Reference no: EM133249450

Overhead Cost Allocation

The Visteon Limited company manufactures a wide range of motor parts for the automotive industry. The company uses a job-order costing system with a predetermined overhead rate on a plantwide basis, based on the number of direct labour hours. The controller of the company made an estimate of the company's overhead rate for 2022 on 20th July, 2021. This new rate was calculated based on $2,475,000 in manufacturing overhead costs and 52,000 total direct labour hours estimated for 2022:

Predetermined overhead rate = $2,475,000/ 52,000 hours = $47.60 per direct labour-hour

In a meeting on 21st July, top managers were informed of this new predetermined overhead rate. Because of the fact that this overhead rate was within a few dollars of the overhead rate which had been used during the year 2021, no comments were made about it. During the meeting, the production manager proposed buying an automated milling machine built by the Evotec Group. In order to discuss the proposal further, Visteon Limited's president, Steven Richards, agreed to meet with Evotec Group's regional sales representative.

A day after the meeting, Mr. Richards met with Alex Smith, a sales representative from Evotec Group. Following is the discussion that took place:

Richards: Philip Potter, our production manager, requested that I meet with you regarding the installation of an automated milling machine. To be honest, I am sceptical. It's going to be up to you to convince me that this is not just another expensive toy that Philip's people will play with.

Smith: That shouldn't be a problem, Mr. Richards. There are three major advantages to using an automated milling machine. First of all, it is much faster than the manual method that you are currently using. It is capable of processing approximately twice as many parts per hour as your current milling machines. The second advantage is that it is much more flexible. It is true that there are some up-front programming costs, but once these have been incurred, almost no setup is required for standard operations on the machines. You simply need to punch in the code for the standard operation, load the machine's hopper with raw materials, and let it do the rest.

Richards: Sure, but how much does it cost? We won't gain much by having twice the capacity in the milling machine area. The current milling machine is idle most of the time anyway.

Smith: I was getting there. The third advantage of an automated milling machine is its lower cost. In reviewing your current operations, Philip Potter and I calculated that the automated equipment would eliminate the need for approximately 6,000 direct labour hours per year. How much does your direct labour cost per hour?

Richards: The average wage rate in the milling area is about $21 per hour. With fringe benefits, that figure rises to about $30 per hour.

Smith: Make sure you consider your overhead as well.
Richards: The overhead rate for next year will be approximately $48 per hour.

Smith: In other words, including the costs of fringe benefits and overhead, the cost per direct labour hour is about $78.

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Richards: Yes, that's correct.
Smith: As 6,000 direct labour hours can be saved per year, the cost savings would be approximately

$468,000 each year.
Richards: That's pretty impressive, but you are not giving this equipment away, are you?

Smith: There are several options available, including leasing and outright purchase. In comparison, our 60- month lease plan would require annual payments of only $300,000.

Richards: Sold! I am interested in the installation of the equipment. When can you do it?

The company's controller was informed shortly after this meeting that Mr. Richards had decided to lease the new equipment, which would be installed during the Christmas vacation period. Based on this decision, the controller realised that the predetermined overhead rate for the year 2022 would have to be recalculated since the decision would affect both manufacturing overhead and direct labour hours. Following a discussion with both the production manager and the sales representative from Evotec Group, the controller concluded that, in addition to the annual lease cost of $300,000, the new machine would also require a skilled technician/programmer who would be paid $45,000 annually to maintain and program the machine. Factory overhead would include both of these costs. In terms of total manufacturing overhead costs, which are almost entirely fixed, there would be no other changes. According to the controller, the new machine would result in a reduction of 6,000 direct labour hours for the year from the levels initially projected.

As soon as the revised predetermined overhead rate for the year 2022 was circulated among the company's top managers, there was considerable dissatisfaction.

Required

1. Calculate the predetermined rate again assuming the new machine will be installed. Why is the new predetermined overhead rate higher (or lower) than the rate that was originally estimated for 2022?

2. Could this new rate have any impact (if any) on the cost of jobs that do not require the use of the new automated milling machine?

3. Can you explain why managers might be concerned about the new overhead rate?

4. Following the presentation of the new predetermined overhead rate, the production manager admitted that he probably would not be able to eliminate all of the 6,000 direct labour hours. Initially, he had hoped to achieve the reduction by not replacing workers who retire or quit, but this was not possible. Therefore, the real labour savings would be approximately 2,000 hours, or one worker. Taking into consideration the additional information that is now available to you, evaluate the original decision to acquire the automated milling machine from the Evotec Group.