A company uses a job cost system and allocates overhead on the basis of direct l

Question

A company uses a job cost system and allocates overhead on the basis of direct labor hours, with over- or underallocated overhead closed to cost of goods sold at the end of the year. Managers are paid a bonus if net income (before deducting the bonus) exceeds a target amount. Stockholders are paid dividends based on operating cash flows after deducting any bonus paid to managers. In order to increase the likelihood of earning the bonuses, some managers suggest estimating direct labor hours in a manner that would create a favorable year-end overhead adjustment. Required: 1. What direction (over- or underestimating direct labor hours) would achieve the desired effect? Why? 2. What parties would be positively affected, and why? 3. What parties would be negatively affected, and why? 4. Would this action be considered ethical? Why or why not? 5. What policy change could management implement to reduce the motivation for suggesting this action?

Explanation / Answer

Many companies calculate and apply this overhead rate using, not actual overhead costs and the actual quantity of the allocation base, but rather budgeted overhead costs and the budgeted quantity of the allocation base. When a company uses budgeted overhead rates in its costing system, but all other information in the costing system is based on actual costs, the company is using what is called a normal costing system. It is important to remember that although there are no rules in management accounting, companies always, as a matter of practice, use either budgeted numbers in both the numerator and the denominator of the overhead rate, or actual numbers in both the numerator and the denominator of the overhead rate. Companies never use budgeted overhead divided by the actual quantity of the allocation base, or actual overhead divided by the budgeted quantity of the allocation base. It is also important to remember that in a normal costing system, the budgeted overhead rate is multiplied by the actual quantity of the allocation base incurred. In Chapter 10, we will discuss another type of accounting system, called a standard costing system, that multiplies the budgeted overhead rate by a flexible budget quantity for the allocation base: the amount of the allocation base that should have been used for the amount of output achieved. However, in a normal costing system, the only budgeted number is the overhead rate; direct costs are recorded at their actual cost, and the overhead rate is multiplied by the actual quantity of the allocation base used during the period. Advantages of Using Budgeted Overhead Rates: There are three principal reasons that many companies in all sectors of the economy use budgeted overhead rates, either as part of a normal costing system or as part of a standard costing system. Actual overhead rates are not known in a timely manner: Factory managers often use production cost information in their monitoring of the manufacturing process. Control of manufacturing activities is a daily or weekly process, not a monthly or quarterly process. The challenge of collecting and reporting actual direct costs—the cost of materials and labor used in production—within one or two days of actual production is difficult, but increasingly possible. For example, all materials used in production have already been purchased, and the cost of those materials can be ascertained. Also, sophisticated data collection systems, often called real-time systems, can track the movement of inventory, and track labor resources incurred at various work stations, as production occurs. Even the quantity of the overhead cost allocation base used in production can probably be ascertained, because the allocation base is usually a measure of a direct input. However, many of the components that make up overhead are not paid daily or even weekly. Utilities and property taxes are often paid monthly or quarterly. The factory manager who wants to know the cost of production on January 3 for the purpose of controlling operations on the factory floor will not want to wait until the books are closed on January 31 for that information. Usually, budgeted overhead rates are sufficiently close to actual overhead rates so that normal costing systems provide reasonably accurate cost information for management control purposes, and normal costing can provide this information in a timely manner. Overhead rates are subject to short-run fluctuations: For an apparel factory in El Paso, electric costs are significantly higher in July than in January due to the cost of air conditioning. Should overhead rates be calculated and applied separately for each month, or should overhead rates be averaged over the entire year? The answer to this question is not clear, because it depends on the types of decisions for which management will use factory cost information as an input. For example, if the factory has excess capacity and management is considering suspending factory operations for two weeks, monthly cost data will assist in scheduling the down-time to maximize cost savings (i.e., close the factory for two weeks in July, not January). On the other hand, if several product managers are scheduling production for the coming year, it would seem counterproductive to provide these managers incentives to compete with each other for January factory time, for the sake of obtaining the lower per-unit production cost, if some of them will have to schedule production in July in any case. Using an overhead rate that averages over the entire year might be more reasonable for production costing purposes like this one. In fact, many companies prefer to average overhead rates over a quarter or an entire year, and these companies usually prefer using budgeted overhead rates instead of waiting until actual overhead is known at the end of the period.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.