Question

Two brothers, very interested in fashion/especially men's wear, started their own company named Tiber a few years ago. The main products - traditional men's suits - are produced in a very high quality and sold in luxury men's stores in EU and the Middle East. The head office is located in Milan, Italy, to attract the best designers and tailors. Recently a new production facility has opened in Cairo. The business plan for this plant calls for 325 tailors, who will work 2,000 hours a year. Overhead is allocated to individual suits (products) based on the number of direct labor hours used to produce a suit. The plant use a flexible overhead budget to estimate its overhead rate. Fixed manufacturing overhead next year is budgeted at € 33,865 mill. and variable overhead is budgeted at € 20 per direct labor hour. The scheduled and budgeted production for next year is as follows: Tibor's Planned Production Schedule and Budgeted Direct Labor Hours per Suit Style Next Year Budgeted Direct Labor Hours per Suit 2.0 Suit Model Production Budget Model (Number of Suits) 22,100 55,900 80,600 63,700 52,000 MOUD 3.0 1.0 4.0 2.5 Required: 1. Calculate Tibor's overhead rate for the coming year using expected volume. 2. Calculate Tibor's overhead rate for the coming year using normal volume. 3. Describe why these two calculations do not come up with the same result and gives the pros and cons for both of the two methods. 4. Which method will you recommend the management of Tibor to use in their calculations? And why?

Answer 1

1. Overhead rate using expected volume

Absorption rate = budgeted overhead ÷ budgeted total labour hours

= 33,865,000,000÷677,300

= 50,000 per hour

Calculation of budgeted labour hours :

(22,100*2)+(55,900*3)+(80,600*1)+(63,700*4)+(52,000*2.5)

= 677,300 hrs

Therefore overhead rate per hour = variable + fixed = 20 + 50,000= 50,020 per hour

2. Overhead rate using normal volume

Normal hours = 325 tailors * 2000 hrs = 650,000 hrs

Absorption rate = fixed overhead ÷ normal hours

= 33,865,000,000 ÷ 650,000

= 52,100

Therefore overhead rate per hour = variable + fixed = 20 + 52,100 = 52,120

3. As we can see from the above calculation the absorption rate as per budgeted production is comparatively less than the overhead rate as per normal volume. This is because under budgeted volume we have requirement for more hours of labour compared to normal hours which increases the overhead cost.

If the company follows the budgeted volume method, the company would be able to allocate overall overhead to the respective suit and there will be no under or over absorption of overhead. Further if the company does not reach the budgeted units. Then this calculation may result for over or under absorption of overhead.

In the similar way, if the company follows the normal volume, for which there is no particular basis of estimatooe, for allocation of overhead, and if the company produces budgeted units then there will be over absorption of overhead. Further this method is not suitable for industry where the budget is driven by demand forces rather than a perfect compition market.

4. Management should consider allocating overheads based on budgeted volume as it is more realistic and considers the factor of overall production hours required rather than considering an estimate which is done by the management without any basis