Prepare an income statement for the Mitchell Machinery Corporation for the year
ID: 2460598 • Letter: P
Question
Prepare an income statement for the Mitchell Machinery Corporation for the year ended December 31, 2006. Wrap-It-Up,Inc., manufactures gift wrap for all occasions from Christmas to birthdays to weddings. However, most of its output (70 percent) has a Christmas motif. Because of the lead time needed to get the gift wrap into stores for the Christmas season, production of Christmas-related wrapping paper occurs in March, April, and May. During these months, company employees often work many hours of overtime to get the product ready for shipment. During the rest of the year, production drops back to normal as the company focuses on the production of other types of gift wrap. In an attempt to capture a larger share of the gift wrap market, Wrap-It-Up has recently added designers to its staff, increased the number of designs it offers, and modernized its production line with new automated machinery. Margaret Dreiser, president of the company, is concerned about the wide fluctuations in the amount of overhead applied each month. She is aware that applied overhead iS twice as high in some months as it is in other months (see below). "How can that be?" she asks. In addition, she points out that total applied overhead is also much higher than the actual over-head costs for the year, resulting in a large adjustment at the end of the year to Cost of Goods Sold for overapplied overhead. Wrap-It-Up uses a single overhead application rate based on direct labor hours. Budgeted overhead costs are based on the previous year's actual overhead costs. Total actual overhead costs for the year were $1,294,520. What reasons can you suggest for the monthly fluctuations in applied overhead? What changes would you suggest that Wranp-It-Up make in determining its overhead application rate?Explanation / Answer
It has been observed that in March, April and May, particularly the applied overhead is almost twice the applied overhead in other months when the company operates at normal production level. Moreover, during these three months, the company has to work many hours of overtime to cope up with the demand for Christmas related wrapping paper.
The overhead rate when multiplied by the normal hours as well as the hours worked in overtime, the applied overhead gets increased resulting in huge applied overhead for the March, April and May. The possible reason for such an over application of overhead is that the company while determining the predetermined overhead application rate based on the direct labour, must have considered the budgeted labour hours to find the predetermined overhead rate excluding the overtime hours.
In fact, predetermined overhead rate is calculated by dividing the budgeted overhead by the budgeted labour hours the company expects to use under normal working conditions. So while determining the overhead applied for the aforesaid three months the predetermined rate is being multiplied by the number of labour hours which is greater than the normal working hours due to heavy overtime hours, thus resulting in a higher applied overhead for those months.
To rectify this problem, the company should also take into account the anticipated overtime hours while calculating the predetermined overhead rate. If it is done, the predetermined overhead rate will be reduced thereby reducing the applied overhead for those three months. The predetermined arte should be calculated as follows to rectify this over application overhead:
Predetermined overhead rate = budgeted overhead / total number of hours budgeted to be worked including the budgeted overtime hours