Question

Marvettas Shop applies coating finishes to a variety of materials and parts. The coating involves the application of powder to a surface, after which the powder is fused into a continuous film by the application of heat or radiant energy and the process results in a durable finish that resists rust.

In the previous years at Matvettas Shop, finishes were applied by hand, and manufacturing overhead was allocated to jobs based on direct labor hours the rate was $10 per hour based on overhead of $800,000 and 80,000 direct labor hours.

At the start of the current year, the company purchased and installed a computer-controlled, coating system at a cost of $1,500,000. It has a five-year life, the equipment adds $300,000 a year to manufacturing overhead, the expected total overhead is now $1,100,000. However, labor has been reduced by 20,000 hours per year because the equipment reduces the need for labor, and with an average wage rate of $20 per hour, $400,000 of wages are expected to be saved in the current year.

Marvettas Shop purchased a computer-controlled system including a new spray chamber, it kept its old spray booth and manual equipment for use on small jobs.

Marvettas Shop has just received an order from Donnie’s a small manufacturer of outdoor furniture to powder coat 4 tables and 16 chairs. On small orders such as this, Marvetta uses its old spray booth and manual equipment rather than the new computer controlled system. Material cost for the job will be $400, and 6 labor hours are required.

Use the information provided to estimate the full cost of the job in the current year and assume the company uses one company-wide overhead rate.

What would have been the cost of the job in part (a) in the prior year?

Kathy the plant manager, observed that “Last year, jobs like the one we did for Donnies cost less. But, I know we’re not less efficient at handling small jobs. We use the same equipment, the same labor, and the same products on small jobs this year as last year, and yet the accounting system is making small jobs look more expensive”. Explain to Kathy why the accounting system is making small jobs appear more costly in the current year.

Does the fact that small jobs have a higher cost in the current year suggest that prices for small jobs should be increased?

Answer 1

Current year Manufacturing Overhead = $1,100,000

Current Year Direct Labor hours = 80,000 - 20,000 = 60,000

Current Year Predetermined Overhead rate = $1,100,000 60,000 = $18.33 per labor hour.

1. Full Cost of the Job in the current year:

Material Cost = $400

Direct Labor Cost = 6 labor hours x $20 = $120

Overhead = 6 hours x $18.33 = $110

Total Cost of the job = $400 + $120 + $110 = $630

2. Cost of the job if it was in prior year:

Predetermined overhead rate in prior year = $10 per labor hour.

Total Cost = Materials Cost + Labor Cost + Overhead Rate

= $400 + $120 + 6 hours x $10

= $520 + $60

= $580

Had the job been done in prior year, the cost would be $580

3. The lacunae here is the use of cost driver and the fixed cost included in manufacturing overhead.

This year, the company has purchased a new automated machine, which won't be used for small jobs. Since the company is using one company-wide overhead rate, the fixed cost which solely belongs to Automated department is also included for overhead calculation of Manual department eventhough it is not relavant to Manual department. If the company derive different overhead rates for two departments, the costing would be similar to that of last year.

4. No, higher cost of small jobs doesn't suggest us to increase their price. If the price is increased, the demand might fall and we would lose our share of revenue. In this situation, if the overhead calculation is changed, implementing departmental overhead rate or activity cost drivers, we would get the accurate cost of the job and accordingly the price may be fixed. But in general sense, price is driven by cost upto certain extent and price is definitely driven by the market forces eg., customer demand.