Cristin Madsen has recently been transferred to the Appliances Division of Solequin Corporation. Shortly after taking over here 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 of some importance, since it is used throughout the year and any overapplied or underapplied overhead is closed out to Cost of Goods Sold only at the end of the year. Solequin Corporation uses direct labour hour 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 labour hours for the coming year. She took her computations to the divisions general manager for approval but was quite surprised when he suggested a modification in the base. Her conversation with the geteral manager of the Appliances Division went like this: Madsen: 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. Jusic: 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 labour hours for the year is 110,000 hours. How about cutting that to about 105,000 hours? Madsen: I don't know if I can do that. The production manager says she will need about 110,000 direct labour hours to meet the sales projections for next year. Besides, there are going to be over 108,000 direct labour hours during the current year and sales are projected to be higher next year. Jusic: Cristin, I know all of that. I would still like to reduce the direct labour hours in the base to something like 105.000 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 labour hours every year. That way, we kept a reserve that usually resulted in a big boost to the gross margin at the end of the fiscal year in December. This system has worked well for many years, and I don't want to change it now.

Required: 1) Explain how shaving 5% off the estimated direct labour hours in the base for the predetermined overhead rate usually results in a boost in gross margin (ie the difference between sales and cost of goods sold) at the end of the fiscal year? 2) Discuss if Cristin Madsen should go along with the general manager's request to reduce the direct labour hours in the predetermined overhead rate computation to 105.000 direct labour hours? Refer to at least two ethical principles applicable to professional accountants.