The management of Krach Corporation would like to investigate the possibility of basing its predetermined overhead rate on activity at capacity. The company's controller has provided an example to illustrate how this new system would work. In this example, the allocation base is machine-hours and the estimated amount of the allocation base for the upcoming year is 10,000 machine-hours. Capacity is 16,000 machine-hours and the actual level of activity for the year is assumed to be 8,000 machine-hours. All of the manufacturing overhead is fixed and both the estimated amount at the beginning of the year and the actual amount at the end of the year are assumed to be $40,000 per year. For simplicity, it is assumed that this is the estimated manufacturing overhead for the year as well as the manufacturing overhead at capacity. It is further assumed that this is also the actual amount of manufacturing overhead for the year.If the company bases its predetermined overhead rate on capacity, what would be the cost of unused capacity reported on the income statement prepared for internal management purposes?
A) $6,000
B) $20,000
C) $5,000
D) $25,000

Question

Quizplus · Accepted Answer

To calculate the predetermined overhead rate, we use the formula Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Activity. In this case, the estimated activity is the amount of machine-hours at capacity, which is 16,000. Therefore, the predetermined overhead rate is $40,000 / 16,000 machine-hours = $2.50 per machine-hour.

To calculate the manufacturing overhead cost incurred for the actual level of activity, we use the formula Manufacturing Overhead Cost = Predetermined Overhead Rate x Actual Activity. In this case, the actual activity is 8,000 machine-hours. Therefore, the manufacturing overhead cost incurred is $2.50 per machine-hour x 8,000 machine-hours = $20,000.

To calculate the cost of unused capacity, we first calculate the manufacturing overhead cost that would have been incurred at capacity by multiplying the predetermined overhead rate by the amount of capacity not used. In this case, the amount of capacity not used is 16,000 machine-hours - 8,000 machine-hours = 8,000 machine-hours. Therefore, the manufacturing overhead cost for unused capacity is $2.50 per machine-hour x 8,000 machine-hours = $20,000.

Therefore, the cost of unused capacity reported on the income statement prepared for internal management purposes is $20,000.

The Management of Krach Corporation Would Like to Investigate the Possibility