Case 2B-4 (Algo) Ethics; Predetermined Overhead Rate and Capacity [LO2-2, LO2-6] Pat Miranda, the new controller of Vault Hard Drives, Incorporated, 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, J. Stevens, and the assistant production manager, Marvin Washington. Pat: 3.: Pat: Marvin: J.: Pat: Morvin: Pat: 3.1 Pat: 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. We're all ears. We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year, which is all a fixed cost, by the estimated total units produced for the coming year. We've been doing that as long as I've been with the company. And it has been done that way at every other company I've worked at, except at most places they divide by direct labor-hours. 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 basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity.. Oh, the Marketing Department will love that. It will drop the costs on all of our products.. They'11 go wild over there cutting prices.. That is a worry, but I wanted to talk to both of you first before going over to Marketing. Aren't you always going to have a lot of unused capacity costs? 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 Budgeted sales Capacity Selling price Variable manufacturing cost Total manufacturing overhead cost (all fixed) Selling and administrative expenses (all fixed) Beginning inventories 81,000 units 81,000 units 100,000 units $ 71 per unit $ 16 per unit $ 2,106,000 $ 2,128,000 $ 0 Traditional Approach to Computation of the Predetermined Overhead Rate Estimated total manufacturing overhead cost, $2,106,000/ Estimated total units produced, 81,000 $26.00 per unit Revenue (81,000 units x $71 per unit) Cost of goods sold: X Budgeted Income Statement Variable manufacturing (81,000 units $16 per unit) Manufacturing overhead applied (81,000 units $26 per unit) Gross margin Selling and administrative expenses Net operating income $ 5,751,000 $ 1,296,000 2,106,000 3,402,000 2,349,000 2,128,000 $ 221,000 New Approach to Computation of the Predetermined Overhead Rate Using Capacity in the Denominator Estimated total manufacturing overhead cost at capacity. $2,106,000/ Total units at capacity, 100,000 units = $21.06 per unit Revenue (81,000 units x $71 per unit) Cost of goods sold: Budgeted Income Statement Variable manufacturing (81,000 units x $16 per unit) Manufacturing overhead applied (81,000 units x $21.06 per unit) Gross margin Cost of unused capacity [(100,000 units Selling and administrative expenses Net operating income 3.: Marvin: Pat: 3.: Marvin: 3. Pat: 81,000 units) x $21.06 per unit] $ 5,751,000 $ 1,296,000 1,705,860 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. I'm worried about something else too. What happens when sales are not up to expectations? Can we pull the "hat trick"? I'm sorry, I don't understand. Marvin'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 cones down here and asks us to deliver sone more profits. And we pull them out of our hat. Yeah, we just increase production until we get the profits we want. I still don't understand. You mean you increase sales? 3,001,860 2,749,140 400, 140 2,128,000 $ 221,000 Marvin: 3.: Pat: 3.: Pat: 3.: Required: the president comes down here and asks us to deliver some more profits. And we pull them out of our hat. Yeah, we just increase production until we get the profits we want. I still don't understand. You mean you increase sales? Nope, we increase production. We're the production managers, not the sales managers. I get it. Because you have produced more, the sales force has more units it can sell. Nope, the marketing people don't do a thing. We just build inventories and that does the trick. In all of the questions below, assume that the predetermined overhead rate under the traditional method is $26 per unit, and under the new capacity-based method it is $21.06 per unit 1. Assume actual sales is 76,000 units and the actual production in units, actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Given these assumptions: a. Compute net operating income using the traditional income statement format. b. Compute net operating income using the new income statement format. 2. What effect does the new capacity-based approach have on the volatility of net operating income? 3. Assume that actual sales is 76,000 units and the actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Under the traditional approach, how many units would have to be produced to realize net operating income of $221,000? 4. Assume that actual sales is 76,000 units and the actual selling price, actual variable manufacturing cost per unit, and actual. fixed costs all equal their respective budgeted amounts. Under the new capacity-based approach, how many units would have to be produced to realize net operating income of $221,000? 5. Will the "hat trick" be easier or harder to perform if the new capacity-based method is used? 6. Do you think the "hat trick" is ethical? Complete this question by entering your answers in the tabs below. Req 1A Req 1B Req 2 Req 3 Req 4 Req 5 Req 6 Assume actual sales is 76,000 units and the actual production in units, actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Given these assumptions: Compute net operating income using the traditional income statement format. Sales Vault Hard Drives, Incorporated Income Statement: Traditional Approach Cost of goods sold: Variable manufacturing Manufacturing overhead applied Gross margin Req 1A Req 1B Req 2 Req 3 Req 4 Req 5 Req 6 teck my wo Assume actual sales is 76,000 units and the actual production in units, actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Given these assumptions: Compute net operating income using the traditional income statement format. Vault Hard Drives, Incorporated Income Statement: Traditional Approach Sales Cost of goods sold: Variable manufacturing Manufacturing overhead applied Gross margin Selling and administrative expenses. Net operating income Req 1A Req 1B > cs Req 1A Req 1B Req 2 Req 3 Req 4 Req 5 Req 6 Assume actual sales is 76,000 units and the actual production in units, actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Given these assumptions: Compute net operating income using the new income statement format. Vault Hard Drives, Incorporated Income Statement: New Approach Sales Cost of goods sold: Variable manufacturing Manufacturing overhead applied Gross margin Other expenses: Cost of unused capacity Selling and administrative expenses Net operating income Complete this question by entering your answers in the tabs below. Req 1A Req 1B- Req 2 Req 3 Req 4 Req 5 Req 6 What effect does the new capacity-based approach have on the volatility of net operating income? Effect on net operating Income is < Req 1B Req 3 > Complete this question by entering your answers in the tabs below. Req 1A Req 1B Req 2 Req 3 Req 41 Req 5 Req 6 Assume that actual sales is 76,000 units and the actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Under the traditional approach, how many units would have to be produced to realize net operating income of $221,000? (Do not round your intermediate calculations and round your final answers to the nearest whole unit.) Show less A Traditional approach units < Req 2 Req 4 > Complete this question by entering your answers in the tabs below. Req 1A Req 1B Req 2 Req 3 Req 4 Req 5 Req 6 Assume that actual sales is 76,000 units and the actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Under the new capacity-based approach, how many units would have to be produced to realize net operating income of $221,000? (Do not round your intermediate calculations and round your final answers to the nearest whole unit.) Show less A New approach units: Complete this question by entering your answers in the tabs below. Req 1A Req 18 Req 2 Req 3 Req 4 Req 5 Req 6 Will the "hat trick" be easier or harder to perform if the new capacity-based method is used? Performing hat trick will be < Req 4 Req 6 > Complete this question by entering your answers in the tabs below. Req 1A Req 18 Req 2 Req 3 Req 4 Req 5. Req 6 Do you think the "hat trick" is ethical? Do you think the "hat trick" is ethical? < Req 5 Req6