Reference no: EM13379587
We have grown a lot and done well in the past three years. Most of our shoes are hand made, using very little in the way of machines, and we charge a premium price for them. Recently, however, we decided to diversify so we could compete with the more automated manufactures. We purchased some specialized equipment that we installed in our plant and that we use only for the machine-made shoes. We use very little labor to make these kinds of shoes. However, the problem now is that we don't seem to know how much it costs us to make either kind of shoe. It was easy when we produced only hand-made shoes, but matters are now much more complicated. The problem seems to be with overhead allocation.
The speaker was Joan Smith, CEO of Bally, Inc. (BI). She was speaking at the senior manager's weekly meeting held at the North American headquarters of the corporation in Lafayette, Indiana. BI had been manufacturing shoes in Italy for several generations. Three years ago, after completing her M.B.A. in Business Administration from a School in New England, her father, the company's founder and President had asked Ms. Smith, to initiate BI's North America operations.
BI's overhead costs and some related information on shipments, batch sizes, and machine hours, are shown in Exhibit 1. John McMann, BI's CFO, commented on the nature of the problem.
When we produced only hand made shoes, we allocated all our manufacturing overhead (MOH) to them and there was no problem. Our MOH is relatively high, since receiving and handling the materials from each leather shipment takes a lot of time. Also, as part of receiving and handling, we cut and prepare much of the leather before it enters the manufacturing process, all of which we consider to be manufacturing overhead.
The shift to machine-made shoes has meant more than just some increased depreciation, which we consider to be direct cost, since we use completely different machines for machine-made shoes than for hand-made ones. In addition, however, all the machines need to be repaired and maintained, which seems to be a function of the number of hours that each machine is used. Our repair and maintenance crew works on all of the machines, so we consider them to be part of manufacturing overhead.
Then there's the set-up time for the machines, which is related to the number of batches we run. The hand-made shoes are stitched and formed individually, but then finished up on a machine in batches. And, of course, all of the machine-made shoes are run in batches. A batch is a group of shoes of the same size, and we have to set up the machines to accommodate the particular size. Our set-up crew works on all of the machines, so we consider them to be part of manufacturing overhead also.
In response to this, Ms. Smith commented to John McMann:
Is this diversification move good or not? First you tell me that machine-made shoes are money makers, then you tell me we're losing large sums of money on each pair of them. Which is it?
Ms. Smith's concern about costs arose because Mr. McMann had presented her with some conflicting information. Initially, Mr. McMann had allocated overhead to shoes on the basis of direct labor dollars, as shown in Exhibit 2. Then, deciding that machine hours drove the use of much of the overhead, he had used machine hours to allocate the overhead, as shown in Exhibit 3. Ms. Smith commented:
With the first approach, I was pleased. The machine-made shoes were showing a bigger margin percent than the hand-made ones, which didn't completely make sense to me, since the market for machine-made shoes is much more competitive than the market for hand-made shoes, but I thought that perhaps we were doing something better than our competition. Then along comes the report using machine hours as the basis for allocating overhead. Wow! The margin percent on our hand-made shoes is terrific, but we are losing a bundle on the machine-made shoes.
On top of all this, John has told me that, because we have so much fixed manufacturing overhead, we should be using variable costing, and he's put together a set of financial statements using variable costing that shows we're losing money [Exhibit 4]. This just doesn't make sense, although I suppose if the margins on the machine-made shoes are as bad as they now seem to be, maybe it's true. If that is the case, though, why doesn't the loss show up under the absorption costing process?
At this point, I'm not sure what to do. We've just begun producing machine-made shoes, and are making only a few hundred pairs right now, but this problem could get much bigger if we increase production. My sense is that we should get out of the machine-made shoe business, and stick with the hand-made shoes. We were doing pretty well at that before we began to diversify. It seems as though we've made a big mistake. Or maybe it's all in the accounting. I sure wish I had paid more attention in my Cost Accounting course (ACCT 804) in college.
Exhibit 1. Manufacturing Overhead Statistics and Costs
Most Recent Accounting Period
Machine-Made Hand-Made Total
Manufacturing Statistics
Number of pairs produced 400 1,000 1,400
Number of machine hours 800 200 1,000
Number of batches 5 35 40
Raw material shipments received 2 18 20
Manufacturing Overhead Costs
Machine maintenance $50,000
Machine set-up labor 115,000
Material handling 235,000
$400,000
Exhibit 2. Overhead Allocated with Direct Labor Dollars
Most Recent Accounting Period
Machine-Made Hand-Made Total
Direct Labor $5,000 $35,000 $40,000
Direct Materials 7,000 18,000 25,000
Machine Depreciation (direct) 25,000 5,000 30,000
Manufacturing overhead 50,000 350,000 400,000
Cost of goods manufactured $87,000 $408,000 $495,000
Full cost per pair $217.50 $408.00
Price per pair $300.00 $500.00
Margin percent per pair 27.5% 18.4%
Exhibit 3. Overhead Allocated with Machine Hours
Most Recent Accounting Period
Machine-Made Hand-Made Total
Direct Labor $5,000 $35,000 $40,000
Direct Materials 7,000 18,000 25,000
Machine Depreciation (direct) 25,000 5,000 30,000
Manufacturing overhead 320,000 80,000 400,000
Cost of goods manufactured $357,000 $138,000 $495,000
Full cost per pair $892.50 $138.00
Price per pair $300.00 $500.00
Margin percent per pair -197.5% 72.4%
Exhibit 4. Comparative Income Statements
Most Recent Accounting Period
Absorption Costing Variable Costing
Sales $530,000 $530,000
Cost of goods sold (COGS) 450,000 210,000
Gross margin 80,000 320,000
Overhead volume variance (15,000) 0
Overhead budget variance 2,800 2,800
Adjusted gross margin $ 67,800 $322,800
Less: Fixed manufacturing overhead 0 270,000
Less: Selling, general & admin. 58,000 58,000
Operating income $ 9,800 $ (5,200)
Question 1. Compute the allocation rate that was used for the manufacturing overhead in Exhibits 2 and 3. Show your computations in enough detail and with enough organization to make them easy to follow.
Question 2 Using the rates from Question 1, show the computations that were used for allocating manufacturing overhead in Exhibit 2 and Exhibit 3. Show your computations in enough detail and with enough organization to make them easy to follow.
Machine-made Hand-made
Exhibit 2
Exhibit 3
Question 3. Assuming that all manufacturing overhead is fixed and all units produced are sold, calculate the breakeven (in units and $) for machine-made and hand-made shoes based on Exhibit 2? Is this information useful for decision-making (one sentence only)?
Machine-made shoes: Breakeven units:
Breakeven $:
Hand-made shoes: Breakeven units:
Breakeven $:
Question 4. Using the same logic, calculate the breakeven (in units and $) for machine-made and hand-made shoes based on Exhibit 3? Is this information useful for decision-making?
Machine-made shoes: Breakeven units:
Breakeven $:
Hand-made shoes: Breakeven units:
Breakeven $:
Question 5. Using the same logic, calculate the breakeven (in units and $) for Bally, Inc. based on Exhibit 2? Is this information useful for decision-making?
Breakeven units:
Breakeven $:
Question 6. use the information in Exhibit 1 to identify the cost drivers and compute manufacturing overhead rates for the machine maintenance, machine set up labor, and material handling.
MOH Item Total Cost Cost Driver MOH Rate
Machine maintenance
Machine set up labor
Material handling
Question 7. Use the overhead rates you computed in Question 6 to calculate the cost of goods manufactured for a pair of machine-made shoes and a pair of hand-made shoes, and compute the margin percentages for each. Explain your computations for MOH.
Machine-made Hand-made Explanation
Item
Cost of goods manufactured
Cost of goods manufactured per pair
Price per pair
Margin Percent
Question 8 Ms. Smith has asked you if they should get out of the machine-made shoe business. Please make a recommendation and explain your rationale. (Remember to follow the format of the team memo you wrote earlier in the semester).