# Predetermined Overhead Rate and Capacity:

Companies typically base their predetermined overhead rates on the estimated, or budgeted, amount of allocation base for the upcoming period. This is the method that is used in this chapter, but it is practice that is recently come under severe criticism. An example will be very helpful why.

## Example:

A corporation manufactures music CDs for local recording studios. The company’s CD duplicating machine is capable of producing a new CD every 10 seconds from a master CD. The company leases the CD duplicating machine for \$180,000 per year, and this is the company’s only manufacturing overhead. With allowances for setups and maintenance, the machine is theoretically capable of producing up to 900,000 CDs per year. However due to weak retail sales of CDs the company’s commercial customers are unlikely to order more than 6,00,000 CDs next year. The company uses machine time as the allocation base for applying manufacturing overhead. These data are summarized below:

 Music Corporation Data Total manufacturing overhead cost \$180,000 per year Allocation base: machine time per CD 10 seconds per CD Capacity 900,000 CDs per year Budgeted output for next year 600,000 CDs

If corporation follows common practice and computes its predetermined overhead rate using estimated or budgeted figures then its predetermined overhead rate for next year would be \$0.03 per second of machine time computed as follows:

Predetermined overhead rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base

\$180,000 /( 600,000 CDs × 10 seconds per CD)

= \$0.03 per second

Since the CD requires 10 seconds of machine time, each CD will be charged for \$0.30 of overhead cost.

Critics charge that there are two problems with this procedure. First, if predetermined overhead rates are based on budgeted activity, then the unit product cost will fluctuate depending on the budgeted level of activity for the period. For example, If the budgeted output for the year was only 3,00,000 CDs, the predetermined overhead rate would be \$0.06 per second of machine time or \$0.60 per CD rather than \$0.30 per CD. In general if budgeted output falls, the overhead cost per unit will increase; it will appear that the CDs cost more to market. Managers may then be tempted to increase prices at the worst possible time–just as demand is falling.

Second critics charge that under traditional approach, products are charged for resources they don’t use. when the fixed costs of capacity are spread over estimated activity, the units that are produced must shoulder the costs of unused capacity. That is why the applied overhead cost per unit is increases as the level of activity falls. The critics argue that products should be charged only for the capacity that they use; they should not be charged for the capacity they don’t use. This can be accomplished by basing the predetermined overhead rate on capacity as follows:

[Predetermined overhead rate based on capacity = Estimated total manufacturing overhead cost at capacity / Estimated total units in the allocation base at capacity]

= \$180,000 / (900,000 CDs × 10 seconds per CD)

= \$0.02 per second

Since the predetermined overhead rate is \$0.02 per second, the overhead cost applied to each CD would be \$0.20. This charge is constant and would not be affected by the level of activity during a period. If output falls, the charge would still be \$0.20 per CD.

This method will almost certainly result in under-applied overhead. If actual output at the music corporation is 600,000 CDs, then only \$120,000 of overhead cost would be applied to products (\$0.20 per CD × 600,00 CDs). Since the actual overhead cost is \$180,000, then there would be under-applied overhead of \$60,000. In another departure from tradition, the critics suggest that the under-applied overhead that results from idle capacity should be separately disclosed on the income statement as the cost of unused capacity–a period expense. Disclosing this cost as a lump sum on the income statement, rather than burying it in cost of goods sold or ending inventories, makes it much more visible to managers.

Official pronouncements do not prohibit basing predetermined overhead rates on capacity for external reports. Nevertheless, basing the predetermined overhead rate on estimated or budgeted, activity is a long-established practice in industry, and some managers and accountants may object to the large amounts of under-applied overhead that would often result from using capacity to determine predetermined overhead rates. And some may insist that the under-applied overhead be allocated among cost of goods sold and ending inventories–which would defeat the purpose of basing the predetermined overhead rate on capacity.