We have to write a very detailed analysis of why predetermined overhead rate should be accurate. The professor went on and explained the important parts that we should discuss. I do not exactly understand everything he said but I will type it down here. First let me explain what the question is:
It is dealing with this company that uses direct labor hours as their allocation base of manufacturing overhead. The under-applied or over-applied overhead is closed out to cost of goods sold at the end of the year. What they are doing is that they use less labor hours for the estimate of their predetermined overhead rate than what they think the actual number of hours should be. This way they end up in a high increase in net operating income at the end of the year.
OK .. here we should start the analysis:
so from what I understand, decreasing the estimated total amount of allocation base (labor hours) would increase predetermined overhead rate. OK.. from here I get confused.. Here are my notes from what the professor was saying, if someone could put it in a paragraph form and explain it to me I would really really appreciate it, it is 10% of my grade. so here are my notes:
explain what likely to take place in the company? if the application rate is too high, what happens to product cost? overstated? so inventory overstated?
lets say we only record at the end of the year, and we have no beginning inventory, whatever we produce we sell, and we expense everything (we sold everything).
inventory cost all high, but all is expended, so now adjust to COGS and bring it back to what it should have been.. COGS would be exactly the same. so other stuff going on?
we have inventories, now year end, interim reports showing overstated (something), inventories overstated .. what happens?