3.
To maximize operating income, the executive vice president would favor using normal
capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a
smaller base than practical capacity, resulting in any year-end inventory having a higher unit
cost. Thus, less fixed manufacturing overhead would become a 2006 expense as part of the
production-volume variance if normal capacity utilization were used as the denominator level.

9-40
9-38
(20 min.)
Downward demand spiral.
1. and 2.
Competitive
Original
Situation
Practical capacity (units)
5,000
5,000
Budgeted capacity (units)
5,000
4,000
Variable manufacturing cost per unit
$100
$100
Fixed manufacturing costs
$1,500,000
$1,500,000
Markup percentage
100%
100%
Manufacturing cost per unit
Variable
$100
$100
Fixed (fixed mfg costs
budgeted capacity)
($1,500,000
5,000; $1,500,000
4,000)
300
375
Full manufacturing cost per unit
$400
$475
Selling Price (200% of full manuf. cost per unit)
$800
$950
3.
We can see that when the budgeted production is used as the denominator level and this
level changes with anticipated demand, then the full manufacturing cost per unit and therefore
the selling price can be quite sensitive to the denominator level. In this case, the denominator
level has fallen by 20% [(5,000
â€“
4,000)
5,000] and the allocated fixed cost has increased by
25% [($375
â€“
$300)
300], resulting in an 18.75% [($950
â€“
$800)
$800] increase in selling
price. If MetaT
echâ€˜s market is becoming more competitive
because of foreign entrants, raising
the selling price could further drive away customers, lower the budgeted capacity and raise the
fixed cost per unit, that is, lead to a downward spiral. If MetaT
echâ€˜s production plant was built
for a practical capacity of 5,000 units, a denominator level of 5,000 units should be used, and the
cost of excess capacity should not be charged to the units produced and sold. This will focus
managerial attention on the unused capacity. If the competitive trends continue, MetaTech will
need to cut back its installed capacity to stay competitive.
4.
Suppose MetaTech sells
x
units each year. Its total cost to manufacture the
x
units would
be $100
x
+ $1,500,000. Its total cost to purchase
x
units would be $400
x
+ $300,000. Therefore,
Metatech should manufacture in-house, if $100
x
+ $1,500,000 < $400
x
+ $300,000; i.e., if
x
>
4,000 units. In-house, the cost structure is a low variable cost, high fixed cost structure, and only
worth pursuing for high volumes. The source-outside cost structure is a high variable cost, low
fixed cost structure, and only worth pursuing for small volumes. Currently, demand is exactly at
4,000 units. MetaTech should conduct some research to forecast future demand patterns. If it
seems likely that demand is going to fall below 4,000, it may be better to shut down its
production capacity and outsource all of its needed units. This may also allow the management to
examine and pursue other business options, as its current business gets increasingly competitive.

9-41
9-39
(30 min.)
Denominator level, production volume variance, working backward.
1.
Denominator-Level
Capacity Concept
Production-
Volume
Variance
(1)
Budgeted
Fixed
Manuf.
Overhead
Costs
(2)
Fixed Manuf. Overhead
Costs Allocated
(3) = (2)
â€“
(1) for Unf. PVV