Cristin is an new controller at Solequin Corp. She was asked to develop the predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any underapplied or overapplied overhead is closed out to Cost of Goods Sold at the end of the year. Solequin uses direct labor hours in all of its divisions as the allocation base for manufacturing overhead.
To compute the predetermined overhead rate, Cristin 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 went like this:
Cristin: Here are my calculations for next year's predetermined overhead rate.
GM: Thanks, they look fine. I do have a modification. Your estimate of the direct labor hours for the year is 110,000 hours. How about cutting that to about 105,000 hours?
Cristin: I don't know if I can do that. The production manager says she will need about 110,000 direct labor hours to meet the sales projections for next year. Besides, there are going to be over 108,000 direct labor hours during the current year and sales are projected to be higher next year.
GM: I know that, I would still like to reduce the direct labor hours in the base to 105,000. I had an agreement with your predecesor 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 year. We called it our Christmas Bonus. Corporate has always been very happy about it.
1. Explain how shaving 5% off the estimated direct labor hours in the base of the predetermined overhead rate usually results in a big boost in the net operating income at the end of the year.
2. Should Cristin go along with the general manager's request to reduce the direct labor hours in the computation?
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