Peninsula Manufacturing has just completed a major change in its quality control (QC) process. Previously, products were reviewed by QC inspectors at the end of each major process, and the company's 10 QC inspectors were charged as direct labour to the operation or job. In an effort to improve efficiency and quality, a computerised video QC system was purchased for $500 000. The system consists of a computer, 15 video cameras, other peripheral hardware, and software. The new system uses cameras stationed by QC engineers at key points in the production process. Each time an operation changes or there is a new operation, the cameras are moved, and a new master picture is loaded into the computer by a QC engineer. The camera takes pictures of the units in process, and the computer compares them with a picture of a 'good' unit. Any differences are sent to a QC engineer who removes the bad units and discusses the flaws with the production supervisors. The new system has replaced the 10 QC inspectors with two QC engineers.
The operating costs of the new QC system, including the salaries of the QC engineers, have been included as factory overhead in calculating the company's plant-wide manufacturing overhead rate, which is based on direct labour dollars. The company's managing director is confused. His production manager has told him how efficient the new system is, yet there is a large increase in the overhead rate. The calculation of the overhead rate before and after automation is as follows:
_____________________________________________ Before _________________ After
Budgeted manufacturing overhead ........................ $3 800 000 ................ $4 200 000
Budgeted direct labor cost ................................... $2 000 000 ............... $1 400 000
Budgeted overhead rate (as % of direct labor cost) ......... 190% ......................... 300%
'Three hundred per cent', lamented the managing director. 'How can we complete with such a high overhead rate?
Required:
1. Define 'manufacturing overhead' and cite three examples of typical costs that would be included in manufacturing overhead.
2. Explain why the increase in the overhead rate should not have a negative financial impact on Peninsula Manufacturing.
3. Discuss how an activity-based costing system might benefit Peninsula Manufacturing?