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Allocation of Variable Manufacturing Overheads using Simple Costing System

Prairie Wolf (PW) is a car parts manufacturer and currently uses simple costing system of using machine hours to allocate the manufacturing overheads to its three main customers. The company has three main departments that use the manufacturing overheads. One of the customers have complained of being overcharged, as the allocation of variable manufacturing overheads is not competitive at all. Thus, the management of PW is considering change to the existing costing system to enhance the efficiency of allocation of variable manufacturing overheads to the three customers using the departmental information. Discussion below will help us to make up our mind as to the validity of the proposed changes to the simple costing system (Johnson 2014).

The simple costing system that is in use in Prairie Wolf (PW) to allocate the variable manufacturing overhead to its three customers based on machine hours the variable manufacturing overhead allocated to its three customers namely, United Motors, Alpha Motors and Beta Motors will be as following:

 United Motors 

 Alpha Motors 

 Beta Motors

Variable manufacturing overhead 

     400,000.00

    18,164.13

    241,712.62

     140,123.26

Thus, the actual variable manufacturing overhead of 2015 which is $400000.00 has been allocated to the three customers of PW based on the machine hours used by these three customers. The details of which is available in the table below: 

 Usage of cost drivers by customer contact 

 Department 

 Cost Drivers 

 Variable Manufacturing Overhead (2015)

 United Motors 

 Alpha Motors 

 Beta Motors

 Design 

 CAD-Design hours

       28,000.00

              110

                200

                   80

 Production 

 Engineering Hours 

       40,000.00

                60

                240

                 370

 Engineer

 Machine Hours 

     230,000.00

              140

             1,863

              1,080

The machine hours used by the three customers of the company have been highlighted in bold font for the readers to catch it at a glimpse. Thus, the simple costing system which has been in use for long within the organization to allocate manufacturing overhead to its customers only considers machine hours of engineer department to allocate the manufacturing overhead of design, production and engineering departments to the three customers of the organization (Öker and Ad?güzel 2016).

On the basis of the following information let us allocate the variable manufacturing overhead of 2015 to the three customers using departmental based variable manufacturing overhead rates.

 Usage of cost drivers by customer contact 

 Department 

 Cost Drivers 

 Variable Manufacturing Overhead (2015)

 United Motors 

 Alpha Motors 

 Beta Motors

 Total

 Design 

 CAD-Design hours

       28,000.00

              110

                200

                   80

            390

 Production 

 Engineering Hours 

       40,000.00

                60

                240

                 370

            670

 Engineer

 Machine Hours 

     230,000.00

              140

             1,863

              1,080

         3,083

Based on the information of three main departments of the organization the allocation of variable manufacturing overhead to the three main customers have been made as following:

(Amounts are in $)

 Total

 United Motors 

 Alpha Motors 

 Beta Motors

 Design 

       28,000.00

      7,897.44

      14,358.97

         5,743.59

 Production 

       40,000.00

      3,582.09

      14,328.36

       22,089.55

 Engineer

     230,000.00

    10,444.37

    138,984.76

       80,570.87

 Others 

     102,000.00

      9,134.33

      36,537.31

       56,328.36

 Total 

     400,000.00

    31,058.23

    204,209.40

     164,732.37

Since the total variable manufacturing overhead for the year 2015 is $400000.00 and the three departments total comes to only $298000.00 thus, the additional variable manufacturing overheads of (400000.00 – 298000.00) = $102000.00 has been allocated to the three customers on the basis of engineering hours spent in the production department (Ruiz-de-Arbulo-Lopez et al. 2013) .

Allocation of Variable Manufacturing Overheads using Departmental Based Overhead Rates

In order to answer this part of the document it is important to conduct a comparative analysis of the variable manufacturing overheads allocation to the three customers of the organization under two different methods of costing, i.e. simple costing method used by PW and the departmental based overhead rates. Let us have the allocations of variable manufacturing overheads between three customers of the organization under these two different methods of costing to conduct the comparative analysis. 

On the basis of Simple costing system of machine hours 

 Total

 United Motors 

 Alpha Motors 

 Beta Motors

 Variable manufacturing overhead 

     400,000.00

    18,164.13

    241,712.62

     140,123.26

Under departmental absorbed overhead rates 

 (Amounts are in $)

 Total

 United Motors 

 Alpha Motors 

 Beta Motors

 Design 

       28,000.00

      7,897.44

      14,358.97

         5,743.59

 Production 

       40,000.00

      3,582.09

      14,328.36

       22,089.55

 Engineer

     230,000.00

    10,444.37

    138,984.76

       80,570.87

 Others 

     102,000.00

      9,134.33

      36,537.31

       56,328.36

 Total 

     400,000.00

    31,058.23

    204,209.40

     164,732.37

Comparison 

 Total 

 United Motors 

 Alpha Motors 

 Beta Motors

 On the basis of Simple costing system of machine hours 

     400,000.00

    18,164.13

    241,712.62

     140,123.26

 Under departmental absorbed overhead rates 

     400,000.00

    31,058.23

    204,209.40

     164,732.37

 Changes in variable manufacturing cost 

                    -  

    12,894.10

    (37,503.22)

       24,609.12

From the above comparison, it is clear that if the costing system of PW is changed from the simple costing to departmental based overhead rates. The new system is applied for efficient allocation of variable manufacturing overheads between three customers of the organization Alpha Motors will be befitted as allocation of variable manufacturing overheads in simple costing system is unnecessary burdening the organization, i.e. Alpha Motors. Thus, it is clear Alpha Motors is the one that should be complaining for being overcharged (Laudon and Laudon 2016).

Except Alpha Motors, other two customers United Motors and Beta motors both will be unhappy with the departmental based rates for allocation of variable manufacturing overheads, as both these customers will be charged more under the departmental based overhead rates. The variable manufacturing overheads will be $37503.22 less for Alpha Motors and $12894.10 and $24609.12 more respectively for United Motors and Beta Motors. Thus, Both United Motors and Beta Motors will not be happy with the use of departmental based overhead rates for allocation of variable manufacturing overheads.

Irrespective of one’s happiness or otherwise an organization always looks to improve its accounting and costing system to price its products and allocate its overheads better. Use of departmental based rates to allocate the variable manufacturing overheads will certainly help PW to allocate its overheads better amongst the three customers of the organization than by using simple costing system. Hence, the customers of the organization shall be convinced that use of departmental based rates is appropriate to allocate the variable manufacturing overheads (Heizer 2016).

Apart from allocation of variable manufacturing overheads between the three customers of the organization, PW can also use the available departmental information to allocate other expenditures that have been spent on the production and completion of different car parts for the three customers of the organization. The expenditures that are not directly related to the manufacturing of car parts but associated costs such as carriages, fare, rent of spaces used by the organization, office expenses etc. can also be allocated properly to the three customers based on the departmental information (Popesko 2013).

Comparative Analysis of Two Systems

Activity Based Costing system (ABC system) is an efficient costing systems that identify activities that directly related to the performance of an organization and uses these activities to assign indirect costs to different products of an organization. Recognition of the relationship between costs, activities and products to understand the relationship and assign the indirect costs to the products of the company. Manufacturing industries use ABC system to enhance the reliability of cost data. In case of PW since it is in the business of manufacturing car parts, use of ABC system would be beneficial to the organization, as it will enhance the reliability of cost data.     

However, in case there are number of costs and expenditures that are general in nature and not specific to different activities then the use of ABC system would not be worthwhile to further refine the departmental based overhead rates costing system (Mitra 2016).

In order to improve the productivity of the machine hours in engineering department the first step that the management must take is to reduce the idle hours of engineering department. The manager of the engineering department should be asked to take extra care in order to reduce the unnecessary idle hours in the department. Workers and employees of engineering department should be asked to maintain the time line of entering and exiting the premises. The machines in the engineering department should be maintained properly to ensure that there is no breakdown of machines (Elhamma and Zhang 2013). This will substantially reduce unproductive hours of engineering department. Proper employee should be recruited for different jobs in the engineering department to further enhance the productivity of the department and the company as a whole.

Conclusion:

Taking into consideration the above discussion it is clear that a manufacturing organization should use a proper costing system to allocate its overheads and expenditures properly to its different manufacturing products. This will help an organization to not only allocate the expenditures and overheads properly to different products but also to price it products better.  

References:

Elhamma, A. and Zhang, Y.I., 2013. The relationship between activity based costing, business strategy and performance in Moroccan enterprises. Accounting and Management Information Systems, 12(1), p.22.

Heizer, J., 2016. Operations Management, 11/e. Pearson Education India.

Johnson, P.F., 2014. Purchasing and supply management. McGraw-Hill Higher Education.

Laudon, K.C. and Laudon, J.P., 2016. Management information system. Pearson Education India.

Mitra, A., 2016. Fundamentals of quality control and improvement. John Wiley & Sons.

Öker, F. and Ad?güzel, H., 2016. Time?driven activity?based costing: An implementation in a manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.

Popesko, B., 2013. Specifics of the activity-based costing applications in hospital management. International Journal of Collaborative Research on Internal Medicine & Public Health.

Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5), pp.647-668.

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