Sherri Rowland had recently been transferred to the home security systems division of National Home Products. Shortly after taking over her new position as divisional accountant, she came to know that each of the three division presidents had a lot of autonomy in decision making and reporting. In her first meeting with one division president, Harry Irving, the following conversation took place.

Harry Irving: It is good to have you on our team, Sherri. I am sure we can report better profits to the bosses in the White House (I mean, head office).

Sherri Rowland: What exactly are you thinking about? I have reviewed some files and see that there are inconsistences.

Harry Irving: Are you talking about the poor information system and our estimation techniques? We do that so that we look good at the end of the year.

Sherri Rowland: How so?

Harry Irving: Head office allocates overhead costs on the basis of machine-hours. I have always had an agreement with your predecessor to shave 5% or so off the estimated machine-hours every year. That way, we kept a reserve that usually resulted in a big boost to net income at the end of the fiscal year in December. We called it our holiday bonus. Corporation headquarters always seemed pleased as punch that we could pull off such a miracle at the need of the year. But, recently, they have been asking too many questions.

Sherri Rowland: So, what do you want me to do?

Harry Irving: Looking good in the eyes of our bosses is extremely important in this company. Can we find ways to look good without being the center of attention?

Sherri Rowland: I am not too sure about what we can do.

Harry Irving: I have heard that the accounting standards offer flexibility to users. Can you somehow produce cost information that will always show us in a positive light?

After returning to her office, Sherri Rowland looked up the standards and came across the following:

The cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

She was confident about materials cost but wanted more clarification regarding conversion costs. She read on and came to the following paragraph: the costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.

REQUIRED:

Explain how shaving 5% off the estimated direct labor-hours is in base for the predetermined overhead rate usually results in a big boost in net income at the end of the fiscal year. (The answer should include the end of year treatment of the over- or under applied overhead. (Do not exceed 120 words).