1. The overhead applied to the Fire job would be computed as follows — Alderberry Recording Inc small audio studio company handles work for advertising agencies
Business & ManagementOperationsWorked Solution
Alderberry Recording Inc. is a small audio recording studio. The company handles work for advertising agencies—primarily for radio ads—and has a few singers and bands as clients. Alderberry Recording handles all aspects of recording, from editing to making a digital master from which CDs can be copied. The competition in the audio recording industry has always been tough, but it has been getting even tougher over the last several years. The studio has been losing customers to newer studios that are equipped with more up-to-date equipment and are able to offer very attractive prices and excellent service. Summary data concerning the last two years of operations follow:
The company applies studio overhead to recording jobs on the basis of the hours of studio service provided. For example, 30 hours of studio time were required to record, edit, and master the Fire music CD for a local band. All of the studio overhead is fixed, and the actual overhead cost incurred was exactly as estimated at the beginning of the year in both 2013 and 2014.
Required:
1. Alderberry Recording computes its predetermined overhead rate at the beginning of each year based on the estimated studio overhead and the estimated hours of studio service for the year. How much overhead would have been applied to the Fire job if it had been done in 2013? In 2014? By how much would overhead have been under-applied or over-applied in 2013? In 2014?
2. The president of Alderberry Recording has heard that some companies in the industry have changed to a system of computing the predetermined overhead rate at the beginning of each year based on the estimated studio overhead for the year and the hours of studio service that could be provided at capacity. He would like to know what effect this method would have on job costs. How much overhead would have been applied using this method to the Fire job if it had been done in 2013? In 2014?
By how much would overhead have been under-applied or over-applied in 2013 using this method? In 2014?
3. How would you interpret the under-applied or over-applied overhead that results from using studio-hours at capacity to compute the predetermined overhead rate?
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4. What fundamental business problem is Alderberry Recording facing? Which method of computing the predetermined overhead rate is likely to be more helpful in facing this problem? Explain.
SOLUTION
1. The overhead applied to the Fire job would be computed as follows:
2013
2014
Estimated studio overhead cost (a)
$90,000
$90,000
Estimated hours of studio service (b)
1,000
750
Predetermined overhead rate (a) ÷ (b)
$90
$120
Fire job’s studio hours
× 30
× 30
Overhead applied to the Fire job
$2,700
$3,600
Overhead is under-applied for both years as computed below:
2013
2014
Predetermined overhead rate (see above) (a)
$90
$120
Actual hours of studio service provided (b)
900
600
Overhead applied (a) × (b)
$81,000
$72,000
Actual studio cost incurred
90,000
90,000
Under-applied overhead
$ 9,000
$18,000
2.
If the predetermined overhead rate is based on the hours of studio service at capacity, the computations would be:
2013
2014
Estimated studio overhead cost (a)
$90,000
$90,000
Hours of studio service at capacity (b)
1,800
1,800
Predetermined overhead rate (a) ÷ (b)
$50
$50
Fire job’s studio hours
× 30
× 30
Overhead applied to the Fire job
$1,500
$1,500
Overhead is under-applied for both years under this method as well:
2013
2014
Predetermined overhead rate (see above) (a)
$50
$50
Actual hours of studio service provided (b)
900
600
Overhead applied (a) × (b)
$45,000
$30,000
Actual studio cost incurred
90,000
90,000
Under-applied overhead
$45,000
$60,000
3.
When the predetermined overhead rate is based on capacity, underapplied overhead is interpreted as the cost of idle capacity. Indeed, proponents of this method suggest that underapplied overhead be treated as a period expense that would be separately disclosed on the income statement as Cost of Unused Capacity.
4.
Alderberry Recording’s fundamental problem is the competition that is drawing customers away. The competition is able to offer the latest equipment, excellent service, and attractive prices. The company must do something to counter this threat or it will ultimately face failure.
Under the conventional approach in which the predetermined overhead rate is based on the estimated studio hours, the apparent cost of the Fire job has increased between 2013 and 2014. That happens because the company is losing business to competitors and therefore the company’s fixed overhead costs are being spread over a smaller base. This results in costs that seem to increase as the volume declines. Alderberry Recording’s managers may be misled into thinking that the problem is rising costs and they may be tempted to raise prices to recover their apparently increasing costs. This would almost surely accelerate the company’s decline.
Under the alternative approach, the overhead cost of the Fire job is stable at $1,500 and lower than the costs reported under the conventional method. Under the conventional method, managers may be misled into thinking that they are actually losing money on the Fire job and they might refuse such jobs in the future—another sure road to disaster. This is much less likely to happen if the lower cost of $1,500 is reported. It is true that the under-applied overhead under the alternative approach is much larger than under the conventional approach and is growing. However, if it is properly labeled as the cost of idle capacity, management is much more likely to draw the appropriate conclusion that the real problem is the loss of business (and therefore more idle capacity) rather than an increase in costs.
While basing the predetermined rate on capacity rather than on estimated activity will not solve the company’s basic problems, at least this method will be less likely to send managers misleading signals.