Question

Melinda Baker had recently been transferred to the Home Security Division of ADP. Shortly after taking over her new position as 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 all year long and any overapplied or under- applied overhead is closed out to Cost of Goods Sold at the end of the year. ADP uses direct labor-hours as the allocation base for manufacturing overhead.
To compute the predetermined overhead rate, Baker divided her estimate of the total manufacturing overhead for the upcoming 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 GM for approval but was surprised when he suggested a modification in the base. Their conversation was as follows:
Baker:
Here are the calculations for next year’s predetermined overhead rate. Once approved we can enter the rate into the computer on January 1 and be up and running right away
GM:
Thanks for coming up with the calculations so quickly. There is, however, one slight modification I would like to see. Your estimate of the total direct labor- hours for the year is 340.000 hours. How about cutting that to about 320,000 hours?
Baker:
I don’t know if I can do that. The division manager says she will need about 340,000 direct labor-hours to meet projections for the year. Additionally, there are going to be over 330,000 direct labor-hours during the current year and sales are projected to be higher next year.
GM:
I would still like to reduce the direct labor-hours in the base to about 320,000 hours. I had an agreement with your predecessor as divisional controller to shave 3% or so off the estimated direct labor hours every year. This gave a big boost to net operating income at the end of the fiscal year in December. We called it our yearly bonus.

1. Explain how shaving 3% off the estimated direct labor-hours in the base for the predetermined overhead rate will cause a boost in net operating income at the end of the fiscal year. No formulas or math is needed. A detailed answer providing all possible financial report modifications will suffice.

2. Should Baker go along with the general manager’s request to reduce the direct labor hours?

3. What violations are occurring? What is Baker's best course of action?

Answer 1

1) Shaving off 3% of direct labor-hours will reduce the cost of goods sold.

Operating income = sales – cost of goods sold – operating expenses.

Therefore reducing the cost of goods sold will boost operating income.

2) Baker should not go along with the manager’s request to reduce the direct labor hours.

3) The financial statements are being manipulated to show an incorrect operating profit. This can mislead investors. Baker should escalate the matter to someone higher than the GM.