Question

FORUM DESCRIPTION Salvo Inc., a specialized equipment manufacturer, uses a job order costing system. The overhead is allocated to jobs on the basis of direct labor hours. The overhead rate is now $1,500 per direct labor hour. The design engineer thinks that this is illogical. The design engineer has stated the following: Our accounting system doesn't make any sense to me. It tells me that every labor hour carries an additional burden of $1,500. This means that direct labor makes up only 6% of our total product cost, yet it drives all our costs. In addition, these rates give my design engineers incentives to "design out" direct labor by using machine technology. Yet, over the past years as we have had less and less direct labor, the overhead rate keeps going up and up. I won't be surprised if next year the rate is $2,000 per direct labor hours. I'm also concerned because small errors in our estimates of the direct labor content can have a large impact on our estimated costs. Just a 30-minute error in our estimate of assembly time is worth $750. Small mistakes in our direct labor time estimates really swing our bids around. I think this puts us at a disadvantage when we are going after business. 1. What is the engineer's concern about the overhead going "up and up? 2. What did the engineer mean about the large overhead rate being a disadvantage when placing bids and seeking new business? 3. What do you think is a possible solution? Note: The use of standard English, grammar, punctuation and spelling is required including the use of complete sentences, proper subject verb agreement, and complete words (not text message style communications).

Answer 1

1) The engineer's concern is that, as more mechanization is carried, out the labor content goes down due to which the overhead assignment rate based on direct labor hours is bound to go up. He is indirectly pointing out that direct labor hours are no longer the correct cost driver for the entire overheads as labor content is getting reduced due to increased mechanization. The result is that the assignment of the entire overheads on the basis of labor hours, the single cost driver, would result in irrational assignment of overhead costs which, should now have more cost pools to include the machine related overheads.

2) As the labor hour based overhead rate is not appropriate for a mechanized manufacturing environment, overhead assignment will be faulty and would not be related to the consumption of resources by the various jobs. This will result in under costing or over costing of jobs. When jobs are quoted for based on such wrong cost of production, losses will be made on jobs awarded and profits will be lost on jobs not awarded.

3) The possible solution will be in the introduction of Activity Based Costing System under which, the overheads would be classified under different cost pools with each cost pool having a different cost driver.

ABC would allocate overheads on the basis of consumption of resources by the different jobs through multiple overhead rates. This will make way for more rational costing of jobs and enable reasonable bidding for the jobs.