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Terri ronsin had recently been transferred to home security division of national home products. Shortly after taking over her new position as divisional controller, she was asked to develop the divisions predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any oversupplied or under applied 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 totals manufacturing overhead for the coming year by the production managers estimate of the total direct labor hours for the coming year. She took her computations to the divisions general manager for approval but was quite surprised when h suggested a modification in the base. Her conversation with the general manager, harry Irving, went like this:
Ronsin: here are my calculations for next years predetermined overhead rate. If you approve, we can endure the rate into the computer for 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 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 of 5% or so off the estimated direct labor hours ever year. That way, we kept a reserve that usually resulted in a big boost to her operating income at the end of the fiscal year in December. We called r our Christmas bonus. Corporate headquarters always seemed as pleased as a 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.
Questions:
Explain how shaving off 5% off the estimated direct labor hours in the base for the predetermined overhead rate usually resulted in a big boost in net operating income at the end of the fiscal year?
Should Terri go along with the general managers request to reduce direct labor-hours in the predetermined overhead rate computation to 420,000 direct labor-hours?
I think I have a solid response to the second question but the first question is a little confusing at the moment, anybody have the chance to help me out and give me some clarity?
To compute the predetermined overhead rate, Terri divided her estimate of totals manufacturing overhead for the coming year by the production managers estimate of the total direct labor hours for the coming year. She took her computations to the divisions general manager for approval but was quite surprised when h suggested a modification in the base. Her conversation with the general manager, harry Irving, went like this:
Ronsin: here are my calculations for next years predetermined overhead rate. If you approve, we can endure the rate into the computer for 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 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 of 5% or so off the estimated direct labor hours ever year. That way, we kept a reserve that usually resulted in a big boost to her operating income at the end of the fiscal year in December. We called r our Christmas bonus. Corporate headquarters always seemed as pleased as a 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.
Questions:
Explain how shaving off 5% off the estimated direct labor hours in the base for the predetermined overhead rate usually resulted in a big boost in net operating income at the end of the fiscal year?
Should Terri go along with the general managers request to reduce direct labor-hours in the predetermined overhead rate computation to 420,000 direct labor-hours?
I think I have a solid response to the second question but the first question is a little confusing at the moment, anybody have the chance to help me out and give me some clarity?