Normal costing: alternative denominator volumes: engineering firm Thomas Pty Ltd is a defense engineering business. Contracts are costed using a normal job costing system, with a plantwide overhead rate based on practical capacity. I.M. Rite, the firm’s accountant, has recommended a switch from practical capacity to the budgeted volume of cost driver for the coming year. Rite believes that the volume of production for the current year will be well below the practical capacity. He is worried that by the end of the year there will be a significant difference between actual and applied overhead.
The marketing manager. U.R. Slick, is strongly opposed to the proposed change in denominator volume. Most of the company’s business is obtained by tendering for contracts on a cost-plus basis. Tenders are based on the estimated cost for the job plus a 40 per cent markup.
The normal business cycle for Thomas Pty Ltd tends to fluctuate over two years. At its peak the company operates almost at practical capacity. Predictions for the coming year are based on the expected trough in the cycle.
1. If the firm continues to use practical capacity as its denominator volume for the coming year, what will be the effect on underapplied or overapplied overhead at the end of the coming year? What will be the effect on job costs and tender quotes during the year?
2. Why would Slick oppose the change of denominator volume from practical capacity to the budgeted volume for the coming year?
3. If the company used normal volume as its denominator volume, what would be the effect on underapplied or overapplied overhead at the end of the coming year and at the end of the next year? What will be the effect on job costs and tender quotes over each of the next two years?