’s about the way we compute predetermined overhead rates.
J.:
We’re all ears.
Pat:
We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year by the estimated total units produced for the coming year.
Marvin:
We’ve been doing that as long as I’ve been with the company.
J.:
And it has been done that way at every other company I’ve worked at, except at most places they divide by direct labor-hours.
Pat:
We use units because it is simpler and we basically make one product with minor variations. But, there’s another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity.
Marvin:
Oh, the Marketing Department will love that. It will drop the costs on all of our products. They’ll go wild over there cutting prices.
Pat:
That is a worry, but I wanted to talk to both of you first before going over to Marketing.
J.:
Aren’t you always going to have a lot of underapplied overhead?
Pat:
That’s correct, but let me show you how we would handle it. Here’s an example based on our budget for next year.
Traditional Approach to Computation of the Predetermined Overhead Rate
New Approach to Computation of the Predetermined Overhead Rate
Using Capacity in the Denominator
J.:
Whoa!! I don’t think I like the
Pat:
I ran across an idea that I wanted to check out with both of you. It’s about the way we compute predetermined overhead rates.
J.:
We’re all ears.
Pat:
We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year by the estimated total units produced for the coming year.
Marvin:
We’ve been doing that as long as I’ve been with the company.
J.:
And it has been done that way at every other company I’ve worked at, except at most places they divide by direct labor-hours.
Pat:
We use units because it is simpler and we basically make one product with minor variations. But, there’s another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity.
Marvin:
Oh, the Marketing Department will love that. It will drop the costs on all of our products. They’ll go wild over there cutting prices.
Pat:
That is a worry, but I wanted to talk to both of you first before going over to Marketing.
J.:
Aren’t you always going to have a lot of underapplied overhead?
Pat:
That’s correct, but let me show you how we would handle it. Here’s an example based on our budget for next year.
Traditional Approach to Computation of the Predetermined Overhead Rate
New Approach to Computation of the Predetermined Overhead Rate
Using Capacity in the Denominator
J.:
Whoa!! I don’t think I like the