Discussion: Predetermined Overhead and Managerial Ethics

As you will recall from Unit 1, product costs include manufacturing overhead, as well as direct costs such as labor and materials. In Job-order costing this manufacturing overhead needs to be computed and included in the cost of the “job”. However, there are some problems with computing how much of the overhead should be assigned.

Manufacturing Overhead is an indirect cost, so it is almost impossible to figure out how much overhead each job uses up.

Manufacturing Overhead includes some fixed costs. So, if a company has a seasonal production (producing a lot of units in one period, but not many in another), the individual product cost will vary widely. Conversely, if the company has a level-production schedule, but a widely fluctuating level of fixed costs (such as high utility bills in the summer or winter), then the per unit cost will also vary widely.

The way around these problems is to allocate manufacturing overhead by using a common base. An allocation base such as Direct labor hours or direct machine hours allows managers to proportionately assign costs to a job. Typically, managers estimate the total amount of the allocation base that they believe they will need for the reporting period before the reporting period starts. In this way, they can assign costs to a job through-out the period. The estimate is called the predetermined overhead rate. It is computed using the following formula:

For example: if a company estimates that its overhead will be $1,500,000 over the coming year, and that they will need 200,000 labor hours to produce their product, the predetermined overhead would be:

This means that for every labor hour (or fraction thereof) needed to produce one unit, the proportionate amount of $7.50 will be added to the per unit product cost. If it takes half an hour to make one unit then the per unit cost will increase by $3.75.

As you can see, these estimates can play a very crucial role in the bottom line of a company’s financial statements. If the predetermined overhead rate is very high (overestimating product costs) then estimated net profit will be low. Conversely, if the predetermined rate is low, the profit estimates are better. Can you see how this may affect a manager’s decision on choosing an allocation base, or in making the estimates?

Instructions:

Read the Ethics scenario on page 158 of your book and respond to the following questions.

Why would the controller want to use the maximum capacity to compute the predetermined overhead rate?

What effect would this have on the financial statements?

What is the “hat trick”? Why does it work?

Are the “hat trick” and the capacity methods ethical?

What stakeholders are affected?