Reference no: EM133064737

Case study - Product Costing Macquarie Electronics

This case highlights the deficiencies of traditional methods of product costing which employ single volume drivers of overhead cost allocation. It provides the opportunity to apply other costing methods in order to demonstrate differences in cost and price outcomes.

Problem:
Macquarie Electronics manufactures specialised engines to customers' specifications and operates a job costing system. Manufacturing overhead cost is applied to jobs on the basis of direct labour cost. The following estimates were made at the beginning of the year:

Jobs require varying amounts of work in the three departments. The Hastings job (private sector business), for example, would have required manufacturing costs in the three departments as follows:

The company uses a plant-wide overhead rate to apply manufacturing overhead cost to jobs.

Tonya Donovan, the management accountant of Macquarie Electronics, was meeting with Adam Williams, the manager of the production division, who is also a member of CPA. The topic of discussion was the assignment of overhead costs to jobs and their impact on the division's pricing decisions. Their conversations is reproduced below.

Tonya: Adam, as you know, about 25% of our business is based on government contracts, with the other 75% based on jobs from private sources won through bidding. During the last several years, our private business has declined. We have been losing more bids than usual. After some careful investigation, I have concluded that we are overpricing some jobs because of improper assignment of overhead costs.

Adam: I think I understand. We have three production departments. The labour-intensive department Assembly generates much less overhead than the machine-intensive departments Cutting and Machining. However, we have been using plant-wide rate based on direct labour costs to assign overhead costs to all jobs. As a result, labour-intensive jobs receive a greater share of the machine-intensive departments' overhead than they deserve. This problem actually can be greatly alleviated by switching to departmental overhead rates. The change would lower our bidding price for those jobs which were overestimated due to the application of a plant-wide rate. By increasing the accuracy of our product costing, we can make better pricing decisions and win back much of our private-sector business.
Tonya: Sounds good. When can you implement the change in overhead rates?

Adam: It won't take long. I can have the new system working within four to six weeks, certainly by the start of the new financial year.
Tonya: Hold it. I just thought of a possible complication. As I recall, most of our government contract work is mainly done in the labour-intensive department. This new overhead assignment scheme will push down the cost on the government jobs, and we will lose revenues. They pay us full cost plus our standard markup. This business is not threatened by our current costing procedures, but we can't switch our rates for only the private business. Government auditors would question the lack of consistency in our costing procedures.

Adam: I thought of this issue too. According to my estimates, we will gain more revenues from the private sector than we will lose from our government contracts. Besides, the costs of our government jobs are distorted. In effect, we are overcharging the government. However, they don't know that, and never would, unless we switch our overhead assignment procedures. I think I have the solution. Officially, let's keep our plant-wide overhead rate. All of the official records will reflect this overhead costing approach for both our private and government business. Unofficially, I want you to develop a separate set of books that can be used to generate the information we need to prepare competitive bids for our private-sector business.

Required:
1. Analyse the problems with the current costing systems and how it can be improved.
(Hint: Using the Hastings job as an example explain what has been happening as a result of using the business's current costing system. Assume that it is customary in the industry to bid jobs at 150% of total manufacturing cost, compare the current Hastings job price with the new price if separate predetermined overhead rate is applied within each department).

2. Do you believe that the solution proposed by Adam is ethical? Explain. You may like to consider the professional accountants code of conduct (see p.27 of your textbook).

3. Suppose that Tonya decides that Adam's solution is not right and objects strongly. Further suppose that, despite Tonya's objections, Adam insists strongly on implementing the action. What should Tonya do?

You are required to present your answers in a group presentation with maximum duration of 10 minutes. No individual presentation is allowed. Each student within the group must participate and deliver the presentation. Each student should speak for a minimum of 2 minutes. Students are required to present their answers in a group presentation in the week 9 tutorial. The duration of the group presentation should be a maximum of 10 minutes.