Question

Ethics Challenge Ch3p133 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 overhead 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, however, 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 something 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: 1. Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the fiscal year. 2. Should Terri Ronsin go along with the general manager's request to reduce the direct labor-hours in the predetermined overhead rate computation to 420,000 direct labor-hours?

Answer 1

1. Decrease in the number of labour hours will lead to increase in overhead absorption rate as labour hours are used as the denominator in the calculation of overhead absorption rate. This will end up in increase in the cost of product manufactured. Eventually may have increase the selling price charged on customers. If the selling price is increased, it will result inot increase in net income of the business.

one more impact when the budgeted labour hours are reduced is, the production manager will try to reduce the actual hours of labour to avoid any adverse variance in labour cost. This will again reduce the labour cost and will improve the net income generated by the firm.

Increased overhead absorption will result in overabsoption of overhead, again its a profit for the company as it is adjusted in cost of goods sold.

Multiple effect of decrease in the labour hours will result in increase the net income of the business.

2. It would be better to go with the suggestion of the manager to reduce the labour hours as

• it will improve their net operating income
• it is a strategic policy of the firm

But increased overhead may result in increasing in the selling price of the product. They have to check the impact of selling price increase. If the competitiors are offering at a lower price the customes may move awya from us. so greater care should be given to reatin our customers while increasing our net income.