QUESTION After presenting your results to the CEO she sugges

QUESTION: After presenting your results to the CEO, she suggests that if Candor needs to change the way it allocates overhead, a full investigation of overhead methods be conducted. Potentially you could also allocate overhead by departments (Cutting, Finishing and Assembly). As a result, the CEO wou ld like a full comparison and analysis of the three alternatives suggested (plant-wide rate using direct labor hours, plant-wide rate using machine hours and allocation by departments). In addition, she wants you to recommend which method should be implemented.

Include rationale for your recommendation and an explanation of why costs differ between methods. Departmental information is located in Exhibit 2. In addition, a description of the departments can be found in the next page

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Our costs are out of control, our accounting system is screwed up, or both!\" screamed the sales manager. \"We are simply not competitive on a great many of the jobs we bid on. Just last week we lost a customer when a competitor under-bid us by 25% ! And I bid the job at cost because the customer has been with us for years but has been complaining about our prices.\" This problem, raised at the weekly management meeting, has been getting worse over the years. The Candor Medical Instrument Company produces custom medical instruments for specific customer orders. When the firm first became successful, it employed nearly 500 skilled machinists. Over the years the firm became increasingly automated and now uses a number of different robotic machines. The firm currently employs only 75 production workers, but output has quadrupled The problems raised by the sales manager can be seen in the portions of two bid sheets brought to the meeting (Exhibit 1). These bids represent a typical small Job (Bid # 74683) and a typical large job (Bid # 74687). Each job has direct material, direct labor and overhead, which is allocated to jobs using a plant-wide overhead rate based of direct labor hours. For the current period, Candor expects to use 27,000 direct labor hours. Overhead, consisting mostly of depreciation on the robotic equipment, is expected to be $4,030,000 An employee can typically set up any job on the appropriate equipment in about 15 minutes. Once machines are operating, an employee oversees five to eight machines simultaneously. All that is required is to load or unload materials and monitor calibrations. The robotic machines will log a total of 59461 hours of run time in the current period For bid # 74683 the firm was substantially underbid by a competitor. The firm did get the job for bid # 74687, but the larger jobs are harder to find. Small jobs arise frequently, but the firm is having more difficulty in successfully obtaining them.

Solution

1) Overhead cost allocation using plant wide rate of direct labour hours.

Bid 74683 - Total cost = $1507.12

Bid 74687 - Total cost = $6885.62

2) Overhead cost allocation using plant wide rate of machine hours.

Overhead allocation rate = Total overhead costs / total machine hours

= 4030000 / 59461

= $67.77

Bid 74683 cost under plant wide machine hours rate

Bid 74687 total cost

3) Allocation by departments

For allocating the overheads costs on the basis of deparments, we use cost drivers based on their use by respective departments. Hence for cutting depaartment we use machine hours, for finishing dept. we use labour cost and for assembly dept. we use direct labour hours. Hence, we calculate the three overheads rates as follows:

Cost allocation

Bid 74683

Bid 74687

A comparison of total cost of each bod under the three alternatives is presented below:

The company should prefer allocation by department method as it gives a more logical cost of the bids and also shows the lowest cost. the other methods of allocation resulted in higher cost of bids and hence the company should go for allocation by department method.

	Hours	Rate	Cost ($)
Direct materials			563.25
Direct labour
labor	3	18	45.00
Equipment set up	1	13	9.38
Equipment tending	3	13	31.25
Overhead	9	68	609.93
Total costs			1,258.81