A10-5 Factory overhead rate
Fabricator Inc., a specialized equipment manufacturer, uses a job order costing
system. The overhead is allocated to jobs on the basis of direct labor hours. The
overhead rate is now $3,000 per direct labor hour. The design engineer thinks
that this is illogical. The design engineer has stated the following:
Our accounting system doesn’t make any sense to me. It tells me that every labor
hour carries an additional burden of $3,000. This means that while direct labor
makes up only 5% of our total product cost, it drives all our costs. In addition,
these rates give my design engineers incentives to “design out” direct labor by
using machine technology. Yet, over the past years as we have had less and less
direct labor, the overhead rate keeps going up and up. I won’t be surprised if next
year the rate is $4,000 per direct labor hour. I’m also concerned because small
errors in our estimates of the direct labor content can have a large impact on our
estimated costs. Just a 30-minute error in our estimate of assembly time is worth
$1,500. Small mistakes in our direct labor time estimates really swing our bids
around. I think this puts us at a disadvantage when we are going after business.
1. What is the engineer’s concern about the overhead rate going “up and up”?
2. What did the engineer mean about the large overhead rate being a disadvantage when placing bids and seeking new business?
3. What do you think is a possible solution?
A10-6 Classifying costs
With a group of students, visit a local copy and graphics shop or a pizza restau-
rant. As you observe the operation, consider the costs associated with running
the business. As a group, identify as many costs as you can and classify them
according to the following table headings:
Cost Direct Materials Direct Labor Overhead Selling Expense
A10-7 Just-in-time principles
Warm Space Inc. manufactures electric space heaters. While the CEO, Gwen
Willis is visiting the production facility, the following conversation takes place
with the plant manager, Tyra Chastain:
Gwen: As I walk around the facility, I can’t help noticing all the materials in-
inventories. What’s going on?
Tyra: I have found our suppliers to be very unreliable in meeting their delivery
commitments. Thus, I keep a lot of materials on hand so as to not risk running
out and shutting down production.
Gwen: Not only do I see a lot of materials inventory, but there also seems to be
a lot of finished goods inventory on hand. Why is this?
Tyra: As you know, I am evaluated on maintaining a low cost per unit. The
one way that I am able to reduce my unit costs is by producing as many space
heaters as possible. This allows me to spread my fixed costs over a larger base.
When orders are down, the excess production builds up as inventory, as we are
seeing now. But don’t worry—I’m really keeping our unit costs down this way.
Gwen: I’m not so sure. It seems that this inventory must cost us something.