Set-Up Company produces blue things and gray things. Blue things are in much gre

Question

Set-Up Company produces blue things and gray things. Blue things are in much greater demand in the market and the firm sells 120,000 blue things a year. Set-Up Co. sells 6,000 gray things per year in small boutiques. Things have a short shelf life. They must be distributed, sold, and consumed within two months of manufacture.
Both things use the identical production process and production facilities. Direct labor is $0.50 per thing and direct material is $0.50 per thing. Things are produced in batches. Blue things are produced in batches of 600 units and gray things in batches of 30. Each batch of things goes through the thingamajig, which is the machine that converts raw inputs into things. Each batch requires engineers to reset the machine for the next batch, calibrate settings, and test the first 10 things for product quality and conformity to standards. Even if sequential batches of the same things are made, setups must be performed for each new batch. All the overhead costs are incurred in setups. Indirect labor, indirect materials, and supplies consumed during setup cost $360,000 per year. The only costs of producing things are direct labor, direct materials, and the overhead of setups. The company is currently allocating setup costs to things based on direct labor cost.
The firm has been selling blue things for $4 per unit and gray things for $6 per unit. But foreign competition for blue things is starting to put pressure on the $4 price. Some competitors are selling blue things for as low as $3 per unit. Management is considering putting more emphasis on selling gray things, whose margins are higher. On the other hand, management worries that the current system for allocating overhead costs is misrepresenting the costs of the two products because direct labor costs are not representative of the time spent by each product on the thingamajig. Management is considering allocating setup costs using machine hours on the thingamajig. A batch of gray things requires one hour of machine time and a batch of blue things requires 20 hours of machine time.


Analyze the present situation. Is there anything wrong with the costing system? If so, should management change to the proposed allocation base of machine hours? Hint: Present your three scenarios with line items related to Units per year, Direct Labor Cost, Direct Material cost, Overhead allocated, Total Cost and Unit Cost. There may be other line items for each scenario, but these should be in all 3 scenarios. As part of final analysis, also look at the opportunity cost of producing a graything.

Explanation / Answer

Blue Grey Over Head allocated based on Direct Labor Cost Direct Material and Direct LAbor 1 1 Annual Sales 120000 6000 Units Per Batch 600 30 Number of batches produced 200 200 Direct Labor Cost 60000 3000 Set up Costs 360000 Set up Costs based on Labor Cost 5.71 * Labor cost (5.71= 360,000 / 63,000 ) Set up Costs based on Labor Cost 342,857 17143 Total Costs 462,857 23143 Unit Costs 3.86 3.86 Over Head allocated based on Machine hours Machine Time required for each batch 1 20 Total Machine Hours required 200 4000 Set up Costs 360000 Set up Costs based on Machine hours 85.7 per MH Set up Costs 17143 342857 Total Costs 137143 348857 Unit Costs 1.142858333 58.14283333 The above analysis shows Grey thing shows an abnormally high cost if overheads are allocated based on M hours. It is better if overheads are allocated to Grey things based on Labor cost and Blue things based on Machine hours.

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