Case 18-1

Huron Automotive Company*

Sandy Bond, a recent business school graduate who had recently been employed by Huron automotive Company, was asked by Huron's president to review the company's present cost accounting procedures. In outlining this project to Bond, the president had expressed three concerns about the present system: (1) its adequacy for purposes of cost control, (2) its accuracy in arriving at the true cost of products, and (3) its usefulness in providing data to judge supervisor's performance.

Huron Automotive was a relatively small supplier of selected vehicle parts to the large automobile and truck companies. Huron competed on a price basis with larger suppliers that were long-established in the market. Huron had competed successfully in the past by focusing on parts that, relative to the industry, were of small volume and hence did not permit Huron's competitors to take advantage of economics of scale. For example, Huron produced certain parts required only by "off-the-road" equipment such as front loaders.

Bond began the cost accounting study in Huron's carburetor and fuel injector (CFI) division, which accounted for about 40 percent of Huron's sales. This division contained five production departments: casting and stamping, grinding, machining, custom work, and assembly.The casting and stamping department produced cases, valves, and certain other parts. The grinding department prepared these parts for further machining and precision ground those parts requiring close tolerances. The machining department performed all necessary machining operations on standard products, whereas the custom work department performed part of the machining and certain other operations on custom products, which usually were replacement carburetors for antique cars or other highly specialized applications. The assembly department assembled and tested all products, both standard and custom.

Thus, custom products passed through all five departments and standard products passed through departments except custom work. Spare parts produced for inventory went through only the first three departments. Both standard and custom products were produced to order; there were no inventories of completed carburetors or fuel injectors.

Bond's investigation showed that with the exception of materials costs, all product costing was done based on a single, plantwide, direct labor hourly rate. This rate included both direct labor and factory overhead costs. Each batch of products was assigned its labor and overhead cost by having workers charge their time to the job number assigned to the batch, and then multiplying the total hours charged to the job number by the hourly rate. Exhibit 1 shows how the July hourly rate of $55.96 was calculated.

It seemed to Bond that because the average labor skill level varied from department to department, each department should have its own hourly costing rate. With this approach, time would be charged to each batch by department; then the hours charged by a department would be multiplied by that department's costing rate to arrive at a departmental labor and over-head cost for the batch; and finally these departmental labor and overhead costs would be added (along with materials cost) to obtain the cost of a batch.

Bond decided to see what impact this approach would have on product costs. The division's accountant pointed out to Bond that labor hours and payroll costs were already traceable to departments. Also, some overhead items, such as departmental supervisors' salaries and equipment depreciation, could be charged directly to the relevant department.However, many other overhead items, including heat, electricity, property taxes, and insurance, would need to be allocated to each department if the new approach were implemented.Accordingly, Bond determined a reasonable allocation basis for each of these joint costs (e.g., cubic feet of space occupied as the basis of allocating heating costs), and then used these bases to recast July's costs on a departmental basis. Bond then calculated hourly rates for each department, as shown in Exhibit 2.

In order to have some concrete number to show the president, Bond decided to apply the proposed approach to three CFI division activities: production of model CS-29 fuel injectors (CFI's best-selling product), production of spare parts for inventory, and work done by the division for other Huron divisions. Exhibit 3 summarizes the hourly requirements of these activities by department. Bond then costed these three activities using both the July plantwide rate and the proforma July departmental rates.

Upon seeing Bond's numbers, the president noted that there was a large difference in the indicated cost of CS-29 injectors as calculated under the present and proposed methods. The present method was therefore probably leading to incorrect inferences about the profitability of each product, the president surmised.The impact of the proposed method on spare parts inventory valuation was similarly noted. the president therefore was leaning toward adopting the new method, but told Bond that the departmental supervisors should be consulted before any change was made.

Bond's explanation of the proposal to the supervisor's prompted strong opposition from some of them. The supervisors of the outside departments for which the CFI division did work each month felt it would be unfair to increase their costs by increasing charges from the CFI division. One of them stated:

The CFI division handles our department's overflow machining work when we're at capacity. I can't control costs in the CFI division, but if they increase their charges, I'll never be able to meet my department's cost budget. They're already charging us more than we can do the work for in our own department, if we had enough capacity, and you're proposing to charge us still more!

Also opposed was the production manager of the CFI division:

I've got enough to do getting good quality output to our customers on time, without getting involved in more paperwork! What's more, my department supervisors haven't got time to become bookkeepers, either.We're already charging all of the division's production costs to products and work for other departments; why do we need this extra complication?

The company's sales manager also did not favor the proposal, telling Bond:

We already have trouble being competitive with the big companies in our industry. If we start playing games with our costing system, then we'll have to start changing our prices. You're new here, so perhaps you don't realize that we have to carry some low-profit-or even loss-items in order to sell the more profitable ones. As far as I'm concerned, if a product line is showing an adequate profit, I'm not hung up about cost variations among items withinthe line.

The strongest criticism of Bond's proposed new system came from Huron's director of financial planning:

Departmentalizing the costing rate may be a good idea, but I'm not sure you're attacking the main problem. How can we do anything with these cost estimates when you change the rates every month? When volume is rising, all of our product make money, no matter which system you use.But when overall volume is falling, some products begin to show losses even though their own sales continue to hold up. I don't know whether they're really losing money or whether they just can't carry a full share of the costs of idle capacity. I don't see how your system is going to help me answer that question.

Faced with all these arguments, Bond decided to make some more calculations before going back to the president. First, bond asked the industrial engineering department to estimate the monthly volume at which each of the five production departments typically operated over the course of a year (normal volume). Then Bond assembled a new set of overhead cost estimates and recalculated the proposed overhead rates, as shown in Exhibit 4. Finally, Bond recalculated the labor and overhead costs of a 100-unit lot of model CS-29 injectors and of a typical month's spare partsproduction and work for other divisions, based on the "normalized" departmental rates.

When Bond circulated these new calculations, the production manager of the CFI division was even more perturbed than before:

That's even worse! Now you're piling paperwork on paperwork! And on top of everything, we won't be able to charge out all of our costs. What am I supposed to do with the costs in machining and assembly if I can't charge them to products or spare parts or the work we do for other divisions?

When Bond reported the various managers' opposition to the president, the president replied:

You're not telling me anything that I haven't already heard from unsolicited phone calls from several supervisors the last few days. I don't want to cram anything down their throats - but I'm still not satisfied our current system is adequate. Sandy, what do you think we should do?

Questions

1. Using the data in the exhibits, determine the cost of a 100-unit batch of model CS-29, a month's spare parts, and a month's work done for other divisions under the present method, Bond's first proposal, and Bond's revised proposal.

2. Are the cost differences among the methods significant? What causes these differences?

3. Suppose that Huron purchased a new machine costing $400,000 for the custom work department. Its expected useful life is five years. This machine would reduce machining time and result in higher quality custom carburetors.As a result, the department's direct labor-hours would be reduced by 30 percent, and this extra labor would be transferred to departments outside the carburetor division. About 10 percent of the custom work department's overhead is variable with respect to direct labor-hours. Using July's data:

a. Calculate the plantwide hourly rate (present method) if the new machine were acquired. Then calculate indicated costs for the custom work department in July, using both this new plantwide rate and the former $55.96 rate.

b. Calculate the hourly rate for the custom work department only (first proposed method), assuming the machine was acquired and the first proposed costing procedure was adopted. Then calculate indicated costs for the custom work department in July, using both this new rate and the former $55.96 rate.

c. Under the present costing procedures, what is the impact on the indicated costs of custom products if the new machine is acquired? What is this impact if the first proposed costing procedure is used?What inference do you then draw concerning the usefulness of the present and proposed methods?

4. Assume that producing a batch of 100 model CS-29 injectors requires 126 hours, distributed by department as shown in Exhibit 3, and $4,200 worth of materials.Huron sells these carburetors $113 each.Should the CS-29 price be increased? Should the CS-29 be dropped from the product line? (Answer using both the present and the first proposed costing methods.)

5. What benefits, if any, do you see to Huron if either proposed costing method is adopted? Consider this question from the standpoint of (a) product pricing, (b) cost control, (c) inventory valuation, (d) charges to outside departments, (e) judging departmental performance, and (f) diagnostic uses of cost data. What do you conclude Huron should do regarding its costing procedures?

EXHIBIT 1 Calculation of Plantwide Labor and Overhead Hourly Rate Month ofJuly :1 Dollars Hours Labor: Casting/stamping $ 54,604 2,528 Grinding 38,520 2,140 Machining 191,876 7,675 Custom work 81,664 3,712 Assembly 291,784 15,357 Total Labor 658,448 31,412 Overhead 1,099,323 Total labor and overhead 5 1,757,771 Hourly rate = 51'757'771 = 5 55.96 per hour 31,412 ($20.96 labor + $ 35.00 overhead) EXHIBIT 2 | Proposed Departmental Labor and Overhead Hourly Rates Labor Rate Overhead Total Cost Department per Hour per Hour per Hour Casting/stamping $21.60 $31.37 $52.97 Grinding $18.00 $30.14 $48.14 Machining $25.00 $62.52 $87.52 Custom Work $22.00 $40.48 $62.48 Assembly $19.00 $21.19 $40.19EXHIBIT 3 _ Direct Labor-Hour Distribution for Three Carburetor Division Activities CS-29 Injectors Spare Parts for Work for other (per batch of Inventory Divisions Department 100) (per typical month) (per typical month) pasting/stamping 21 hrs. 304 hrs. 674 hrs. _Grinding 12 270 540 7 Machining 58 1,115 2,158 Custom Work _Assembly 35 - - iTotaI 126 hrs. 1,689 hrs. 3,372 hrs. :EXHIBIT 4 Departmental Overhead Rates Based on Normal Volume Normal Normal Overhead Volume Overhead per Direct (DLH) Cost* Labor-Hour _Casting/stamping 2,500 S 78,800 S 31.52 _Grinding 2,400 69,000 28.75 _ Machining 8,000 492,000 61.50 _Custom work 3,600 147,820 41.06 Assembly 17,500 352,450 20.14 _ Total 34,000 $ 1,140,070 $ 33.53 * Estimated overhead cost if each department operates at its normal volume