"Firms Need to Use the Capacity of the Equipment or Division

question 161

Essay

"Firms need to use the capacity of the equipment or division that is the 'bottleneck' of the manufacturing process as the denominator volume in setting the fixed overhead allocation rate. In cases where there is more than one 'bottleneck,' the denominator should be the smallest capacity among the bottleneck production processes."

Required:
1. What type of variance is related to this "denominator?" Explain.
2. Define the terms theoretical capacity, practical capacity, and budgeted capacity utilization. Of the three, which is considered most relevant for setting the predetermined overhead application rate for internal reporting purposes, particularly for fixed overhead costs? Explain.

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Definitions:

Total Cost

The sum of all costs associated with the production of goods or services, including fixed and variable costs.

Extraction Costs

Expenses associated with the removal of natural resources from the earth, such as mining or drilling.

User Costs

The costs incurred by using a product or service, including purchase price, maintenance, and operation expenses.

Level

A stage, degree, or magnitude in a hierarchical system, often used to describe intensity, development, or achievement.