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Pat Miranda, the new controller of Vault Hard Drives, Incorporated, has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at first, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, J$.$ Stevens, and the assistant production manager, Marvin Washington.

Budgeted $($estimated$)$ production $83,000$ units

Budgeted sales $83,000$ units

Capacity $100,000$ units

Selling price $ $72$ per unit

Variable manufacturing cost $ $20$ per unit

Total manufacturing overhead cost $($all fixed$)$ $ $1,909,000$

Selling and administrative expenses $($all fixed$)$ $ $2,212,000$

Beginning inventories $ $0$

Traditional Approach to Computation of the Predetermined Overhead Rate

Estimated total manufacturing overhead cost, $$1,909,000-$: Estimated total units produced, $83,000=$ $$23\mathrm{.}00$ per unit

Budgeted Income Statement

Revenue $(83,000$ units $\backslash$times $$72$ per unit$)$ $ $5,976,000$

Cost of goods sold:

Variable manufacturing $(83,000$ units $\backslash$times $$20$ per unit$)$ $ $1,660,000$

Manufacturing overhead applied $(83,000$ units $\backslash$times $$23$ per unit$)1,909,0003,569,000$

Gross margin $2,407,000$

Selling and administrative expenses $2,212,000$

Net operating income $ $195,000$

New Approach to Computation of the Predetermined Overhead Rate Using Capacity in the Denominator

Estimated total manufacturing overhead cost at capacity, $$1,909,000-$: Total units at capacity, $100,000$ units $=$ $$19\mathrm{.}09$ per unit

$1.$ Assume actual sales is $79,000$ units and the actual production in units, actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Given these assumptions:

a$.$ Compute net operating income using the traditional income statement format.

b$.$ Compute net operating income using the new income statement format.

$2.$ What effect does the new capacity$-$based approach have on the volatility of net operating income?

$3.$ Assume that actual sales is $79,000$ units and the actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Under the traditional approach, how many units would have to be produced to realize net operating income of $$195,000?$

$4.$ Assume that actual sales is $79,000$ units and the actual selling price, actual variable manufacturing cost per unit, and actual fixed costs all equal their respective budgeted amounts. Under the new capacity$-$based approach, how many units would have to be produced to realize net operating income of $$195,000?$

$5.$ Will the $$hat trick$$ be easier or harder to perform if the new capacity$-$based method is used?

$6.$ Do you think the $$hat trick$$ is ethical?

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