Case Study - Skills Hive | Digital Age Delivery - Case Study...budgeted production needs to increase in order to realize a budgeted net income. It will study the volatility of net

MA161 – Management Accounting

Case Study:

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Mayra Maia Fiorini

Course: BABM/F - Group R

Student Number: 11841746

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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 $8,970,000.00

Cost of Goods Sold

Variable Costs $2,235,000.00

M.O. Applied $3,796,329.11 $6,031,329.11

Gross Margin $2,938,670.89

Administrative Expenses $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 $8,970,000.00

Cost of Goods Sold

Variable Costs $2,235,000.00

M.O. Applied $3,029,393.94 $5,264,393.94

Gross Margin $3,705,606.06

Cost of unused Capacity $807,838.38

Administrative Expenses $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 M.O. on Activity

Production 164,804 167,785

Sales 150,000 150,000

Capacity 198,000 198,000

Selling Price $59.80 $59.80

Variable Costs (per unit) $14.90 $14.90

Total M.O. $3,998,800.00 $3,998,800.00

Administrative Expenses $2,698,000.00 $2,698,000.00

Opening Stock 0 0

Closing Stock 14,804 17,785

M.O. Costs Per unit $ 24.26 $ 20.20

Income Statement

Revenue $8,970,000.00 $8,970,000.00

Cost of Goods Sold

Variable Costs $2,235,000.00 $2,235,000.00

M.O. Applied $3,639,606.00 $5,874,606.00 $3,029,393.94 $5,264,393.94

Gross Margin $3,095,394.00 $3,705,606.06

Cost of unused Capacity $610,212.06

Administrative Expenses $2,698,000.00 $2,698,000.00

Net Income $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:




Margin $0.91

When budget production change from 158,000 to 160,000 units, but sales remain 150,000 units:




Margin -$0.32

Table I

Applying M.O. on Production Capacity

When budget production equals sales of 158,000 units:




When sales change from 158,000 to 150,000 units:




Margin $1.18

When budget production change from 158,000 to 160,000 units, but sales remain 150,000 units:




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.

Graph I

-$600,000.00

-$400,000.00

-$200,000.00

$0.00

$200,000.00

$400,000.00

$600,000.00

120,000 130,000 140,000 150,000 158,000

Ne

t In

ocm

e

Sales Levels

Net Income in Relation to Changes in Sales Levels

M.O. Applied on Capacity

M.O. Applied on Activity



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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.

$0.00

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

$1,400,000.00

158,000 168,000 178,000 188,000 198,000

Ne

t In

com

e

Production Levels

Net Income in Relation to Changes in Production

M.O. Applied on Capacity

M.O. Applied on Activity



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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:

Documents

Case Study - Skills Hive | Digital Age Delivery - Case Study...budgeted production needs to increase in order to realize a budgeted net income. It will study the volatility of net