LL Flaunteroy was recently hired by Premier Asphalt as a controller. He was formerly employed by Top Notch CPA LLC. Top Notch performs an annual audit to ensure Premier is playing by the rules and all information released to the public are presented in fair, accurate and ethical manner.

LL Flaunteroy first duty was to develop a predetermined overhead rate for 2023. This rate is important to Premier since it is used continuously throughout the year as a method to apply overhead and misapplied overhead is closed out to cost of goods sold. This seemed simple enough. He used the production manager (Hodges) estimate of production hours (250,000) and the manufacturing overhead estimated for the year ($2,000,000) and developed the predetermined oh rate (POHR). The estimated manufacturing overhead was established by using 2022 numbers as a baseline and then adjusting for 2023 based on changes in expected demand. This rate was applied to manufacturing costs.

Flaunteroy brought this calculation to his immediate supervisor, Chief Financial Officer (Jackson). LL was caught off guard by the demand (maybe it was a suggestion) that he “amend” that estimate of production hours down to about 220,000. Flaunteroy explained his reasoning and his discussions with the Production Manager .... but Jackson became insistent AND that LL needed to reduce that estimate of production hours.

Finally, Jackson explained more thoroughly. By shaving off the estimate of production hours, Premier could “produce” a nice little kicker at the end of the year (when actual results adjusted this reserve account). When misapplied overhead was closed out to COGS it was like magic and an income boost. Rather than letting the income boost fall to retained earnings, management paid holiday bonuses. It was like magic and made everyone happy, why change now.

1.Explain in detail (suggest using sample numbers) how the manipulation of predetermined overhead rate could result in a net operating income “boost” at year end. Would it really ‘create income” ?

2.Should Flaunteroy go along with this and be the team player / Why or why not?

3.If this idea does create income where does the cash come from ?