3 to maximize operating income the executive vice

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3. To maximize operating income, the executive vice president would favor using normal capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a smaller base than practical capacity, resulting in any year-end inventory having a higher unit cost. Thus, less fixed manufacturing overhead would become a 2006 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level.
9-40 9-38 (20 min.) Downward demand spiral. 1. and 2. Competitive Original Situation Practical capacity (units) 5,000 5,000 Budgeted capacity (units) 5,000 4,000 Variable manufacturing cost per unit $100 $100 Fixed manufacturing costs $1,500,000 $1,500,000 Markup percentage 100% 100% Manufacturing cost per unit Variable $100 $100 Fixed (fixed mfg costs budgeted capacity) ($1,500,000 5,000; $1,500,000 4,000) 300 375 Full manufacturing cost per unit $400 $475 Selling Price (200% of full manuf. cost per unit) $800 $950 3. We can see that when the budgeted production is used as the denominator level and this level changes with anticipated demand, then the full manufacturing cost per unit and therefore the selling price can be quite sensitive to the denominator level. In this case, the denominator level has fallen by 20% [(5,000 4,000) 5,000] and the allocated fixed cost has increased by 25% [($375 $300) 300], resulting in an 18.75% [($950 $800) $800] increase in selling price. If MetaT ech‘s market is becoming more competitive because of foreign entrants, raising the selling price could further drive away customers, lower the budgeted capacity and raise the fixed cost per unit, that is, lead to a downward spiral. If MetaT ech‘s production plant was built for a practical capacity of 5,000 units, a denominator level of 5,000 units should be used, and the cost of excess capacity should not be charged to the units produced and sold. This will focus managerial attention on the unused capacity. If the competitive trends continue, MetaTech will need to cut back its installed capacity to stay competitive. 4. Suppose MetaTech sells x units each year. Its total cost to manufacture the x units would be $100 x + $1,500,000. Its total cost to purchase x units would be $400 x + $300,000. Therefore, Metatech should manufacture in-house, if $100 x + $1,500,000 < $400 x + $300,000; i.e., if x > 4,000 units. In-house, the cost structure is a low variable cost, high fixed cost structure, and only worth pursuing for high volumes. The source-outside cost structure is a high variable cost, low fixed cost structure, and only worth pursuing for small volumes. Currently, demand is exactly at 4,000 units. MetaTech should conduct some research to forecast future demand patterns. If it seems likely that demand is going to fall below 4,000, it may be better to shut down its production capacity and outsource all of its needed units. This may also allow the management to examine and pursue other business options, as its current business gets increasingly competitive.
9-41 9-39 (30 min.) Denominator level, production volume variance, working backward. 1. Denominator-Level Capacity Concept Production- Volume Variance (1) Budgeted Fixed Manuf. Overhead Costs (2) Fixed Manuf. Overhead Costs Allocated (3) = (2) (1) for Unf. PVV

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