Plantwide, department, and ABC indirect cost rates

Automotive Products (AP) designs and produces automotive parts. In 2014, actual variable manufacturing overhead is $308,600. AP's simple costing system allocates variable manufacturing overhead to its three customers based on machine-hours and prices its contracts based on full costs. One of its customers has regularly complained of being charged noncompetitive prices, so AP's controller Devon Smith realizes that it is time to examine the consumption of overhead resources more closely. He knows that there are three main departments that consume overhead resources: design, production, and engineering. Interviews with the department personnel and examination of time records yield the following detailed information.

Required:
1. Compute the manufacturing overhead allocated to each customer in 2014 using the simple costing system that uses machine-hours as the allocation base.
2. Compute the manufacturing overhead allocated to each customer in 2014 using department-based manufacturing overhead rates.
3. Comment on your answers in requirements 1 and 2. Which customer do you think was complaining about being overcharged in the simple system? If the new department-based rates are used to price contracts, which customer(s) will be unhappy? How would you respond to these concerns?
4. How else might AP use the information available from its department-by-department analysis of manufacturing overhead costs?
5. AP's managers are wondering if they should further refine the department-by-department costing system into an ABC system by identifying different activities within each department. Under what conditions would it not be worthwhile to further refine the department costing system into an ABC system?

1.
Actual plantwide variable MOH rate based on machine hours, $308,600 4,000

$77.15 per machine hour

United Motors Holden Motors Leland Auto Total
Variable manufacturing overhead, allocated based on machine hours
($77.15 120; $77.15 2,800; $77.15 1,080)
$9,258 $216,020 $83,322 $308,600

2.

Department MOH in 2014 Total
Driver Units Rate
Design $39,000 390 $100 per CAD-design hour
Production 29,600 370 $ 80 per engineering hour
Engineering 240,000 4,000 $ 60 per machine hour

United Motors Holden
Motors Leland Auto Total
Design-related overhead, allocated on CAD-design hours
(110 $100; 200 $100; 80 $100)
$11,000 $ 20,000 $ 8,000 $ 39,000
Production-related overhead, allocated on engineering hours
(70 $80; 60 $80; 240 $80)
5,600 4,800 19,200 29,600
Engineering-related overhead, allocated on machine hours
(120 $60; 2,800 $60; 1,080 $60)
7,200 168,000 64,800 240,000
Total $23,800 $192,800 $92,000 $308,600

3.

United
Motors Holden
Motors Leland
Auto
a. Department rates
(Requirement 2)
b. Plantwide rate
(Requirement 1)
$23,800

$ 9,258
$192,800

$216,020
$92,000

$83,322
Ratio of (a) ÷ (b) 2.57 0.89 1.10
The manufacturing overhead allocated to United Motors increases by 157% under the department rates, the overhead allocated to Holden decreases by about 11%, and the overhead allocated to Leland increases by about 10%.
The three contracts differ sizably in the way they use the resources of the three departments.

The percentage of total driver units in each department used by the companies is:

Department Cost
Driver United
Motors Holden
Motors Leland
Auto
Design
Engineering
Production CAD-design hours
Engineering hours
Machine hours 28%
19
3 51%
16
70 21%
65
27
The United Motors contract uses only 3% of total machines hours in 2011, yet uses 28% of CAD design-hours and 19% of engineering hours. The result is that the plantwide rate, based on machine hours, will greatly underestimate the cost of resources used on the United Motors contract. This explains the 157% increase in indirect costs assigned to the United Motors contract when department rates are used. The Leland Auto contract also uses far fewer machine-hours than engineering-hours and is also undercosted.
In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%) than of machine-hours (70%). Hence, the use of department rates will report lower indirect costs for Holden Motors than does a plantwide rate.
Holden Motors was probably complaining under the use of the simple system because its contract was being overcosted relative to its consumption of MOH resources. United and Leland, on the other hand, were having their contracts undercosted and underpriced by the simple system. Assuming that AP is an efficient and competitive supplier, if the new department-based rates are used to price contracts, United and Leland will be unhappy. AP should explain to United and Leland how the calculation was done, and point out United's high use of design and engineering resources and Leland's high use of engineering resources relative to production machine hours. Discuss ways of reducing the consumption of those resources, if possible, and show willingness to partner with them to do so. If the price rise is going to be steep, perhaps offer to phase in the new prices.

4. Other than for pricing, AP can also use the information from the department-based system to examine and streamline its own operations so that there is maximum value-added from all indirect resources. It might set targets over time to reduce both the consumption of each indirect resource and the unit costs of the resources. The department-based system gives AP more opportunities for targeted cost management.

5. It would not be worthwhile to further refine the cost system into an ABC system if (1) a single activity accounts for a sizable proportion of the department's costs or (2) significant costs are incurred on different activities within a department, but each activity has the same cost driver or (3) there wasn't much variation among contracts in the consumption of activities within a department. If, for example, most activities within the design department were, in fact, driven by CAD-design hours, then the more refined system would be more costly and no more accurate than the department-based cost system. Even if there was sufficient variation, considering the relative sizes of the three department cost pools, it may only be cost-effective to further analyze the engineering cost pool, which consumes 78% ($240,000 $308,600) of the manufacturing overhead.