Evans, Inc., has a unit-based costing system. Evans’s Miami plant produces 10 different electronic products. The demand for each product is about the same. Although they differ in complexity, each product uses about the same labor time and materials. The plant has used direct labor hours for years to assign overhead to products. To help design engineers understand the assumed cost relationships, the Cost Accounting Department developed the following cost equation. (The equation describes the relationship between total manufacturing costs and direct labor hours; the equation is supported by a coefficient of determination of 60 percent.)
Y ¼ $5,000,000 þ $30X, where X ¼ direct labor hours
The variable rate of $30 is broken down as follows:
Direct labor........$ 9
Variable overhead...... 5
Direct materials.....16
Because of competitive pressures, product engineering was given the charge to redesign products to reduce the total cost of manufacturing. Using the above cost relationships, product engineering adopted the strategy of redesigning to reduce direct labor content. As each design was completed, an engineering change order was cut, triggering a series of events such as design approval, vendor selection, bill of materials update, redrawing of schematic, test runs, changes in setup procedures, development of new inspection procedures, and so on.
After one year of design changes, the normal volume of direct labor was reduced from
250,000 hours to 200,000 hours, with the same number of products being produced. Although each product differs in its labor content, the redesign efforts reduced the labor content for all products. On average, the labor content per unit of product dropped from 1.25 hours per unit to one hour per unit. Fixed overhead, however, increased from $5,000,000 to $6,600,000 per year. Suppose that a consultant was hired to explain the increase in fixed overhead costs. The consultant’s study revealed that the $30 per hour rate captured the unit-level variable costs; however, the cost behavior of other activities was quite different. For example, setting up equipment is a step-fixed cost, where each step is 2,000 setup hours, costing $90,000. The study also revealed that the cost of receiving goods is a function of the number of different components.
This activity has a variable cost of $2,000 per component type and a fixed cost that follows a
step-cost pattern. The step is defined by 20 components with a cost of $50,000 per step. Assume also that the consultant indicated that the design adopted by the engineers increased the demand for setups from 20,000 setup hours to 40,000 setup hours and the number of different components from 100 to 250. The demand for other non-unit-level activities remained unchanged. The consultant also recommended that management take a look at a rejected design for its products. This rejected design increased direct labor content from 250,000 hours to 260,000 hours, decreased the demand for setups from 20,000 hours to 10,000 hours, and decreased the demand for purchasing from 100 component types to 75 component types, while the demand for all other activities remained unchanged.
Required:
1. Using normal volume, compute the manufacturing cost per labor hour before the year of
design changes. What is the cost per unit of an “average” product?
2. Using normal volume after the one year of design changes, compute the manufacturing cost
per hour. What is the cost per unit of an “average” product?
3. Before considering the consultant’s study, what do you think is the most likely explanation for the failure of the design changes to reduce manufacturing costs? Now use the information from the consultant’s study to explain the increase in the average cost per unit of product. What changes would you suggest to improve Evans’s efforts to reduce costs?
4. Explain why the consultant recommended a second look at a rejected design. Provide computational support. What does this tell you about the strategic importance of cost management?