A company uses a job cost system and allocates overhead on the basis of direct labor hours, with over- or under allocated overhead closed to cost of goods sold at the end of the year. Managers are paid a bonus if net income (before deducting the bonus) exceeds a target amount. Stockholders are paid dividends based on operating cash flows after deducting any bonus paid to managers. In order to increase the likelihood of earning the bonuses, some managers suggest estimating direct labor hours in a manner that would create a favorable year-end overhead adjustment.
Required:
1. What direction (over- or underestimating direct labor hours) would achieve the desired effect? Why?
2. What parties would be positively affected, and why?
3. What parties would be negatively affected, and why?
4. Would this action be considered ethical? Why or why not? 5. What policy change could management implement to reduce the motivation for suggesting this action?