Chapter 03B – Lecture Notes
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I. Appendix 3B: The Predetermined Overhead Rate and
Capacity (Slide #1 is a title slide)
Learning Objective 9: Understand the implications of
basing the predetermined overhead rate on activity at
capacity rather than on estimated activity for the
period.
A. Calculating predetermined overhead rates using an
estimated, or budgeted amount of the allocation
base
i. This method was used throughout the chapter;
however, recently it has been criticized in two
ways:
1. Basing the predetermined overhead rate on
budgeted activity results in product costs
that fluctuate depending upon the activity
level.
2. Calculating predetermined rates based upon
budgeted activity charges products for
costs that they do not use.
B. Capacity-based overhead rates
i. The aforementioned criticisms can be overcome by
using “estimated total units in the allocation base at
capacity” in the denominator of the predetermined
overhead rate calculation (rather than the
“estimated total units in the allocation base” in the
denominator).
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ii. The following example will help distinguish
between these two approaches.
1. Assume that a company leases a piece of
equipment for $100,000 per year. If run at
full capacity, the machine can produce
50,000 units per year.
2. The company estimates that 40,000 units will
be produced and sold next year.
3. The predetermined overhead rate, if based on
the estimated number of units that will be
produced and sold, is $2.50 per unit.
4. The predetermined overhead rate, if based on
capacity, is $2.00.
Quick Check
−
estimated units of allocation base vs.
capacity of the allocation base
C. Income statement preparation
i. Critics suggest that the underapplied overhead that
results from idle capacity should be disclosed on
the income statement as the cost of unused
capacity − a period expense.
1. Using a measure of capacity in the
denominator of the predetermined overhead
rate enables this type of disclosure.
2. Using the estimated or budgeted amount of
the allocation base in the denominator of the
predetermined overhead rate calculation does
not enable this type of disclosure.
a. Underapplied overhead is not treated
as a period expense, rather it is closed
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Chapter 03B – Lecture Notes
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b. out to work in process, finished
goods, and/or cost of goods sold.
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