Question

CASE 3–18 Ethics and the Manager [Course Objective B] Terri Ronsin had recently been transferred to the Home Security Systems Division of National Home Products. Shortly after taking over her new position as divisional controller, she was asked to develop the division’s predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any overapplied or underapplied over- head is closed out to Cost of Goods Sold at the end of the year. National Home Products uses direct labor-hours in all of its divisions as the allocation base for manufacturing overhead.

To compute the predetermined overhead rate, Terri divided her estimate of the total manufacturing overhead for the coming year by the production manager’s estimate of the total direct labor-hours for the coming year. She took her computations to the division’s general manager for approval but was quite surprised when he suggested a modification in the base. Her conversation with the general manager of the Home Security Systems Division, Harry Irving, went like this:

Ronsin: Here are my calculations for next year’s predetermined overhead rate. If you approve, we can enter the rate into the computer on January 1 and be up and running in the job-order costing system right away this year.

Irving:    Thanks for coming up with the calculations so quickly, and they look just fine. There is, how- ever, one slight modification I would like to see. Your estimate of the total direct labor-hours for the year is 440,000 hours. How about cutting that to about 420,000 hours?

Ronsin: I don’t know if I can do that. The production manager says she will need about 440,000 direct labor-hours to meet the sales projections for the year. Besides, there are going to be over 430,000 direct labor-hours during the current year and sales are projected to be higher next year.

Irving: Teri, I know all of that. I would still like to reduce the direct labor-hours in the base to some- thing like 420,000 hours. You probably don’t know that I had an agreement with your predecessor as divisional controller to shave 5% or so off the estimated direct labor-hours every year. That way, we kept a reserve that usually resulted in a big boost to net operating income at the end of the fiscal year in December. We called it our Christmas bonus. Corporate headquarters always seemed as pleased as punch that we could pull off such a miracle at the end of the year. This system has worked well for many years, and I don’t want to change it now.

Required:

Assume the following information:

Direct Materials	$40	per unit
Direct Labor	$20	per unit
Total Estimated Manufacturing Overhead	$8,400,000
Manufacturing overhead is allocated based on estimated direct-labor hours. Each unit of product requires 1 direct labor hour.

During the year, the company produced and sold 442,000 units, and incurred actual overhead of $8,450,000, what is the under/overapplied overhead if:

The estimated Direct Labor Hours is 440,000.

The estimated Direct Labor Hours is 420,000.

All over-applied and under-applied overhead applied directly to cost of goods sold. Assume that the company had $900,000 in net operating income before the over/under applied overhead adjustment is made. What is the revised net income after the over/underapplied overhead adjustment?

Answer 1

	440000 DLH	420000 DLH
direct mat	$40	$40
direct labor	$20	20
Overhead applied	(8400000/440000) = 19.09	(8400000/420000) = 20
Cost per unit	$79.09	$80
Applied overhead to WIP	442000*19.09=$8437780	442000*20=$8840000
Actual overhead	$84,50,000.00	$84,50,000.00
Under applied	$12,220.00
Over applied		$3,90,000.00
Before NOI	$9,00,000.00	$9,00,000.00
After NOI	$8,87,780.00	$12,90,000.00

By reducing the direct labor hours in the predetermined overhead rate computation to 442,000 hours, the general manager has been over-appling the overhead to the production. It would make the cost per unit high than the actual. At the end of the year, the over-applied overhead has to be reversed to some cost absorbent. It is ethically not correct because it raised the cost indicated by the produced output than that of actual cost incurred.