EXERCISE 3-17 (30 MINUTES)

4. Platinum Track’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 some-

thing 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

Verde Baja job has increased between 2004 and 2005. 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.

Under this method, Platinum Track’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 al-

most surely accelerate the company’s decline.

Problem 3-28 (continued)

Under the alternative approach, the overhead cost of the Verde Baja job

is stable at $4,000 and lower than the costs reported under the conven-

tional method. Under the conventional method, managers may be mis-

led into thinking that they are actually losing money on the Verde Baja

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 $4,000 is

reported. It is true that the underapplied 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 esti-

mated activity will not solve the company’s basic problems, at least this

method is less likely to send managers misleading signals.

© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

Solutions Manual, Chapter 3 119

Problem 3-29 (30 minutes)