New Millennium Technologies uses a standard cost system. It budgeted 50,000 machine hours to manufacture 100,000 units in 2022. The budgeted total fixed factory overhead was $9,000,000. The company manufactured and sold 80,000 units in 2022 and would report a loss of $9,600,000 after charging the production volume variance to Cost of Goods Sold (COGS) 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 the 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 results in briefing financial analysts.

Required

1. Consider the two changes being considered: (a) What is the estimated operating income (loss) if both changes are implemented? (b) What portion of the change identified in part (a) is attributable to the elimination of the unfavorable production volume variance? (c) What portion of the change identified in part (a) is attributable to the decrease in fixed overhead cost applied to production?

2. Is it ethical for Bob to make the changes? (Consult www.imanet.org/career-resources/ethicscenter for the IMA’s Statement of Ethical Professional Practice, revised July 1, 2017.) 

3. Do the provisions of GAAP regarding inventory costing (viz., FASB ASC 330-10-30, previously SFAS No. 151—available at www.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?