Ethics; Predetermined Overhead Rate and Capacity Pat Miranda, the new controller of Vault Hard Drives, Inc.

, has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at first, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, J. Stevens, and the assistant production manager, Marvin Washington. Pat: I ran across an idea that I wanted to check out with both of you. Its about the way we compute predetermined overhead rates. J.: Were all ears. Pat: We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year by the estimated total units produced for the coming year. Marvin: Weve been doing that as long as Ive been with the company. J.: And it has been done that way at every other company Ive worked at, except at most places they divide by direct labor-hours. Pat: We use units because it is simpler and we basically make one product with minor variations. But, theres another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity. Marvin: Oh, the Marketing Department will love that. It will drop the costs on all of our products. Theyll go wild over there cutting prices. Pat: That is a worry, but I wanted to talk to both of you first before going over to Marketing. J.: Arent you always going to have a lot of underapplied overhead? Pat: Thats correct, but let me show you how we would handle it. Heres an example based on our budget for next year. Traditional Approach to Computation Predetermined Overhead Rate of the

J.: Whoa!! I dont think I like the looks of that Cost of unused capacity: If that thing shows up on the income statement, someone from headquarters is likely to come down here looking for some people to lay off. Marvin: Im worried about something else too. What happens when sales are not up to expectations? Can we pull the hat trick? Pat: Im sorry, I dont understand. J.: Marvins talking about something that happens fairly regularly. When sales are down and profits look like they are going to be lower than the president told the owners they were going to be, the president comes down here and asks us to deliver some more profits. Marvin: And we pull them out of our hat. j.: Yeah, we just increase production until we get the profits we want. Pat: I still dont understand. You mean you increase sales? J.: Nope, we increase production. Were the production managers, not the sales managers. Pat: I get it. Since you have produced more, the sales force has more units it can sell. J.: Nope, the marketing people dont do a thing. We just build inventories and that does the trick. Required: In all of the questions below, assume that the predetermined overhead rate under the traditional method is $25 per unit, and under the new method it is $20 per unit. Also assume that under the traditional method any underapplied or overapplied overhead is taken directly to the income statement as an adjustment to Cost of Goods Sold. 1. Suppose actual production is 160,000 units. Compute the net operating incomes that would be realized under the traditional and new methods if actual sales are 150,000 units and everything else turns out as expected.

New Approach to Computation of the Predetermined Overhead Rate Using Capacity in the Denominator

2. How many units would have to be produce under each of the methods in order to realize the budgeted net operating income of $500,000 if actual sales are 150,000 units and everything else turns out as expected?

3. What effect does the new method based on capacity have on the volatility of net operating income? 4. Will the hat trick be easier or harder to perform if the new method based on capacity is used? 5. Do you think the hat trick is ethical?

Ina of t q st ll he ue ions be , a low ssum t tt pre t rm dove a ra eu rt t dit l m t e ha he de e ine rhe d t nde he ra iona e hodis $ 5pe un , a dun t n wm t 2 r it n der he e e hoditis $ 0pe unit Also a 2 r . ssum e t tund rt et dit a m t ha e h ra ion l e hoda y un ra n de pplie orove pp dove e dis t ke dire ly t t incom st t m nta a a just e t Costof G d ra lie rh a a n ct o he e a e e s n d m nt o oods Sold. p e 1 Supposeactual productionis 160,000units.Com utethenetoperatingincom s ) t tw ldbere lize und rt et d ion l a n wm t ha ou a d e h ra it a nd e e hods ifa ua sa s a 1 0 0 ct l le re 5 ,0 0 unit a e ryt inge t s nd ve h lse urns outa e ct d. s xpe e Sa s le Costof G s S ood old Manuf uringCost Variable act Tot Produced al Manuf uringCost Variable act (D eductInv ory Ending) ent , Manuf uringCost Fixed Ov act erhead Tot Produced al Manuf uringCost Fixed Ov act erhead (D eductInv ory Ending) ent , 9,000,000 a ould e 2 Howm nyunits w haveto beproduceundereachofthem thods inorderto ) re lizet ebu t dn tope t in a h dgee e ra ing com of$ 0 ,0 0if a ua sa s a 1 0 0 unit e 50 0 ct l le re 5 ,0 0 s a e ryt nd ve hinge t rns outa e ct d? lse u s xpe e Sa s le Costof G s S ood old Manuf uring Cost Variable act Tot Produced al Manuf uring Cost Variable act (D eductInv ory Ending) ent , Manuf uring Cost Fixed Ov act erhead Tot Produced al Manuf uring Cost Fixed Ov act erhead (D eductInv ory Ending) ent , Add(D educt Underapplied (Ov ): erapplied) Gross M rgin a Se llinga dA in n dm N tope t incom e ra ing e 9,000,000

TR D N A ITIO AL

160,000 (10,000) 160,000 (10,000)

15 15 25 25

2,400,000 (150,000) 4,000,000 (250,000) 6,000,000

168,000 (18,000) 168,000 (18,000)

15 15 25 25

2,520,000 (270,000) 4,200,000 (450,000) (200,000) 5,800,000 3,200,000 2,700,000 500,000

Gross M rgin a Se llinga A in nd dm N tope t incom e ra ing e

3,000,000 2,700,000 300,000

Under t t ional approach, t report netoperat incom can be increasedby he radit he ed ing e increasingt product lev w t result in ov he ion el hich hen s erappliedov erheadw is deduct f hich ed rom CostofGoods Sold. 4,000,00 $200,000 Addit ional netoperat incom requiredt ing e o this only is how m we uch atain t t argetnetoperat incom ($500,000 ing e allocated $300,000) (a) $25per unit Ov erhead applied per unitofout (b) put but we overproduced and 8,000unit s Addit ional out required t atain t put o t argetnet applied the same POR bringingour overhead cost operat incom (a) (b) ing e $4 ,000,000 applied to Act t al m act ual ot anuf uring ov erhead cost 4,200,000 incurred Manuf uring ov act erhead applied thuswe overapplied 4 ,200,000 [(160,000 unit +8,000 unit $25 per unit s s) ] Ov erhead ov erapplied N A PR ACH EW P O Sa s le Costof G s S ood old Manuf uringCost Variable act Tot Produced al Manuf uringCost Variable act (D eductInv ory Ending) ent , Manuf uringCost Fixed Ov act erhead Tot Produced al Manuf uringCost Fixed Ov act erhead (D eductInv ory Ending) ent , Gross M rgin a Costof u nuse ca cit d pa y Se llinga A in nd dm N tope t incom e ra ing e 9,000,000 Sa s le Costof G s S ood old Manuf uring Cost Variable act Tot Produced al Manuf uring Cost Variable act (D eductInv ory Ending) ent , Manuf uring Cost Fixed Ov act erhead Tot Produced al Manuf uring Cost Fixed Ov act erhead (D eductInv ory Ending) ent , Gross M rgin a Costof u nuse ca cit d pa y Add( e D duct: U ra ) nde pplie (O ra plie ) d ve p d Se llinga dA in n dm N tope t incom e ra ing e 9,000,000
$200,000

160,000 (10,000) 160,000 (10,000) 40,000

15 15 20 20 20

2,400,000 (150,000) 3,200,000 (200,000) 5,250,000 3,750,000 800,000 2,700,000 250,000

172,500 (22,500) 172,500 (22,500) 40,000 (12,500)

15 15 20 20 20 20

2,587,500 (337,500) 3,450,000 (450,000) 800,000 (250,000) 5,250,000 3,750,000 550,000 2,700,000 500,000

Newapproach: Under t newapproach, t report netoperat incom canbe increased byincreasing t he he ed ing e he product lev This result in less ofa deduct on t incom st em f t CostofUnused ion el. s ion he e at ent or he Capacit . y 4,000,000 $250,000 Addit ional netoperat incom requiredt ing e o this only is how m we uch atain t t argetnetoperat incom ($500,000 ing e allocated $250,000) (a) $20per unit Ov erhead applied per unitofout (b) put but we overproduced and 12,500un s it Addit ional out required t atain t put o t argetnet applied the sam POR e operat incom (a) (b) ing e bringingour overhead cost 160,000 unit s Est at num ofunit produced im ed ber s applied to 172,500 unit s Act num ofunit t be produced ual ber so 4,250,000 thuswe overapplied