Melissa Loester, the new controller of Power-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, Jan Laird, and the assistant production manager, Lonny Lee.
Loester: I ran across an idea that I wanted to check out with both of you. It's about the way we compute predetermined overhead rates.
Laird: We're all ears.
Loester: 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.
Lee: We've been doing that as long as I've been with the company.
Laird: And it has been done that way at every other company I've worked at, except at most places they divide by direct labour-hours.
Loester: We use units because it is simpler and we basically make one product with minor variations. But, there's another way to do it. Instead of dividing the estimated total factory overhead by the estimated total units produced for the coming year, we could divide by the total units produced at capacity.
Lee: Oh, the Marketing Department will love that. It will drop the costs on all of our products.
They'll go wild over there cutting prices.
Loester: That is a worry, but I wanted to talk to both of you first before going over to Marketing.
Laird: Aren't you always going to have a lot of under-applied overhead?
Loester: That's correct, but let me show you how we would handle it. Here's an example based on our budget for next year:
Budgeted (estimated) production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 units
Budgeted sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 units
Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70 per unit
Variable manufacturing cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18 per unit
Total manufacturing overhead cost (all fixed) . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000
Selling and administrative expenses (all fixed) . . . . . . . . . . . . . . . . . . . . . . . $ 1,950,000
Beginning inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0
Traditional approach to computing the predetermined overhead rate:

Budgeted Income Statement

New approach to computing the predetermined overhead rate using capacity in the denominator:

Budgeted Income Statement

Laird: Whoa!! I don't 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.
Lee: I'm worried about something else, too. What happens when sales are not up to expectations?
Can we pull the "hat trick"?
Loester: I'm sorry, I don't understand.
Laird: Lonny's 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.
Lee: And we pull them out of our hat.
Laird: Yeah, we just increase production until we get the profits we want.
Loester: I still don't understand. You mean you increase sales?
Laird: Nope, we increase production. We're the production managers, not the sales managers.
Loester: I get it. Since you have produced more, the sales force has more units it can sell.
Laird: Nope, the marketing people don't 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 (used for internal reporting), any under-applied or over-applied overhead is taken directly to the income statement as an adjustment to Cost of Goods Sold. Assume the company has decided to use these overhead methods for internal reporting.
1. Suppose actual production is 80,000 units. Compute the operating incomes that would be realized under the traditional and new methods if actual sales are 75,000 units and everything else turns out as expected.
2. How many units would have to be produced under each of the methods in order to realize the budgeted operating income of $210,000 if actual sales are 75,000 units and everything else turns out as expected?
3. What effect does the new method based on capacity have on the volatility of 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?

Transcribed Image Text:

Estimated total manufacturing overhead cost Predetermined overhead rate Estimated total amount of the allocation base $25 per unit $2,000,000 80,000 units Revenue (80,000 units × $70 per unit)... Cost of goods sold: Variable manufacturing (80,000 units x $18 per unit).. . $1,40,000 Manufacturing overhead applied (80,000 units x $25 per unit).. Gross margin.. Selling and administrative expenses. Operating income.. $5,600,000 .... 2,000,000 3,440,000 2,160,000 1,950,000 .**.. $ 210,000