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MA161 – Management Accounting
Case Study:
E t h ic s , P r e d e t e r m in e d O v e r h e a d R at e a n d C a p a c it y
Mayra Maia Fiorini
Course: BABM/F - Group R
Student Number: 11841746
Man ag em ent Accounting
Contents:
Introduction: ...................................................................................................................................................3
Changes in Net Income: ...............................................................................................................................4
Effects of changes in production levels: .................................................................................................6
Volatility of Net Income: ..............................................................................................................................8
The “Hat Trick”:.......................................................................................................................................... 11
Ethical Issues of the “Hat Trick”: .......................................................................................................... 12
Conclusion: .................................................................................................................................................. 13
References: .................................................................................................................................................. 14
Appendix: ..................................................................................................................................................... 15
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Introduction:
This assignment will consider the option of applying manufacturing overhead (M.O.)
on production at capacity, instead of the traditional method of applying M.O. on
predetermined activity levels, and the ethical advantages present on that option. It will
examine the differences in net income when budgeted sales are not realized and compare the
changes of net income according to the way M.O. is applied. It will then calculate if changes on
budgeted production changes net income when production exceed actual sales and how much
budgeted production needs to increase in order to realize a budgeted net income. It will study
the volatility of net income when M.O. is applied on production at capacity and compare with
volatility of the traditional method. Finally it will discuss the called “Hat Trick”, its ethical issues
and see if change in M.O. distribution changes its performance.
This assignment will work based on the case of Sunshine Inc., a fictional company
studying the possibility to change the way its M.O. is applied. The company has originally an
inventory of zero units; budget productions of 158,000 units, a production capacity of 198,000
units, budget sales of 158,000 units, each unit is sold at $59.80 and have a variable
manufacturing cost of $14.90. The company has fixed total M.O. costs of $3,998,800 and a
fixed administration and selling expenses of $2,698,000.
This assignment’s objective is to demonstrate that M.O. applied on production at
capacity ensures a more reliable Income Statement and makes it difficult to realize unethical
strategies like the “Hat Trick”. Applying M.O. on production at capacity helps management
create more realistic budgets that could increase actual profits.
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Changes in Net Income:
Assuming that actual production was 158,000 units and actual sales were 150,000
units, the difference of net income when different methods of M.O. application are used can
be seen at Income Statement I and Income Statement II.
Overhead applied per unit using the traditional method:
Total M.O. Costs/Budget Production=
$3,998,800/158,000=
$25.31 per unit
Income Statement
M.O. Applied on Production Activity
Revenue
Cost of Goods Sold
Variable Costs
M.O. Applied
Gross Margin
$8,970,000.00
$2,235,000.00
$3,796,329.11
Administrative Expenses
$6,031,329.11
$2,938,670.89
$2,698,000.00
Net Income
$240,670.89
Income Statement I
Overhead applied per unit using production at capacity:
Total M.O. Costs/Production Capacity=
$3,998,800/198,000=
$20.20 per unit
Income Statement
M.O. Applied on Production Capacity
Revenue
Cost of Goods Sold
Variable Costs
M.O. Applied
Gross Margin
$8,970,000.00
$2,235,000.00
$3,029,393.94
Cost of unused Capacity
Administrative Expenses
$5,264,393.94
$3,705,606.06
$807,838.38
$2,698,000.00
Net Income
$199,767.68
Income Statement II
In the Income Statement unsold products are not taken into consideration. All costs
are applied on units sold; all remaining units at inventory are treated as current assets and can
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be sold on the next period. The costs of their production are transferred to the finished goods
account and incurred in the Income Statement when they are sold.
In the case budgets were realized and all units produced were sold, the net income on
both Income Statements would have been the same. M.O. applied per unit using production at
capacity levels is lower than when applying M.O. on activity levels, the difference is shown as
cost of unused capacity. When there are unsold units in the end of a period their accumulated
costs is lower since M.O. costs per unit are lower. There is an increase in costs when not
producing at capacity and a reduction of cost of goods sold.
Applying M.O. costs on production at capacity creates a more realistic Income
Statement and Statement of Financial Position since cost of goods sold is more accurate and
fair in relation to production. When applying M.O. costs on capacity levels the M.O. costs per
unit does not change according to production levels, making net income more stable with
changes in production.
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Changes in production levels:
Using the traditional method, increases in production reduces M.O. costs applied per
unit since the costs are spread though a higher number of units. When applying M.O. on
capacity, increase on production levels reduces cost of unused capacity; M.O. costs per unit
remains the same.
Increase in production levels may help realize a budget net income when sales are
lower than expected. In order to realize its budgeted net income of $397,394, Sunshine Inc.’s
production team is trying to increase their budget production while actual sales remain as
150,000 units. The Income Statements using both methods are shown on Income Statement
III.
Data:
M.O. on Production
Production
Sales
Capacity
Selling Price
Variable Costs (per unit)
Total M.O.
Administrative Expenses
Opening Stock
Closing Stock
M.O. Costs Per unit
Revenue
Cost of Goods Sold
Variable Costs
M.O. Applied
Gross Margin
Cost of unused Capacity
Administrative Expenses
Net Income
M.O. on Activity
164,804
150,000
198,000
$59.80
$14.90
$3,998,800.00
$2,698,000.00
0
14,804
$
24.26
167,785
150,000
198,000
$59.80
$14.90
$3,998,800.00
$2,698,000.00
0
17,785
$
Income Statement
$8,970,000.00
$2,235,000.00
$3,639,606.00
20.20
$8,970,000.00
$5,874,606.00
$3,095,394.00
$2,235,000.00
$3,029,393.94 $5,264,393.94
$3,705,606.06
$2,698,000.00
$610,212.06
$2,698,000.00
$397,394.00
$397,394.00
Income Statement III
In Order to realize the budget net income when applying M.O. on production at
capacity, Sunshine Inc.’s production team would have to increase their production by over
10,000 units. This value is lower when using the traditional method of M.O. application.
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When M.O. is applied on capacity, increases on production reduces costs of unused
capacity, decreasing costs and revenue staying the same, net income increases. This process
can be called “Hat Trick” and will be discussed in more detail later in the assignment.
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Volatility of Net Income:
Net income volatility can be measured by comparing the profit per unit using both
methods of M.O. distribution and their changes according to sales and production levels. Profit
per unit can be calculated dividing net income by total sales. The changes on sales from
158,000 units to 150,000 units and the change in production from 158,000 units to 160,000
units, and its effects on net income and profit per unit, is shown on Table I, when applying
M.O. on production levels, and on Table II, when applying M.O. on production at capacity.
Applying M.O. on Budgeted Production
When budget production equals sales of 158,000 units:
Net Income (Profit)
$397,400.00
Actual Sales
158,000
Profit Per Unit
$2.52
When sales change from 158,000 to 150,000 units:
Net Income (Profit)
$240,670.89
Actual Sales
150,000
Profit Per Unit
$1.60
Margin
$0.91
When budget production change from 158,000 to 160,000 units, but sales remain 150,000 units:
Net Income (Profit)
$288,125.00
Actual Sales
150,000
Profit Per Unit
$1.92
Margin
-$0.32
Table I
Applying M.O. on Production Capacity
When budget production equals sales of 158,000 units:
Net Income (Profit)
$397,400.00
Actual Sales
158,000
Profit Per Unit
$2.52
When sales change from 158,000 to 150,000 units:
Net Income (Profit)
$199,767.68
Actual Sales
150,000
Profit Per Unit
$1.33
Margin
$1.18
When budget production change from 158,000 to 160,000 units, but sales remain 150,000 units:
Net Income (Profit)
$240,159.60
Actual Sales
160,000
Profit Per Unit
$1.50
Margin
-$0.17
Table II
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When sales are reduced the revenue decreases decreasing net income and profits per
unit. This effect is greater when M.O. is applied on capacity since M.O. applied per unit on
remaining inventory is lower than when M.O. is applied on production. Lower sales produce
lower revenue while M.O. costs per unit and unused capacity costs remain the same, this
reduces net income. Unsold units appear as assets on the Statement of Financial Position as
they can still be sold in a future period.
Increasing production increases net income. By applying M.O. on production at
capacity, M.O. costs per unit do not change with changes in production, the cost of unused
capacity is reduced since production levels are closer to capacity levels, but this reduction is
proportional to M.O. costs applied per unit that remains the same, while applying M.O. on
production levels, an increase in production reduces M.O. cost per unit proportionally to the
increase of production.
Applying M.O. costs on capacity levels creates a more volatile net income in relation to
changes on sales levels, but less volatile in relation to changes in production levels. The
volatility of both methods of M.O. application in relation to changes on sales is shown on
Graph I and in relation to changes in production is shown on Graph II.
Net Income in Relation to Changes in Sales
Levels
$600,000.00
$400,000.00
Net Inocme
$200,000.00
$0.00
120,000
130,000
140,000
150,000
158,000
-$200,000.00
M.O. Applied on
Capacity
-$400,000.00
M.O. Applied on Activity
-$600,000.00
Sales Levels
Graph I
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Net Income in Relation to Changes in
Production
$1,400,000.00
$1,200,000.00
Net Income
$1,000,000.00
$800,000.00
$600,000.00
M.O. Applied on
Capacity
$400,000.00
M.O. Applied on Activity
$200,000.00
$0.00
158,000
168,000
178,000
188,000
Production Levels
198,000
Graph II
Changes in sales levels have greater effect on net income when M.O. is applied on
capacity; net income then coincides with net income of M.O. applied on production levels
when sales levels equal production levels. When M.O. is applied on capacity the M.O. cost per
unit does not change with changes in production, with production changes the M.O. applied
on capacity curve remains linear, net income is less volatile. The increase in production
reduces unused capacity costs proportionally.
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The “Hat Trick”:
The “Hat Trick” is the process of consciously increasing production levels when sales
are low in order to increase net income in the Income Statement. When budget production
increases M.O. costs are spread over higher production decreasing M.O. costs per unit.
The production increase generates more units but does not increase sales. Unsold
items remain on finished goods account and are carried out to the next period as assets
waiting to be sold. The “Hat Trick” increases net income in the Income Statement and
increases the company’s assets values, but these profits are not realistic since unsold stock is
not guaranteed to be sold.
Large inventories go against the Lean Production Method or Just in Time method.
Keeping large quantities of stocks incur large costs. Inventory is not guaranteed to be sold and
money gets tied up in assets, it reduces work productivity and may increase quantity of
defects. Keeping large inventories also decreases production effectiveness increasing the
amount of time required to complete a product (Garrison, Noreen and Brewer, 2010).
Inventory items may also depreciate over time creating further expenses to the
company. The increase of net income resulting of the “Hat Trick” is misleading. If sales
department cannot cope with production increase the costs are postponed and can increase in
the long run generating losses.
Applying M.O. on production at capacity makes the “Hat Trick” work differently. M.O.
costs per unit remain unchanged and unused capacity costs decrease. M.O. costs applied per
unit is also lower than when M.O. is applied on production, requiring a larger change in
production levels in order to make significant difference.
M.O. applied on capacity levels makes net income less volatile to changes in
production. The volatility of net income facilitates the performance of the “Hat Trick”, applying
M.O. on capacity reduces the “Hat Trick’s” effectiveness.
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Ethical Issues of the “Hat Trick”:
IMA Statement of Ethical Professional Practice states that all members of the Institute
of Management Accountants (IMA) should follow an ethic conduct and practice some ethical
principles and standards.
By making use of tricks that manipulate the income statement such as the “Hat Trick”
one is going against some of these principles. Using the “Hat Trick” makes the information
provided by the Income Statement and Statement of Financial Position cease to be accurate.
According to the Competence Standard stated in IMA’s Ethical Statement, each member has
the responsibility to “provide decision support information and recommendations that are
accurate, clear, concise and timely”( Garrison, Noreen and Brewer, 2010, p15). The “Hat Trick”
also opposes IMA’s Integrity Standard that states that each member should have the
responsibility to reduce conflicts of interest. The main purpose of the “Hat Trick” is to increase
net income in order to realize budget with no concern of the situation in other departments.
This conflict of interest put in danger the ethical and financial situation of the company as a
whole (IMA Statement of Ethical Professional Practice, cited in Garrison, Noreen and Brewer,
2010).
The “Hat Trick” is an unethical procedure and should be avoided to protect the
integrity of the company and its employees. IMA also declares that any member that fails to
comply with such ethical procedures could suffer disciplinary action.
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Conclusion:
This assignment’s objective was to demonstrate why applying M.O. on production at
capacity is a better and more reliable way of M.O. distribution. It has shown that by using this
method a new cost category is created, the cost of unused capacity, helping management to
visualize the Income Statement and understand where costs are incurred. It also helps
management’s decision making and the creation of more realistic budgets.
Applying M.O. on capacity decreases net income when sales do not cover all
production, but also creates a more stable and trustworthy Income Statement and Statement
of Financial Position. The reduction of costs applied per unit better suits reality since it ceases
to discriminate costs by production levels, creating a fairer net income.
This assignment has shown that by using the new method of M.O. distribution reduces
the volatility of net income with changes on production levels, creating a more stable Income
Statement and reducing the effectiveness of changes in production in order to superficially
increase net income, also known as the “Hat Trick”. The new method also increases volatility
of net income with changes on sales levels, reacting better to the decrease on revenue.
It was shown that some procedures like the “Hat Trick” are considered unethical and
may harm the company’s reputation and its effects can be reduced when M.O. is applied on
capacity levels.
It can be concluded that applying M.O. on production at capacity is a more ethical
decision since it complies with IMA principles and standards, providing a more accurate,
reliable and prudent representation of accounts.
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References:
Garrison, R.H., Noreen, E.W. and Brewer, P.C., 2010. Managerial Accounting. 13th ed. New
York: McGraw-Hill/Irwin.
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Appendix:
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