Ethics and the Manager
Emily Carrigan was recently transferred to the Appliances Division of Delancy Corporation. Shortly after taking over her new position as divisional controller, Carrigan was asked to de- velop the division's predetermined overhead rate for the upcoming year. The accuracy of the rate is important. Delancy Corporation uses direct labour-hours in all of its divisions as the allocation base for manufacturing overhead.
To compute the predetermined overhead rate, Carrigan divided her estimate of the total manufacturing overhead for the coming year by the production manager's estimate of the total direct labour-hours for the coming year. She took her computations to the division's general manager for approval but was quite surprised when he suggested a modification in the base. Her conversation with the general manager of the Appliances Division, Harry Dafoe, went like this:
Carrigan: Here are my calculations for next year's 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 for this year.
Dafoe: Thanks for coming up with the calculations so quickly. They look just fine. There is, however, one slight modification Id' like to see. Your estimate of the total direct labour-hours for the year is 110,000 hours. How about cutting that to about 105,000 hours?
Carrigan: I don't know if I can do that. The production manager says she will need about 110,000 direct labour-hours to meet the sales projections for next year. Besides, there will be over 108,000 direct labour-hours during the current year, and sales are projected to be higher next year.
Dafoe: Emily, I know all of that. I would still like to reduce the direct labour-hours in the base to something like 105,000 hours. You probably don't know that I had an agreement with your predecessor as divisional controller to shave 5% or so off the estimated direct labour-hours every year. That way, we kept a reserve that usually resulted in a big boost to operating in- come at the end of the fiscal year in December. We called it our Christmas bonus. 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 don't want to change it now.
Required:
1. Explain how shaving 5% off the estimated direct labour-hours in the base for the predeter- mined overhead rate usually results in a big boost in operating income at the end of the fiscal year.
2. Should Carrigan go along with the general manager's request to reduce the direct la- bour-hours in the predetermined overhead rate computation to 105,000 direct labour- hours?