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Blunt is considering a new project but is unsure how much overhead to include in the calculations to help him decide whether or not to proceed. Existing fixed overheads are absorbed at the rate of $8 per hour worked. Blunt is certain that the project will involve an incremental 500 labour hours. The project will involve extra machine running costs and these variable overheads cost him $4 per hour. The number of extra machine hours is expected to be 450 hours. The difference between this figure and the 500 labour hours above is expected idle time. The project will require a little more temporary space that can be rented at a fixed cost of $1,200 for the period of hire. This overhead is not included in the fixed overhead absorption rate above. What is the overhead to be charged to the project?
A $3,000
B $3,200
C $7,000
D $7,200Sir, Why isn’t the 500 incremental labour hours included for calculating the fixed overhead costs?
Won’t the word incremental mean that this 500 is more than the Normal capacity (the existing OAR is $8) and hence there would be like a step up fixed overhead costs? please help me outThe relevant cash flow is:
Extra variable overheads: 450 hours × $4/hr $1,800
Rent $1,200
Total $3,000
Fixed costs are not incremental and idle time would normally mean that the machines are not in use are so are not an incurred cost.Regarding your question about the 500 incremental labour hours, they are not included in calculating fixed overhead costs because they are considered incremental and do not lead to an increase in fixed overheads, which are typically absorbed based on normal capacity. The fixed overhead absorption rate applies to the normal level of activity, and any additional hours beyond that do not incur additional fixed costs.
Sir does this mean that the total fixed cost would remain the same and only the hours based on which the total fixed overhead is absorbed is increased (the denominator in calculating OAR is increased , but the numerator is the same)) and so it’ll decrease the OAR, but not the total fixed overhead?
So does this conclude that unless the Q. states that there is a step up fixed costs or the TOTAL fixed costs is increased somehow, we would assume there is no increase in fixed costs total because of the incease in volume, only the volume has increased, even though this increase in volume is more than the Normal capacity?
Please just clarify this , then all my doubts regarding relevant fixed costs will be cleared 🙂Yes, you are correct. The total fixed costs remain unchanged regardless of the increase in production volume. The fixed OAR is calculated by dividing the total fixed overheads by the total hours worked. If the number of hours worked increases, while the total fixed overheads stay the same, the OAR will decrease.
This means that unless the question explicitly states that there is an increase in total fixed costs due to specific circumstances, we assume that the total fixed costs do not change with an increase in volume.
The increase in volume does not lead to an increase in fixed costs; it only affects the allocation of those fixed costs across a larger number of hours. Therefore, the assumption is that fixed costs remain constant unless otherwise specified in the question.
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