Question

You have recently been hired as an accountant for the largest residential construction company in the state. Your primary responsibility is to track costs for each home being constructed. Tracking the costs for direct material and direct labor is relatively straightforward. Each home under construction has a job cost sheet. Materials requisitioned for each home site are carefully tracked and the construction workers are very careful about assigning their time to the homes they work on.

Accounting for manufacturing overhead costs, on the other hand, presents quite a problem. In the past, overhead has been allocated on the basis of direct labor hours. As a result, since larger houses require more workers, those houses have been allocated a larger share of the overhead.

Your company was recently selected by the state to build a number of low-income housing complexes. The state has agreed to an arrangement whereby they will pay your costs plus a 10 percent profit. Construction of these low-income housing units will be relatively simple and will not require a great deal of materials or labor, compared to the average house the company builds.

At a meeting following the granting by the state of the construction contract, the production foreman proposes the following idea: “Since the state has agreed to pay our costs plus 10 percent, the higher the costs on the project, the more money we make. What we need to do is to funnel as much of our costs as possible to this low-income housing project. Now I don’t want anyone to think I am proposing something unethical. I am not saying that we should charge the state for fictitious costs. What I am saying is that we should allocate as much overhead as possible to the low-income project. Therefore, I propose that we allocate overhead on a per-house basis with each house, regardless of size, being allocated the same amount of overhead.”

You have analyzed the activities that drive overhead costs and have found that bigger houses, in addition to requiring more direct materials and direct labor, require more inspections, more supervisions, etc. You can see that most in attendance at the meeting are being persuaded by the production foreman’s idea. You slowly raise your hand. It takes about ten seconds before al the voices go quiet. You look around the table and see ten of your colleagues staring at you. You open your mouth and…

Questions

1. What would you do in this situation? Is the overhead allocation method being proposed by the production foreman illegal? Is it unethical? Is it good strategy?

2. Suppose you argue that overhead should continue to be allocated on the basis of direct labor hours. After hearing your points, the group votes to go with the production foreman and allocate the overhead on a per-house basis. What would you do next?

3. Now, go back to your responses above and think carefully about what might be wrong with your logic or your approach. What are the potential risks or problems in your answers?

Answer 1

1. It is unethical to impose unnecessary overheads on any production or construction. Just because the contract is on the basis of cost +10% it would be grossly unethical to attach fictitious costs to construction to make money. Since, the bigger house will require more direct materials and labour along with overhead it is the responsibility of the accountant to raise the issue and explain gross unethical practice in the proposed accounting treatment. It is not illegal however, the Foreman production allocation method is certainly unethical and not at all a good strategy as the proper inspection by the government authority will ensure that the gross misleading accounting treatments unearth sooner than later.   
2. In the accounting report the accounting treatment to allocate overhead on the basis of each house should be mentioned after quantifying the impact of such accounting treatment on the contract and unethical aspect of the overhead treatment. A note shall be attached as part of the financial statements to attract the attention of the users of the financial statements on the topic of overhead allocation.   

There is nothing wrong with the responses of the accountants as far as the matter of overhead allocation is concerned however, the potential risk with the allocation of overhead on the basis of direct labour is the reduced profit that the organization will earn since the contract is on the basis of cost + 10% thus, higher the cost higher would have been the profit.