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How does shaving 5% off the estimated direct labor hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the fiscal year?
Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the fiscal year.
To understand how shaving 5% off the estimated direct labor hours can result in a boost in net operating income, we need to dive into the concept of predetermined overhead rates and their impact on financial performance.
Predetermined overhead rates are used to allocate indirect manufacturing costs to individual products or services. These costs, such as rent, utilities, and equipment depreciation, are not directly traceable to a specific product but are necessary for production. To calculate the predetermined overhead rate, a company estimates its total overhead costs and then divides this estimate by a logical cost driver, such as direct labor hours.
Now, let's consider a scenario where a company overestimates its direct labor hours as a basis for the predetermined overhead rate. If the actual direct labor hours turn out to be lower than estimated, then the predetermined overhead rate will be too high. This means that the allocated overhead costs will also be higher than necessary.
By shaving 5% off the estimated direct labor hours, the company effectively reduces the predetermined overhead rate. As a result, fewer indirect manufacturing costs are allocated to each unit of product or service. This reduction in allocated costs can have two positive effects on net operating income:
1. Cost Reduction: With a lower predetermined overhead rate, the allocated indirect manufacturing costs per unit decrease. This, in turn, reduces the overall cost per unit. If the selling price remains the same, the company can achieve higher profit margins per unit sold.
2. Cost Recovery: If the company has already produced and sold some units before realizing the overestimation, the excess overhead costs are charged against the net operating income. Shaving 5% off the estimated direct labor hours helps to recover these costs since fewer costs will be allocated going forward.
Ultimately, when the predetermined overhead rate is adjusted based on accurate direct labor hours, it ensures a more accurate allocation of costs, resulting in improved profitability. However, it is important to note that the impact on net operating income will depend on various factors specific to each business and industry.