The Purpose of Predetermined Overhead Rate - Assignment Example

Cost Accounting 1. To estimate the number of temporary workers required, we use regression analysis equation which is Y= a+bx Where X is the total number of orders for the month Y is the number of workers required Using regression 1, X = 12,740 a= 21.938 b = 0.0043 Hence: Y= 21.938+ 0.0043(12,740) Y= 21.938 +54.782 Y =76.72 Workers Hence, the company would need a total of 77 workers for the month of July according to regression 1 However, the company employs 60 permanent workers. Hence, Temporary workers = 77-60 = 17 Hence, the company would need to employ 17 temporary workers Using Regression 2 a = -46.569 b = 0.0051 X = 12,740 Thus: Y = -46.569+ 0.0051(12,740) Y= -46.569+64.974 Y = 18.45 Hence, the company would need to employ 18 temporary workers during the period. Thought the two equations give differing number of temporary workers at 17 and 18, I think that Michael Fowler would be better off relying on equation 2 since it gives the exact number of temporary workers the company would need without having to reconstitute again. Equation 1 gives the total number of employees the company would need and hence it is not the best equation for computing the number of temporary workers required. Thus, the correct number of temporary workers required is 18. 2. The purpose of predetermined overhead rate Predetermined overhead rate is a rate that is used in applying manufacturing overheads. The purpose of predetermined overhead rate is to help the company applying manufacturing overhead to products or job orders. The predetermined overhead rate is computed by dividing the estimated manufacturing overhead cost by an allocation base or activity driver. The most commonly used allocation bases include direct labor dollars, direct labor hours, machine hours as well as direct materials. The formula for calculating predetermined overhead rate is as follows; Predetermined overhead rate = Estimated manufacturing overhead cost Estimated total units in the allocation base Companies use predetermined overhead rates for a number of reasons including; i) Companies often use job costing when manufacturing differing products. As such, companies would use predetermined overhead rate in fulfilling GAAP’s matching principal by way of assigning overhead costs while products are still in production. This provides companies with a way of calculating an average cost per unit when costs differ owing to the fact that the products being manufactured are different. ii) It is an easier cost tracking method while it helps managers assign overhead costs as a group which helps in saving time and tedious work. iii) Use of predetermined rate facilitates decision making especially evaluation of price strategies and budget making decisions. In this regard, use of predetermined overhead rate would allow managers estimate and allocate overhead costs while products are in production since most overheads are not known until the end of the production process thus facilitating cost-based business decisions. iv) Use of pre-determined overhead rate simplifies year end overhead reconciliation. 3. Overhead rate = overhead cost/ direct labor hours Variable Job 57 = 300,000/100,000 =$3 per hour Job 58 = 345,000/100,000 = $3.45 per hour Job 59= 390,000/130,000 =$3 per hour Actual overhead rate = overhead cost/ direct labor hours Job 57 = $3 *115,000 = $345,000 Job 58 = $3.45*115,000 =$ 396,750 Job 59 = $3*115,000 = $345,000 Under/over absorption Under/Over-absorption = applied overhead – Actual overhead Job 57 = $300,000- $345,000 = -$45,000 Under-absorption Job 58 = $345,000- $396,750 = - $51,750 Under- absorption Job 59 = $390,000 - $345,000 = $45,000 Over- absorption Under-absorption of t overheads has the effect of reducing the company’s profit since more overheads than those that had been budgeted are used. On the other hand, Over-absorption implies than less overhead than was budgeted are used. This results in increased profit for the company than had been budgeted. Gordon ought to use this information in a bid to come up with strategies for reducing the under absorption so that the company realizes more profits which is good for the overall performance of the company. 4. The meaning of cost drivers and cost pools as they are used in ABC and how ABC can improve costing for Shirley Robson Cost driver – A cost driver is a factor which influences and/ or contributes to the expense of particular operations of the business. In ABC costing, a cost driver is regarded as something or factor which drives the cost of a certain activity. For instance, factories usually have running machinery as activities. Thus, the activity cost driver that would be associated with running the machinery would be the machine hours that would drive the cost of labor, power consumption in running the machinery activity as well as the machinery maintenance. In other words, a cost driver is simply a factor that cause change in an activity’s cost. Cost pools- on the other hand, cost pool refers to grouping of individual costs by service center or department from where cost allocation is done. For instance, the cost of the department in charge of maintenance could be accumulated in a cost pool from where it can be allocated to the departments that require maintenance. Cost pools are important in allocating costs to activities. How ABC can improve costing for Shirley Robson ABC can improve costing for Shirley in a number of ways. First, ABC helps in improving business processes it is worth noting that ABC allows indirect costs to be allocated on the basis of a product’s cost driver. Thus as costs are allocated to the product, a clear picture is created of the business processes that perform well as well as those that need improvement. In this regard, ABC is useful in identification of non-value added activities and hence helps in better allocation of resources to the more efficient and hence profitable activities. In addition, ABC would help in identification of wasteful products since it would help one to better understand where overhead costs are going. This is because it accounts for costs in a way similar to how production work is carried out. In this regard, the management is able to identify wasteful products as well as unnecessary costs and thus resources will be used productively. In addition, ABC will help Shirley in fixing the price of products which are incorrect. Overall, ABC will result in better management of cost while improving product quality. 5. The profitability of Optimus and Sentinel using ABC and the recommendation on whether Optimus should be phased out and focus is placed on Sentinel Allocation of overheads = cost/ cost allocation base Cost pool Total activity Cost Allocation base Optimus Allocation rate Sentinel Allocation rate Optimus Allocation Sentinel Allocation Soldering $942,000 Number of soldering points 1,185,000/1,570,000 = 0.754777 385,000/1,570,000 =0.245223 =0.75477*$942,000 =$710,999.90 =0.245223*$942,000 =$231,000.10 Shipments $860,000 Number of shipments 16,200/20,000 =0.81 3,800/20,000 =0.19 = 0.81*860,000 =$696,600 =0.91*860,000 =$163,400 Quality control $1,240,000 Number ofinspections 56,200/77500 =0.725161 21,300/77500 =0.274839 =0.725161*$1,240,000 =$ 899,199.60 =0.274839*$1,240,000=$340,800.40 Purchase orders $950,400 Number of orders 80,100/190,080 =0.421402 109,980/190,080 =0.573864 =0.421402*$950,400 =$400500 =0.573864*$950,400 =$549,900 Machine power $57,600 Machine hours 176,000/192,000 =0.916667 16,000/192,000 =0.083333 =0.916667*$57,600 =$52,800.02 =0.083333*$57,600 =$4799.98 Machine set-ups $750,000 Number of setups 16,000/30,000 =0.533333 14,000/30,000 =0.466667 =0.533333*750,000 =$399,999.75 =0.466667*750,000 =$350,000.25 Total $4,800,000 $3,160,099 $1,639,901 Total units produced and sold Optimus = 22,000 Sentinel = 4,000 Manufacturing overhead per unit = Total cost/ Units produced Optimus = $3,160,099/22,000 units = $143.64/unit Sentinel =$1,639,901/4,000 units = $409.98/ unit Production cost of Optimus and Sentinel based on 22,000 units of Optimus and 4,000 units of Sentinel Optimus Sentinel Direct materials $208.00 $584.00 Direct labor Optimus (1.5hrs*$12) $18.00 Sentinel (3.5hrs*$12) $42.00 Machine costs Optimus (8 hrs*$18) $144.00 Sentinel (4 hrs *$12) $72.00 Manufacturing overheads $143.64 $409.98 Total costs $513.64 $1107.98 Total cost $11,300,080 $4,431,920 Oaktree division Income statement For the year ended 30th June 2015 Optimus Sentinel Total Revenue $19,800,000 $4,560,000 $24,360,000 Cost of goods sold $11,300,080 $4,431,920 $15,732,000 Gross margin $8,499,920 $128,080 $8,628,000.00 Selling and administrative expense $5,830,000 $978,000 $6,808,000 Operating income/Loss $2,669,920 -$849,920 $1820000 Units produced and sold 22,000 4,000 Net income for each unit sold $121.36 -$212.48 From the above calculations, it is clear that after changing the accounting system to ABC costing, it will be found that Sentinel has actually been operating at a huge loss of $212.48 per unit and not at a profit of $97.50 as indicated by the earlier accounting system. On the other hand, it will be found that Optimus has actually been operating at a $121.36 profit per unit as opposed to the $65.00 as indicated by the earlier accounting system. As such, it would be unwise to phase out Optimus and replace it with sentinel. This is because if this happens, the company will start operating at a loss. In fact, the company should consider doing otherwise by phasing out sentinel and replacing it with Optimus. This is because by so doing, the company will see its profits increase. 6. The limitations that Shirley should be aware of when using ABC In implementing the ABC costing system Shirley needs to be aware of the following limitations, i) ABC is a complex system, which hinders its widespread application. It is also costly to operate as it requires management to not only estimate costs of each activity and also identify and measure the activities cost drivers. These also have to be updated on a regular basis. This is unlike the traditional management accounting that uses a single center approach. ABC will require division of costs into many cost pools that represent the many activities. This is costly in terms of consuming organizational resources as well as time. ii) The system is not perfect and has weaknesses including the fact that some overhead costs such as the managing director’s salary are impossible to divide and allocate it on a per product usage basis. In addition, not all productive activities add value to products. An example a first aid trainer and fire safety drills are productive activities though they do not add value to the end product. Such business sustaining costs are assigned to products on a proportionate basis or on the basis of assumptions thus rendering the system imperfect. iii) ABC places too much attention to detail and control on processes. This obscures the bigger picture as the organization loses sight of strategic long-term objectives in pursuit of small savings in the short run. For example, ABC may choose a single distribution channel as nonremunerative when the channeling might be chosen to achieve strategic depth as opposed to prioritizing profit. Read More