New Millennium Technologies uses a standard cost system and budgeted 50,000 machine hours to manufacture 100,000 units in 2010. The budgeted total fixed factory overhead was $9,000,000. The company manufactured and sold 80,000 units in 2010 and would report a loss of $9,600,000 after charging the production-volume variance to cost of goods sold (CGS) of the period. Bob Evans, VP–Finance, believes that the denominator activity level of 50,000 machine hours is too low. The maximum capacity of the firm is between 5,000,000 and 6,000,000 machine hours. Bob considers a denominator level at half the low-end capacity to be reasonable. Furthermore, he believes that the unfavorable production-volume variance should be capitalized (rather than written off against current period’s earnings) because the demand for the firm’s products has been increasing rapidly. A conservative projection of the firm’s sales places the total sales at a level that will require at least 5 million machine hours in less than 5 years. Bob was able to show a substantial improvement in operating income after revising the cost data. He used the revised operating result in briefing financial analysts.

Budgeted machine hours	50,000	MHs
Budgeted output (units)	100,000	units
Budgeted MH/unit	0.50	MH/unit
Budgeted fixed overhead	$9,000,000
Actual production/sales (units)	80,000	units
Operating profit (loss)	($9,600,000)
Current denom activity level	50,000	MHs
Max Capacity--Low End:	5,000,000	MHs
Max Capacity--High End:	6,000,000	MHs
Estimated future use of capacity	5,000,000	MHs

Required

1. Compute the net effect on operating income of the two changes made regarding fixed factory overhead.

2. Is it ethical for Bob to make the changes? (Consult www.imanet.org.)

3. Do the provisions of GAAP regarding inventory costing (i.e., FASB ASC 330-10-30, previously SFAS No. 151—available at www.asc.fasb.org) bear upon the current issue? If so, how?

4. How does the choice of the denominator volume level in setting (fixed) overhead application rates provide managers with an opportunity to manage earnings?