Emily Carrigan was recently transferred to the Appliances Division of Delancy Corporation. Shortly after taking over her new position as divisional controller, Carrigan was asked to develop the division’s predetermined overhead rate for the upcoming year. The accuracy of the rate is important. Delancy Corporation uses direct labour-hours in all of its divisions as the allocation base for manufacturing overhead.
To compute the predetermined overhead rate, Carrigan divided her estimate of the total manufacturing overhead for the coming year by the production manager’s estimate of the total direct labour-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 Appliances Division, Harry Dafoe, went like this: Carrigan: 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 for this year.
1. Explain how shaving 5% off the estimated direct labour-hours in the base for the predetermined overhead rate usually results in a big boost in operating income at the end of the fiscal year.
2. Should Carrigan go along with the general manager’s request to reduce the direct labour-hours in the predetermined overhead rate computation to 105,000 direct labour- hours?