Explain how shaving 5% off the estimated direct labor hours in the base for the predetermined overhead rate usually results in a bog boost in net operating income at the end of the fiscal year.
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Shaving 5% off the estimated direct labor hours in the base for the predetermined overhead rate can result in a significant boost in net operating income at the end of the fiscal year. Here is a step-by-step explanation of how this can happen:
1. Understanding the predetermined overhead rate: The predetermined overhead rate is a factor used to allocate indirect manufacturing costs to products or services. It is calculated by dividing estimated total manufacturing overhead costs by an estimated base, which is typically direct labor hours.
2. Impact of direct labor on predetermined overhead rate: Direct labor is often used as the base for calculating the predetermined overhead rate because it is considered a significant driver of indirect manufacturing costs. By reducing the estimated direct labor hours, it lowers the denominator in the calculation of the predetermined overhead rate.
3. Effect on allocated overhead costs: As the denominator decreases, the predetermined overhead rate increases. This means that a higher percentage of indirect manufacturing costs will be allocated to each unit of production.
4. Lowering production costs per unit: When a higher percentage of overhead costs is allocated to each unit produced, the reported production costs per unit will be higher. This can result in a perceived increase in production costs.
5. Impact on pricing decisions: Higher reported production costs per unit may lead to higher selling prices to maintain profitability. This can result in increased revenue per unit sold.
6. Enhanced profitability: If revenue per unit sold remains relatively constant and production costs per unit decrease (due to shaving off estimated direct labor hours), the difference between revenue and production costs will increase. This increased margin per unit translates into higher net operating income at the end of the fiscal year.
It's important to note that these steps are based on assumptions and general principles. The actual impact on net operating income will depend on several factors, such as the volume of production, the accuracy of the estimates, and the specific cost structure of the business.
Shaving off 5% of the estimated direct labor hours in the base for the predetermined overhead rate can potentially result in a significant boost in net operating income at the end of the fiscal year. To understand why, let's break it down.
First, let's define a few terms:
1. Direct labor hours: The total amount of time worked by employees directly involved in the production process. This includes all the time spent on activities that directly contribute to the manufacturing of a product or the provision of a service.
2. Predetermined overhead rate: This is a calculation used by companies to allocate indirect manufacturing costs to their products or services. It is usually expressed as a percentage of direct labor hours and is used to estimate the total overhead costs for a specific time period.
Now, let's dive into the explanation:
1. Cost allocation: By reducing the estimated direct labor hours in the base for the predetermined overhead rate, the allocated manufacturing overhead costs will also decrease. This is because the predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead costs by the estimated total direct labor hours. As a result, a smaller allocation of overhead costs will be assigned to each product or service produced.
2. Cost of goods sold (COGS): Since the allocated manufacturing overhead costs are part of the cost of goods sold, reducing these allocated costs will subsequently reduce the COGS. By lowering the COGS, the company's gross profit margin will increase, positively impacting its net operating income.
3. Operating income impact: The boost in net operating income comes from the reduction in manufacturing overhead costs allocated to each product or service. This reduction leads to an improvement in the company's overall profitability. When the COGS decreases, the difference between revenue and expenses widens, resulting in higher operating income.
It's important to note that this explanation assumes all other factors remain constant. Changes in sales volume, selling prices, or other cost components may also impact the net operating income.
To summarize, shaving off 5% of the estimated direct labor hours in the base for the predetermined overhead rate reduces the allocated manufacturing overhead costs. This leads to a lower COGS, increased gross profit margin, and ultimately, a boost in net operating income at the end of the fiscal year.