Cleveland Custom Cabinets is a specialty cabinet manufacturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinet makers and installers. There are 30 administrative and sales staff working for the company.

James Leroy owns Custom Cabinets. His accounting manager is Marcus Sims. Sims manages fifteen accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and external financial reports. The internal reports are used by management for decision making. The external reports are used to support bank loan applications.

The company applies overhead to jobs based on direct labor hours. For 2011, it estimated total overhead to be $9,600,000 and 80,000 direct labor hours. The cost of direct materials used during the first quarter of the year is $600,000 and direct labor cost is $400,000 (based on 20,000 hours worked). The companys accounting system is old and does not provide actual overhead information until about four weeks after the close of a quarter. As a result, the applied overhead amount is used for quarterly reports.

On April 10, 2011, Leroy came into Simss office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million expansion loan. He knew the bank would be reluctant to grant the loan based on the following income numbers.

Exhibit 1

Cleveland Custom Cabinets

Net Income for the Quarter Ended March 31, 2011

Sales $6,400,000

Cost of goods manufactured 4,800,000

Gross margin $1,600,000

Selling and administrative expenses 1,510,000

Net income $ 90,000

Leroy asked Sims to explain how net income could have gone from 14.2% of sales for the year ended December 31, 2010 to 1.4% for March 31, 2011? Sims pointed out that the estimated overhead cost had doubled for 2011 when compared with the actual cost for 2010. He explained to Leroy that rent had doubled and the cost of utilities skyrocketed. In addition, the custom making machinery was wearing out more rapidly so the companys repair and maintenance costs also doubled from 2010.

Leroy understood but wouldnt accept Simss explanation. Instead, he told Sims that as the sole owner of the company, there was no reason not to tweak the numbers on a one-time basis. I own the board of directors so no worries there. Listen, this is a one time deal. I wont ask you to do it again. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, Ill leave the creative accounting to you.

Assume Sims decided to reduce the estimated overhead for the year by 50 percent:

• How would that change the net income for the quarter?
• What would it be as a percentage of sales?
• Do you think Leroy would like the result?
• Do you think he will be content with the tweaking occurring just this one time?