Salvo Inc., a specialized equipment manufacturer, uses a job order costing syste

Question

Salvo 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 $ 1,500 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 $ 1,500. This means that direct labor makes up only 6% of our total product cost, yet 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 $ 2,000 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 $ 750. 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?

Explanation / Answer

Answer:

1. The main concern of the Engineer about the overhead rate going up and up is that even when the direct labor involvement in the production is reducing still the overhead rate per direct labour hour is increasing. He is concerned with the estimates of direct labour hour involved and the machine hours involved and the determination of the Overhead rate.

2. Because the Company applies predetermined overhead allocation rates for calculations of its cost, hence even a small error in estimates and allocation rate will affect the biding pricec of the new business and thus may lead to loss of bids due to excessive pricing or loss in undertaking the bids due to under pricing.

3. The possible solution for the situation can be use of activity based costing for allocation of overheads instead of allocating the overheads on direct labour hour basis. This will give a more realistic overhead allocation rate and scope for errors will also be reduced.

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