How does lowering your estimated direct labor hours increase your net operating income at the end of the fiscal year?
Shaving 5% off the estimated direct labor-hours in the predetermined overhead rate will result in an artificially high overhead rate. The artificially high predetermined overhead rate is likely to result in overapplied overhead for the year. The cumulative effect of overapplying the overhead throughout the year is all recognized in December when the balance in the Manufacturing Overhead account is closed out to Cost of Goods Sold. If the balance were closed out every month or every quarter, this effect would be dissipated over the course of the year.
Lowering the estimated direct labor hours can potentially increase net operating income at the end of the fiscal year due to the following reasons:
1. Labor Cost Savings: By reducing the estimated direct labor hours, a company may be able to save on labor costs. If the estimated labor hours are decreased, it means that fewer hours will be paid, resulting in lower labor expenses. This can positively impact net operating income as it reduces the overall cost of producing goods or providing services.
2. Improved Efficiency: Decreasing estimated direct labor hours can be an indication of increased efficiency in the production process. It suggests that employees can complete the same amount of work in less time. This increased productivity can lead to higher output levels without incurring additional labor costs, ultimately increasing net operating income.
3. Increased Capacity: Lowering the estimated direct labor hours can create more capacity within the existing labor pool. This means that additional tasks or projects can be undertaken without the need to hire more employees or incur overtime expenses. This higher capacity utilization can lead to increased revenue without a proportional increase in labor costs, positively impacting net operating income.
However, it's important to note that the impact on net operating income will also depend on other factors such as the unit selling price, material costs, and other indirect expenses. Therefore, it's crucial to consider the overall cost structure and profitability factors when analyzing the effect of lowering estimated direct labor hours on net operating income.
Lowering your estimated direct labor hours can potentially increase your net operating income at the end of the fiscal year due to the way it affects the calculation of overhead costs.
To explain how this works, let's break it down step by step:
1. Direct labor hours: Direct labor refers to the cost associated with the time employees spend working on a specific product or service. It includes wages and benefits. By estimating lower direct labor hours, you are essentially assuming that it will take less time for your employees to complete the work.
2. Overhead costs: Overhead costs include all the indirect expenses incurred in the production process, such as rent, utilities, depreciation, and indirect labor costs. These costs are not directly tied to the production of a specific product or service but are necessary for the overall operation of the business.
3. Overhead allocation: Overhead costs are allocated to products or services based on an allocation base, which could be direct labor hours, machine hours, or any other suitable measure. Using direct labor hours as the allocation base means that the more direct labor hours you estimate, the higher your allocated overhead costs will be.
4. Impact on product costs: The allocation of overhead costs to products or services affects their respective costs. When you estimate lower direct labor hours, you reduce the allocation base, resulting in a lower allocation of overhead costs to your products or services.
5. Impact on net operating income: Since lower direct labor hours lead to lower overhead costs allocated to products, the overall cost per product or service decreases. Consequently, you may be able to maintain the same selling price while reducing your costs, which can increase your gross profit margin and ultimately your net operating income.
It is important to note that this explanation assumes that the allocation of overhead costs based on direct labor hours is a fair and accurate representation of the actual resource consumption. Additionally, the example provided focuses solely on the impact of direct labor hours on net operating income and does not consider other factors that may influence the final result.
Understanding these concepts can help businesses strategize their estimates and manage costs effectively.