Question

National Motor Company (NMC) is an automobile manufacturer that sells cars predominantly in the North American market. Times have been tough for the auto industry and NMC is no different. The company is under tremendous pressure to turn a profit. Several years ago, as analysts were predicting a large downturn in the auto industry, NMC decided to purchase a smaller niche automaker in the hopes of capturing a different segment of the consumer market and to better learn the manufacturing processes of other automakers.

NMC still operates as two separate divisions, Classic and New Wave, with each division manager employing a different manufacturing philosophy. The Classic manager is concerned with low input costs and quantity in production in addition to brand recognition and automobile power. The New Wave manager is concerned with quality and innovation in manufacturing in addition to fuel efficient and environmentally friendly automobiles.

NMC continued to suffer losses even with the addition of the New Wave division. While Classic appears to have good margins its sales levels are dwindling despite a large marketing campaign. New Wave has had good sales levels but there is concern that its quality and innovation focus is not cost-effective. Upper management wants to adopt one manufacturing philosophy for the entire company and has hired you as an outside consultant to provide guidance on their performance evaluation of the two managers.

Discussions with the controller revealed the following:

• NMC feels it has a good handle on direct costs. Since the two divisions use different input materials, these costs are tracked by division rather than allocated to the two divisions. Direct labour is allocated on the basis of manufacturing labour hours (MLH); New Wave generally uses 60% of total MLH but its focus on quality makes it relatively more labour/less capital intensive than Classic. Thus, New Wave generally uses only 40% of total machine hours.

• Indirect manufacturing costs are broken down into a number of categories based on the allocation method used to assign these costs to the two divisions’ cost of goods sold. Categories include carrying costs, variable overhead, fixed overhead-general, and fixed overhead-support.

• Carrying costs, like direct costs, are tracked by division and include storage space rental, insurance, spoilage and obsolescence. The first two items are recorded through third-party billing whereas the latter two items are determined by each division manager.

• Variable overhead includes indirect labour such as rework labour, supervisor and plant manager wages as well as indirect materials such as scrap and warranty expense estimates. This cost category is allocated to the two divisions on the basis of MLH.

Fixed overhead-general includes plant amortization, equipment amortization, plant power/utilities, property taxes, and payments for guard and janitor services. NMC’s allocation method was suggested by the Classic manager; allocate costs on an equal (50-50) basis since the two divisions take up relatively the same amount of plant space.

• Fixed overhead-support mainly includes the costs from two production support departments, quality control and repairs & maintenance (equipment and products). These two departments provide services to both the Classic and New Wave division. NMC uses a cost allocation method suggested by the New Wave manager; allocate costs on the basis of defective products per 1,000 units produced, per division.

• NMC treats non-production related costs as period costs; as such, they are not allocated to the two divisions. Costs include research and development costs and marketing costs (which include marketing personnel salaries and advertising expenses).

• Bonuses to divisional managers are on the basis of Return on Investment (ROI). Returns are derived from gross margins, which are calculated using the allocation rules above. Upper management believes gross margins are also an appropriate measure to evaluate the two divisions.

  Required

  Prepare a memo to NMC upper management that outlines weaknesses in their current cost allocation process and ways to improve it that will assist them in evaluating the performance of the Classic and New Wave divisions. Be sure to discuss manager incentives for manipulating allocation methods to influence performance measures. Please be as detailed as possible.

Answer 1

Memo

To: NMC Managment

From: XYZ Consultants

Date: 15^th  March, 2017.

Subject: Weaknesses in the current cost allocation process and ways to improve them

Our analysis has identified the following weaknesses and flaws in your cost allocation process:

1. First of all direct labor costs should have been allocated to products. Rather the company has allocated direct labor on the basis of manufacturing labor hours. The two divisions - Classic and new wave should keep direct labor cost data separately for each production so as to enhance the allocation of product cost.

2. Allocation of fixed overhead - general is affected by errors as well as by prejudices. To remove all elements of subjectivity costs should be allocated on the basis of a formula that is based on a theoretical rationaloe and this will help in introducing objectivity to the process.

3. Costs like research and development costs and marketing costs should be apportioned to each division to determine how much non production costs are used by each department.

4. Bonuses to divisional managers should not be used on returns on investment that is dervied using gross margins. Instead, net margins should be used. Use of net margins will give the managers on insentive to control operating expenses and other expenses that are related to net margins.

The incentive for managers to manipulate the cost allocation method is to produce better performance measures. Developing and putting in place a sound allocation method will help the company in two ways. Firstly it will be in a better position to track costs and secondly it will be able to reduce unnecessary costs that are applicable for each division