Question

Realforce Ltd. is a keyboard manufacturer. The company’s vice president of

manufacturing, Luke, presented at the management meeting a proposal for automating the Assembly Department. In the proposal, he recommended the company replace the 9 direct labor workers in the Assembly Department with 3 robots. He argued that the automation would result in the elimination of direct labor costs plus the elimination of manufacturing overhead cost in the Assembly Department as Realforce currently applies manufacturing overhead on the basis of direct labor costs using a plant-wide rate. The overhead application data for the current year are presented below:

2

The average annual manufacturing overhead cost is $10,000,000; the average annual direct labor cost is $2,000,000; the average manufacturing overhead rate is 500%.

  

Category Keycap Department PCB Department Assembly Department

Required:

Average Annual Direct Labor $ 1,000,000 $875,000
$ 125,000

Average Annual Overhead Cost $5,500,000 $3,500,000 $1,000,000

         

Discuss the issue of overhead application in Realforce (please be sure to cover the following aspects in your answer and limit your answer to 500 words or less):

• Describe the problems with the company’s current method for applying overhead and make recommendations on how to improve the application of overhead.

• Is it a correct statement that the manufacturing overhead cost in the Assembly Department would be reduced to zero if the automation were adopted? Explain why.

• What allocation base should be used to apply overhead in the Assembly Department if the automation were adopted?

Answer 1

Current Method

The Current method of allocation allocates cost based on the labor cost of the department. Hence it a traditional method of cost allocation which does not consider the activities consumed by products or services to allocate the overheads. Instead a predetermined rate is computed at beginning of the year and overhead is allocated based on the labor cost incurred during the period.

Drawbacks of current method

• No correlation with actual usage of resources
• Inaccurate calculation of product cost
• Product cost not reliable for decision making

Suggested improvements for application of overhead

Realforce Limited should try to deploy Activity Based Costing method which allocates costs based on the activities consumed rather than blanket rate

• Costs should be classified into activities and Activity cost pool should be defined
• Cost drivers should be identified for each Cost pool
• Calculate Cost driver rates
• Allocate Costs based on activities consumed by products

It is wrong statement to say manufacturing overhead would be reduced to zero if the automation is adopted. Though Labor cost would be eliminated there will be cost incurred on Robots. The following costs will be still part of manufacturing overhead

• Depreciation of Robots
• Repairs and Maintenance
• Electricity consumption
• Other operational cost of Robot

If Automation was adopted the allocation base to be used in Assembly Department is Machine hours to allocate the manufacturing overheads to the product. All the estimated overheads should be divided by machine hours and Machine hour rate should be calculated. This machine hour rate should be applied based on actual machine hour consumption.