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. J. Pat: Marvin: 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'll 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? Thats correct, but let me show you how we would handle it. Here's an example based on our budget for next year. Marvin: Pat: Pat: Budgeted (estimated) production Budgeted sales Capacity Selling price Variable manufacturing cost N Total manufacturing overhead cost (all fixed) Selling and administrative expenses (all fixed) Beginning inventories 82,000 units 82,000 units 100,000 units $ 74 per unit $ 16 per unit $ 1,968,000 $ 2,471,000 $ 6 Traditional Approach to Computation of the Predetermined Overhead Rate Estimated total manufacturing overhead cost, $1,968,000 / Estimated total units produced, 82,000 = $24.00 per unit ULICI U 08 per unit 1. Assume actual sales is 75,000 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 75,000 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 $317,000? 4. Assume that actual sales is 75,000 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 $317,000? 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. Reg 1A Reg 1B Reg 2 Reg 3 Req 4 Reg 5 Req6 Compute net operating income using the traditional income statement format. Vault Hard Drives, Incorporated Income Statement: Traditional Approach Sales 0 Cost of goods sold: Variable manufacturing Manufacturing overhead applied Gross margin Selling and administrative expenses Net operating income 0 5 0 Estimated total manufacturing overhead cost, $1,968,000 7 Estimated total units produced. 82.000 = $24.00 per unit $ 6,968,900 Budgeted Income Statement Revenue (82,000 units X $74 per unit) Cost of goods sold: Variable manufacturing (82,000 units X $16 per unit) Manufacturing overhead applied (82,000 units X $24 per unit) Gross margin Selling and administrative expenses Net operating income $11, E12, 600 1.1.1968, 990 3,289,000 2,788,899 2,471,000 $ 317, 900 New Approach to Computation of the Predetermined Overhead Rate Using Capacity in the Denominator Estimated total manufacturing overhead cost at capacity, $1.968,000 Total units at capacity, 100,000 units = $19.68 per unit $ 6,968,000 Budgeted Income statement Revenue (82,000 units X $74 per unit) Cost of goods sold: Variable manufacturing (82,000 units X $16 per unit) Manufacturing overhead applied (82,000 units X $19.68 per unit) Gross margin Cost of unused capacity [(180,000 units - 82,990 units)