ACCT
ACCT303Chapter9

# Practical capacity givens denoted actual costs

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2. Practical capacity. Givens denoted* Actual Costs Incurred (1) Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (2) Flexible Budget: Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (3) Allocated: Budgeted Input Allowed for Actual Output × Budgeted Rate (4) \$52,000 \$48,000* \$48,000* 28,000* × \$1.20 a = \$33,600 \$4,000 U* \$14,400 U* Spending variance Never a variance Prodn. volume variance = \$14,400 = (\$48,000 – X) X = \$33,600 a = \$33,600 ÷ 28,000 machine-hours = \$1.20 per machine-hour Denominator level = \$48,000 ÷ \$1.20 per machine-hour = 40,000 machine-hours 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 2009 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level. 9-38

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9-36 (20 min.) Downward demand spiral. 1. and 2. Competitive Original Situation Practical capacity (units) 7,500 7,500 Budgeted capacity (units) 7,500 6,000 Variable manufacturing cost per unit \$100 \$100 Fixed manufacturing costs \$2,250,00 0 \$2,250,000 Markup percentage 100% 100% Manufacturing cost per unit Variable \$100 \$100 Fixed (fixed mfg costs ÷ budgeted capacity) (\$2,250,000 ÷ 7,500; \$2,250,000 ÷ 6,000) 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% [(7,500 – 6,000) ÷ 7,500] 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 Network’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 Network’s production plant was built for a practical capacity of 7,500 units, a denominator level of 7,500 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, Network will need to cut back its installed capacity to stay competitive. 4. Suppose Network sells x units each year. Its total cost to manufacture the x units would be \$100 x + \$2,250,000. Its total cost to purchase x units would be \$400 x + \$450,000. Therefore, Network should manufacture in-house, if \$100 x + \$2,250,000 < \$400 x + \$450,000; i.e., if x > 6,000 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 6,000 units. Network should conduct some research to forecast future demand patterns. If it
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