4 Reconcilation Theoretical Capacity Operating Income Practical Capacity

# 4 reconcilation theoretical capacity operating income

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smallest when normal capacity utilization is used as the denominator level.4. ReconcilationTheoretical Capacity Operating Income – Practical Capacity Operating Income\$40,000Decrease in inventory level during 200720,000Fixed mfg cost allocated per unit under practical capacity – fixed mfg. cost allocated per unit under theoretical capacity (\$12 – \$10)\$2Additional allocated fixed cost included in COGS under practical capacity = 20,000 units \$2 per unit =\$40,000More fixed manufacturing costs are included in inventory under practical capacity, so, wheninventory level decreases (as it did in 2007), more fixed manufacturing costs are included inCOGS under practical capacity than under theoretical capacity, resulting in a lower operatingincome.9-38
9-37 (20–35 min.)Effects of denominator-level choice.1.Normal capacity utilization. Givens denoted*Actual CostsIncurred(1)Same BudgetedLump Sum(as in Static Budget)Regardless ofOutput Level(2)Flexible Budget:Same BudgetedLump Sum(as in Static Budget)Regardless ofOutput Level(3)Allocated:Budgeted InputAllowed for Actual Output × Budgeted Rate(4)\$130,000\$120,000*\$120,000*70,000 hrs.* × \$2.00a= \$140,000\$10,000 U*\$20,000 F*Spending varianceNever a varianceProdn. volume variance= – \$20,000 = (\$120,000 – X)X= \$140,000=\$140,00070,000 machine-hours= \$2 per machine-hourDenominator level = \$120,000\$2= 60,000 machine-hours9-39
2.Practical capacity. Givens denoted*Actual CostsIncurred(1)Same Lump Sum(as in Static Budget)Regardless ofBudgeted OutputLevel(2)Flexible Budget:Same Lump Sum(as in Static Budget)Regardless ofBudgeted OutputLevel(3)Allocated:Budgeted InputAllowed for Actual Output × Budgeted Rate(4)\$130,000\$120,000*\$120,000*70,000* × \$1.20a= \$84,000\$10,000 U*\$36,000 U*Spending varianceNever a varianceProdn. volume variance= \$36,000 = (\$120,000 – X)X = \$84,000= \$84,00070,000 machine-hours= \$1.20 per machine-hourDenominator level = \$120,000\$1.20=100,000 machine-hours3.To maximize operating income, the executive vice president would favor using normalcapacity utilization rather than practical capacity. Why? Because normal capacity utilization is asmaller base than practical capacity, resulting in any year-end inventory having a higher unitcost. Thus, less fixed manufacturing overhead would become a 2006 expense as part of theproduction-volume variance if normal capacity utilization were used as the denominator level.9-40
9-38 (20 min.)Downward demand spiral.1. and 2.CompetitiveOriginal SituationPractical capacity (units)5,0005,000Budgeted capacity (units)5,0004,000Variable manufacturing cost per unit\$100\$100Fixed manufacturing costs\$1,500,000\$1,500,000Markup percentage100%100%Manufacturing cost per unitVariable\$100\$100Fixed (fixed mfg costsbudgeted capacity)(\$1,500,0005,000; \$1,500,0004,000)300375Full manufacturing cost per unit\$400\$475Selling Price (200% of full manuf. cost per unit)\$800\$9503.We can see that when the budgeted production is used as the denominator level and thislevel changes with anticipated demand, then the full manufacturing cost per unit and thereforethe selling price can be quite sensitive to the denominator level. In this case, the denominatorlevel has fallen by 20% [(5,000 – 4,000) 5,000] and the allocated fixed cost has increased by25% [(\$375 – \$300) 300], resulting in an 18.75% [(\$950 – \$800) \$800] increase in sellingprice. If MetaTech’s market is becoming more competitive because of foreign entrants, raisingthe selling price could further drive away customers, lower the budgeted capacity and raise the

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