Question

In September, Larissa Keener was asked to explore new methods of cost accounting for Keener Doors and Windows Company, which is owned by her father. Simon Keener wants to control costs better because his small window and patio door manufacturing company competes with large corporations that dominate the market.

First, Larissa decided to analyze the cost system in the company's patio door division. Half of the company's total volume of sales came from patio doors. The patio door division contained drilling and grinding machines, glass cutting equipment, and assembly space. All the operations for the production of patio doors were completed here.

The division occupied nearly half the total floor space in the two-story plant. The glass cutting department was located on the first floor of the plant and occupied about a third of that floor. The office and the frames department were also located on the first floor. Two other departments (hardware and grinding/machining), as well as the tool room and stock room, were all located on the second floor. Part of the assembly department was located on the first floor and part of it was on the second floor.

As an order came in, several departments began work at the same time. In the glass cutting department, glass was cut and edges were beveled for each order. In the frames department, door frames were cut from metal sheeting. The grinding and machining department smoothed and rounded the edges of the frames. The hardware for each door was assembled or manufactured in the hardware department. Each department sent their completed jobs to the assembly department where the doors for each order were assembled and then shipped out.

Larissa discovered that her father’s accountant used a division-wide allocation pool and used direct labor hours as an allocation base. The hours each batch of product spent in every department were tracked. When the batch was complete, manufacturing overhead and direct labor costs were lumped together and allocated based on the number of hours the product had spent in all of the departments. Exhibit 1 shows the number of direct labor hours and the amount of overhead for the month of March. The overhead application rate for the company is also calculated.

Larissa believed that the costing system was not very accurate. She was concerned that product costs might appear distorted under this method. She thought that collecting data by department and allocating the costs of the department to work done by that department would better reflect the flow of resources. The company already tracked the time each order spent in every department, so that information could be used as the allocation base.

Larissa remembered that she needed to trace as many costs as possible to each department and then assign those costs that couldn’t be traced. She dug out her cost accounting textbook from college to review the job costing method. She decided to assign all of the costs of the building and equipment first. She allocated building-related costs such as depreciation, insurance, utilities, and property taxes based on each department’s square footage. She traced other costs, such as supervisor’s salaries and indirect supplies used to each department. Exhibit 2 outlines the costs for each department.

She decided to analyze the cost of several different types of products using this new system and to compare the new costs to the old costs. Standard doors use standard hardware, which is supplied to the assembly department by a vendor. Therefore the orders do not go through the hardware department. The following work is done per batch of standard patio doors.

Department                                                                               Hours

Glass Cutting                                                                                  30

Frames                                                                                             50

Grinding and Machining                                                                 20

Assembly                                                                                      100

Larissa found a big difference for standard doors under the old and proposed systems. She felt that the current method probably misled managers about the profitability of these doors

The company needs to keep spare parts on hand for contractors doing repairs to their windows and doors. Since these parts are needed immediately, spare parts inventory can be large at times. Larissa believed that under the old method, the cost of spare parts inventory may not accurately reflect the resources used in production. The following amounts of time were usually spent on producing spare parts each month:

Department                                                                               Hours

Glass Cutting                                                                                  75

Frames                                                                                             25

Grinding and machining                                                                 50

Hardware                                                                                      375

Larissa decided to present her new system in a managers’ meeting. She was surprised at the reaction of the various department managers. One concern was the amount of work that Patio Doors did for other divisions in the company. The Hardware Department made most of the hardware for all of the other divisions, and Grinding and Machining did many jobs for other divisions. In March the following hours were spent for other divisions’ work.

Department                                                                               Hours

Glass Cutting                                                                                200

Grinding and Machining                                                               500

Hardware                                                                                      800

The other division managers thought that changing these costs would penalize them under their current budgets. They also complained that they had no control over the costs in the Patio Doors Division. The manager of the sales division was particularly concerned about how these new costs would affect pricing. And the head of the Patio Doors Division thought that the increased paper work would not be worth the effort. His division was providing good service to other departments and always timely in delivering product, so he saw no need to change now.

Simon Keener was unsure which method was better. He wondered if the new method would have any effect on profitability.

Exhibit 1

KEENER DOORS AND WINDOWS

Assigning Direct Labor Cost and Manufacturing Overhead to Jobs – Current Method

March

Department	Labor Charge             per Month	Overhead	Total
Glass Cutting	$15,000
Frames	15,000
Grinding and Machining	35,000
Hardware	23,100
Assembly	24,000
Total	$112,100	$147,600	$259,700
Total number of hours worked: 9,600/month
Average hourly charge: $259,700÷9,600 = $27.05 predetermined overhead application rate

Exhibit 2

KEENER DOORS AND WINDOWS

Assigning Direct Labor Cost and Manufacturing Overhead to Jobs – Proposed Method

March

Section	Total Hours	Labor Charge Per Hour	Overhead Charge Per Hour	Total Cost Per Hour
Glass Cutting	1,000	$15.00	$14.00	$29.00
Frames	1,500	10.00	8.00	18.00
Grinding and Machining	2,000	17.50	33.50	51.00
Hardware	2,100	11.00	16.00	27.00
Assembly	3,000	8.00	7.00	15.00
Total	9,600

Explain how the new system might be used to help with the following:

1.   Product pricing

2.   Inventory valuation

3.   Efficient allocation of work among departments.

Prepare a memo outlining your recommendation to Mr. Keener. In addition, make any other recommendations you have about improving profitability of the company

Prepare a memo allaying the fears of the other division managers and promoting the benefits of the proposed system. Use proper memo format.

Answer 1

Departmental overhead rate is a single overhead rate calculated for a particular department. Departmental overhead rates are more accurate than plant-wide rates. Each department could have its own rate calculated based on its own cost drivers. Accounting for each overhead amount is tracked by keeping separate factory overhead and applied overhead accounts for each departments. As with the plant-wide rate misallocation of costs can occur if the cost driver chosen is not truly relating to all activities for a department. So, departmental rates should be only used if the departments are similar in nature and if cause and effect relationship can be defined between each job and the selected cost driver. The dangers of improperly allocating costs is certain products will appear less profitable than they really are and vice versa and risking mismanagement of the product lines.

When the methods discussed above are not accurate, an activity based costing method can be used where it assigns factory overhead costs to produce or services using multiple cost pools and multiple cost drivers. The cost drivers are selected based on cause and effect relationship and can be actively based and volume based.

Activity based overhead allocation may help management identify inefficient products, departments, and activities when it attempts to eliminate activities that don’t provide value to products and services. Activity based overhead allocation may encourage focusing resources on profitable products, departments and activities and controlling costs.

Since there is different type of products that are produced which ultimately goes through all the departments requires an efficient system of cost allocation which is obviously not based on departmental wide rate. By this system of allocation each product gets its share of costs based on the resources used by them. Accordingly, all the costs are incurred and pooled together for each product so that the mangers are in a better position to cope with the determination of each cost of the product and their profitability. Although initially the system may appear to be not cost-effective due to its heavy installation but in a long-run these might come handy and useful while deciding upon the factors like shut-down or continue, making or buying etc.