Rose Bach has recently been hired as controller of Empco Inc., a sheet-metal man
ID: 2436132 • Letter: R
Question
Rose Bach has recently been hired as controller of Empco Inc., a sheet-metal manufacturer. Empco has been in the sheet-metal business for many years and is currently investigating ways to modernize its manufacturing process. At the first staff meeting Bach attended, Bob Kelley, chief engineer, presented a proposal for automating the drilling department. Kelley recommended that Empco purchase two robots that could replace the eight direct labor workers in the department. The cost savings outlined in Kelley's proposal include two elements. First, direct labor cost in the drilling department is eliminated. Second, manufacturing overhead cost in the department is reduced to zero because Empco charges manufacturing overhead on the basis of direct labor dollars using a plantwide rate.
The president of Empco felt that Kelley's explanation of the cost savings made no sense. Bach agreed and explained that as firms become more automated, they should rethink their manufacturing overhead systems. The president asked Bach to look into the matter and prepare a report for the next staff meeting.
To refresh her knowledge, Bach reviewed articles on manufacturing overhead allocation for an automated factory and discussed the matter with some of her peers. She also gathered the historical data presented below on the manufacturing overhead rates experienced by Empco over the years. Bach also wanted to have some departmental data to present at the meeting. Using Empco's accounting records, she was able to estimate the annual averages presented below for each manufacturing department in the 1990s.
Historical Data
Date
Average Annual
Direct Labor
Cost
Average Annual
Manufacturing
Overhead Cost
Average
Manufacturing
Overhead
Application Rate
1950s
$1,000,000
$1,000,000
100%
1960s
1,200,000
3,000,000
250
1970s
2,000,000
7,000,000
350
1980s
3,000,000
12,000,000
400
1990s
4,000,000
20,000,000
500
Annual Averages
Cutting
Department
Grinding
Department
Drilling
Department
Direct labor
$ 2,000,000
$1,750,000
$ 250,000
Manufacturing overhead
11,000,000
7,000,000
2,000,000
Required:
a. Disregarding the proposed use of robots in the drilling department, describe the shortcomings of Empco’s current system for applying overhead.
b. Do you agree with Bob Kelley's statement that the manufacturing overhead cost in the drilling department will be reduced to zero if the automation proposal is implemented? Explain.
c. Recommend ways to improve Empco's method for applying overhead by describing how it should revise its overhead accounting system:
(i) in the cutting and grinding departments.
(ii) to accommodate the automation of the drilling department.
Source: CMA adapted.
Historical Data
Date
Average Annual
Direct Labor
Cost
Average Annual
Manufacturing
Overhead Cost
Average
Manufacturing
Overhead
Application Rate
1950s
$1,000,000
$1,000,000
100%
1960s
1,200,000
3,000,000
250
1970s
2,000,000
7,000,000
350
1980s
3,000,000
12,000,000
400
1990s
4,000,000
20,000,000
500
Explanation / Answer
a The current system applies overhead as a percentage of Labor. While this might be correct for some overheads like indirect labor (supervisors, setting up costs), applying the entire over head on the basis of labor cost is wrong. There might be some overhead like depreciation etc do not have anything to do with labor cost.These overheads should be applied on the basis of machine hours b Whether automation would reduce the overheads to zero would depend on what actually constitute the overheads If these are just supervisory or other indirect labor costs , then maybe this claim would be correct However the advatage per unit should be assesed correctly. c If Cutting and Grinding departments are Labor intensive, overheads should be applied on the basis of labor hours. If they are capital intensive, overheads should be allocated on the basis of machine hours
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