Question

Terri Ronsin had recently been transferred to the Home Security Systems Division of National Home Products. Shortly after taking over her new position as divisional controller, she was asked to develop the division’s predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any overapplied or underapplied overhead 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 the total manufacturing overhead for the coming year by the production manager’s estimate of the total direct labor-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 Home Security Systems Division, Harry Irving, went like this:

Ronsin: 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 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 about 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 5% or so off the estimated direct labor-hours every year. That way, we kept a reserve that usually resulted in a big boost to net operating income at the end of the fiscal year in December. We called it our Christmas bonus. Corporate headquarters always seemed as pleased as 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.

Required:

a. Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the fiscal year.

b. Should Terri Ronsin go along with the general manager’s request to reduce the direct labor-hours in the predetermined overhead rate computation to 420,000 direct labor-hours?

Answer 1

a. Shaving 5% off in estimated direct labor hours will boost the net operating income:

Budgets are prepared taking into consideration the performance of previous production periods.

If the number of actual direct labor hours are lower when compared with the budgeted direct labor hours it results in the same quantity of production but with lowered number of direct labor hours. This can be explained with the below example.

Budgeted data for the period xxxx

Production (Units) 10,000

Direct labor hour per unit 5

Total direct labor hours (10000 * 5) 50,000 hours

Rate per hour 10

Budgeted overheads 500,000

Actual data for the period xxxx

Production (Units) 10,000

Direct labor hour per unit 4

Total Direct labor hour 40,000

Rate per hour 10

Actual overheads incurred 400,000

Therefore, from the above example it has been observed that there is an saving of 100,000 when compared with budget and actual data for the period. This is because the efficiency of the workers has been increased which results in decrease in time taken to finish an unit of product for the same level of production. Hence the profit will increase by 100,000.

Similarly, if 5% of the direct labor hours is shaved off then there definitely be an increase in profit. Let us consider the following example.

Given budgeted direct labor hours is 440,000

Assuming budgeted overheads is $ 4400,000

Overhead recovery rate is ( 4400000 /440000 ) = 10 per hour

If the number of hours shaved by 5% , then hours = 440000 * 95% = 418,000 hours

Therefore actual overheads will be 418,000 * 10 = $ 4180,000

Thus we will have an increase in profit by (4400000 - 4180000) = $ 220,000.

b. Terri Ronsin should go with the general manager's request to reduce the direct labor hours in computing pre determined overhead recovery rate, as it will increases the profits, as narrated in the above example.