Terry had recently been transferred to the Home Monitoring Systems Division of National Security Products. Shortly after taking over his new position as divisional controller, he was asked to develop the divisions predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any overapplied or underapplied overhead is closed out to Cost of Goods Sold at the end of the month. National Home Products uses direct labor-hours in all of its divisions as the allocation base for manufacturing overhead.

To compute the predetermined overhead rate, Terry divided his estimate of the total manufacturing overhead for the coming year by the production managers estimate of the total direct labor-hours for the coming year. He took his computations to the divisions general manager for approval but was quite surprised when she suggested a modification in the base. His conversation with the general manager, Tina Piers, went like this:

Terry: Here are my calculations for next years 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.

Piers: 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 labor-hours for the year is 440,000 hours. How about cutting that to about 400,000 hours?

Terry: I dont know if I can do that. The production manager says she will need about 440,000 direct labor-hours to meet the sales projections for the year. Besides, there are going to be over 430,000 direct labor-hours during the current year and sales are projected to be higher next year.

Piers: Terry, I know all of that. I would still like to reduce the direct labor-hours in the base to something like 400,000 hours. You probably dont know that I had an agreement with your predecessor as divisional controller to shave 10% or so off the estimated direct labor-hours every year. That way, we kept a reserve that usually resulted in a big boost to net operating income at the end of the fiscal year in December. We called it our Christmas bonus because the bump in earnings helped us to achieve our goals needed to obtain maximum annual bonus payouts at the end of the year. Corporate headquarters always seemed as pleased as punch that we could pull off such a miracle at the end of the year. This system has worked well for many years, and I dont want to change it now.

Later

Terry goes back to his cubicle. Terry knows that he should not reduce the direct labor-hours in the overhead rate computation to 400,000 direct labor-hours. He is confident in his computations and knows that the 440,000 estimate is accurate. Terry also knows that the production manager, Susan, has the most information about direct-labor hours necessary in the coming year, and she provided Terry with the 440,000 estimates. But Terry is new to the division and new to his role. This was one of his first assignments in the role, and he wants to impress his new boss.

1. Assuming they build exactly the volume they sell, by how much will the net income be misstated at the end of December?
2. Who are the other consumers?
3. Will misstating the rate have any impact?