Term 1 Unit 4 Discussions: Discussion 7, 38 Predetermine

Term 1 Unit 4 Discussionsunit 4 Discussion 7 38 Predetermined Overhe

Marine Components produces parts for airplanes and ships. The parts are produced to customer specifications, with customers paying either a fixed price or a price based on recorded cost plus a fixed fee. For year 2, Marine expects only two clients: one with fixed-price contracts and the other with cost-plus contracts. The estimated manufacturing overhead for the year is $10 million. Budgeted data include machine-hours and direct labor costs for each client.

Compute the predetermined overhead rate using machine-hours as the allocation base. Then, compute it using direct labor cost as the basis. Subsequently, determine which allocation method would result in higher income for Marine Components and discuss the ethical considerations of choosing an allocation method based solely on which increases reported income.

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The practice of assigning manufacturing overhead in cost accounting is crucial for accurately determining product costs and financial performance assessments. Predetermined overhead rates are set at the beginning of a fiscal period and are used to allocate overhead costs to products or jobs throughout that period. These rates can be based on various cost drivers, such as machine-hours or direct labor costs, which influence how overhead is applied and ultimately reported in financial statements.

Calculating the predetermined overhead rate using machine-hours involves dividing the estimated total overhead by the total estimated machine-hours. Given that Marine Components estimates $10 million of overhead and has budgeted 2,000,000 machine-hours for each client (totaling 4,000,000 machine-hours), the rate per machine-hour would be calculated as follows:

\[

\text{Predetermined Overhead Rate (Machine-hours)} = \frac{\$10,000,000}{4,000,000 \text{ hours}} = \$2.50 \text{ per machine-hour}

\]

This rate signifies that for every machine-hour used, Marine allocates $2.50 of overhead costs to the respective job or product.

Alternatively, calculating the overhead rate based on direct labor cost entails dividing the total estimated overhead by the total estimated direct labor costs. With a budgeted $2,500,000 of direct labor for client 1 and $7,500,000 for client 2, the total direct labor cost sums to $10,000,000:

\[

\text{Predetermined Overhead Rate (Labor cost)} = \frac{\$10,000,000}{\$10,000,000} = 1.00 \text{ or 100\% of direct labor cost}

\]

This indicates that overhead will be applied at a rate equivalent to 100% of the direct labor costs incurred.

Determining which method yields higher income depends on how overhead is applied relative to production activity for each client. The machine-hour-based rate, applying $2.50 per hour, emphasizes machine utilization, which may lead to higher overhead charges if machine hours are high. Conversely, the labor-based rate applies overhead directly proportional to labor costs, which could be more accurate if labor constitutes the primary cost driver.

From an income perspective, if the projects for client 2 (cost-plus contracts) are allocated more overhead under one method than the other, it can affect reported profits. For example, if the machine-hour basis allocates less overhead to client 2’s projects, the reported profit will be higher, as overhead costs are lower. Conversely, the labor-based method might spread overhead differently, potentially leading to a different profit outcome.

The ethical concern centers around the intentional selection of an overhead allocation method to manipulate financial results. Choosing an allocation basis solely because it results in higher income, without regard to the actual cost structure or economic substance of the activities, raises ethical issues. It could mislead stakeholders by portraying a more favorable financial position than reality warrants. Ethical accounting standards emphasize accurate and fair reporting, meaning management should select the most appropriate and fair allocation base aligned with the underlying cost drivers rather than for manipulation purposes.

In conclusion, while accounting practices allow flexibility in choosing allocation bases, ethical considerations demand that companies prioritize fairness and accuracy over opportunistic income enhancement. Transparent and justifiable cost allocation methods uphold the integrity of financial reporting and maintain stakeholder trust.

References

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