Case: Shun Electronics Company CASE OBJECTIVES: This is an introductory-level case on overhead cost allocations and cost systems design. This case helps you understand the design of cost systems, in general, and the creation of cost allocation overhead rates, in particular. Objectives are: 1. To provide a basis for the articulation and specification of an overhead cost system's design. In this regard, overhead cost systems rest on two design choices-(a) the designation of cost pools for aggregating overhead costs and (b) the choice of an allocation base for transporting the overhead costs out of each pool to the end product. 2. To provide opportunities for students to implement a cost system's design. 3. To highlight the fact that the product costs changed without any change in operations or supplier costs. Thus, the product costs changed solely due to the changes in the choice of overhead cost pools allocation base. Requirements: Here are two requirements to start with. However, the case discussion can go beyond these two requirements and you should be prepared for: 1. Where did the figures in case Exhibits 1, 2, and 3 come from and how were they computed? 2. To date, the shelf shower radio was thought to cost M$61.00. Manjit Singh says it's more accurately determined cost is M$67.61. Why the difference? SHUN ELECTRONICS COMPANY "Manjit," said Chan Choong Tho, Controller of the Shun Electronics Company's KL Radio Division, "I understand how you arrived at these new cost figures, but I'm not sure how we should present them to our colleagues. May Hwang is not going to be happy when she sees higher costs on four of our six radios, and she may not understand the cost principles involved. I don't know about Azraf-he's apt to say the costs are just estimates and we should stay with the present system." Chan Choong Tho was speaking to Manjit Singh, his new assistant controller. May Hwang was the division's sales manager and Azraf Tahir was the Division Manager. Six weeks earlier Chan had given Manjit the task of examining the division's cost accounting system to see if the product costs it produced were reasonably accurate. Manjit had reconstituted the basic cost data in a way that he thought might be more accurate and was reviewing the results with his boss. The Shun Electronics Company was a medium-sized, family-owned firm in the Malaysian electronics industry. The company had two operating divisions. The KB Monitor Division manufactured computer monitors that were primarily sold to off-brand computer companies. The KL Radio Division made two basic radios-a shelf model and a portable model. Each of the two models were available in three versions: one version was for use in a bathroom shower (a popular option especially in the American market); another had a 1950s-style metal cabinet; and the third version had a wooden cabinet. All six radios were distributed primarily through high-end catalog retailers. THE PRODUCTION PROCESS Radio production was carried out in three departments, two of which were organized into three sections. The Assembly Department assembled the basic chassis using parts purchased from outside the company. In this department, Section 1 was where the various electronic components were staged for production and assembled into functioning, modular units. In Section 2, the modular units were tested and any electronic problems were rectified. In Section 3, the modular units were mounted on a basic chassis and tested again before being passed on to the Fabrication Department. In the Fabrication Department, the radios took one of three routes. Those intended for in-the-shower use went to Section 1 where they were sprayed and treated to protect them against moisture. Before leaving Section 1, the sprayed modular units were encased in a colorful plastic cabinet the division bought from a vendor. Those radios destined to receive a 1950s-type metal cabinet went to Section 2. In that section the cabinets were cut from sheet metal, punched, bent to shape, and painted. The metal cabinet was then mounted on the chassis. In Section 3, Shun's distinctive wooden cabinets were crafted, finished and fitted to the chassis. In the Finished Goods Department, all radios were given a final testing and adjustment in one area and packed for storage or shipment in another area. The Assembly and Fabrication Departments were run by foremen. Reporting to them were section leaders for each of the sections. The Finished Goods Department had no foreman or section leaders and only part of its efforts were devoted to the KL Radio Division. The test area was under the supervision of a quality control engineer who was part of the company's engineering department. The packing area was run by a supervisor. THE PRODUCT COSTING SYSTEM The KL Radio Division used a standard cost system in which a standard product cost was computed for each of the six radios. Exhibit 1 shows a condensed version of the six standard cost sheets based on the most recent year's budget expectations. Budgeted direct material and direct labor costs per radio were based on standard quantities and hours and expected material costs and labor rates. Actual costs were collected periodically by the departments for comparison with the standard cost of work completed in the department. A standard overhead cost allocation rate was applied to direct labor plus direct materials in the Assembly Department, and on direct labor alone in the other two departments. The percentage used for the overhead rate was derived from the expected relationship between budgeted direct labor, direct material, and overhead costs, all at an assumed normal production volume. For example, in the Assembly Department, budgeted overhead equaled 50% of budgeted direct labor and direct material costs combined. The standard overhead charge for each radio was therefore 50% of the standard direct labor and direct material costs for that radio. Overhead cost allocation rates usually had to be revised annually, but the standards for direct labor and direct material costs were changed only when prices, production methods, or product designs changed significantly. The standard costs were used in the division for a number of purposes. They had some bearing on pricing, particularly in bidding on larger orders. The standard cost figures were also used in a variety of longer-run functions such as in determining changes in the product offerings, make-or-buy decisions, financial planning, and corporate management's evaluation of divisional performance. The cost system produced monthly labor, material, and overhead variances which were checked by Azraf Tahir to see if any were significantly out of line. Though he kept in close touch with what was going on in the plant, a variance would occasionally show a deviation over time that was not easy to spot in daily observations. EXAMINATION BY MANJIT SINGH Early in his investigation of the cost system, Manjit Singh began to consider the existing definition of cost centers. He wondered if the total product costs would be different if the aggregation of costs was in more detail than just at the departmental level. Specifically, he wondered if better information could be obtained by using eight cost centers: the six sections in the Assembly and Fabrication Departments and the two areas in the Finished Goods Department. Direct labor and direct material costs were easy to assign to the smaller cost centers since that was the way the standard cost sheets were already computed. In order to identify the overhead costs incurred within the sections, however, he asked the department foremen for estimates of the resource costs incurred in each of their various sections for such items as indirect labor, equipment repair, and supplies. In addition, an examination of recent invoices helped him verify some of the details the foremen submitted. Exhibit 2 shows the existing departmental overhead budget and the results of Manjit Singh's further distribution of those amounts to the six sections and two areas. With this more detailed identification of costs, and based on dropping direct material costs as part of the allocation base used in the Assembly Department, Manjit recalculated the standard cost sheets to see if product costs changed. Exhibit 3 shows the results of these calculations. Of the six types of radios sold, four showed a higher factory cost and two a lower cost. Since he was not sure what his next step should be, he consulted his boss Chan Choong Tho who, after studying the figures, made the response that appears at the beginning of the case. Exhibit 1 SHUN ELECTRONICS COMPANY KL Radio Division Standard Cost Sheets (cost per radio in ringgit (MS)) Portable Model Assembly Department Units Budgeted Direct material Direct labor Section 1 Shelf Model 4,000 3,000 M$ 8.00 M$12.00 1.00 4.00 Direct labor Section 2 2.00 3.00 Direct labor Section 3 1.00 5.00 Total direct labor and direct materials M$12.00 M$24.00 Overhead at 50% direct labor and direct material Total Assembly Department 6.00 12.00 M$18.00 M$36.00 Fabrication Department PS* PM PW SS SM SW Units Budgeted 1,000 2,000 1,000 500 1,500 1,000 Direct material M$5.00 M$2.00 M$4.00 M$6.00 M$3.00 MS8.00 Direct labor 3.00 2.50 2.00 5.00 5.00 2.00 Overhead at 200% of direct labor 6.00 Total Fabrication Department M$14.00 5.00 M$ 9.50 4.00 M$10.00 10.00 M$21.00 M$18.00 10.00 4.00 M$14.00 Finished Goods Department Direct material (packing) Area 1: test direct labor Area 2: packing direct labor Total direct labor Overhead 100% of direct labor Total Finished Goods Department M$ 1.00 .50 .25 M$ .75 _.75 M$ 2.50 M$ 1.50 1.00 .25 M$ 1.25 1.25 M$ 4.00 PS* PM PW SS SM SW Total Direct Factory Cost M$34.50 M$30.00 M$30.50 M$61.00 M$58.00 M$54.00 *PS-portable/shower PM-portable/metal PW-portable/wood SS-shelf/shower SM-shelf/metal SW=shelf/wood Exhibit 2 SHUN ELECTRONICS COMPANY KL Radio Division Overhead Cost Distributions Manjit Singh's Distribution Assembly Department Present Budget Section 1 Section 2 Section 3 Foreman Section leaders Indirect labor M$ 6,000 M$ 2,000 M$ 2,000 M$ 2,000 15,000 5,000 5,000 5,000 12,000 3,500 3,000 5,500 Equipment repair 2,250 500 750 1,000 Supplies 1,250 500 250 500 Occupancy and electricity 5,000 2,000 1,000 2,000 Depreciation on equipment 5,500 500 2,000 3,000 Storage and handling of material 10,000 10,000 -- Miscellaneous 3,000 1.000 1,000 1,000 M$60,000 M$25,000 M$15,000 M$20,000 Fabrication Department Section 1 Section 2 Section 3 Foreman M$ 6,000 M$ 2,000 M$ 2,000 M$ 2,000 Section leaders 15,000 5,000 5,000 5,000 Indirect labor 4,000 1,500 1,500 1,000 Equipment repair 3,750 1,000 2,000 750 Supplies 2,500 2,000 250 250 Occupancy and electricity 3,000 1,000 1,250 750 Depreciation on equipment 4,750 1,500 2,000 1,250 Storage and handling of material 2,000 1,000 500 500 Miscellaneous 3,000 1,000 1,000 1,000 M$44,000 M$16,000 M$15,500 M$12,500 Finished Goods Department Area 1 Area 2 Equipment repair M$ 500 Supplies 1,750 Occupancy and electricity Depreciation on equipment Miscellaneous Total 1,750 250 750 1,000 111 2,250 2,000 250 500 MS 6,750* MS 3,750 250 250 M$ 3,000 *This was the KL Radio Division's share of the Finished Goods Department's total overhead budget. MS 500 MS 1,500 Units Budgeted Exhibit 3 SHUN ELECTRONICS COMPANY KL Radio Division Standard Costs Using Redistributed Overhead Costs Assembly Department Portable Model 4,000 Shelf Model 3,000 Direct material Direct labor Section 1 Overhead Section 1: 156% direct labor Direct labor Section 2 Overhead Section 2: 88% direct labor Direct labor Section 3 Overhead Section 3: M$ 8.00 M$12.00 1.00 4.00 1.56 6.24 2.00 3.00 1.76 2.64 1.00 5.00 105% direct labor 1.05 5.25 Total Assembly Department M$16.37 M$38.13 Fabrication Department PS* PM PW SS SM SW Units Budgeted 1,000 2,000 1,000 500 1,500 Direct material M$5.00 M$2.00 M$4.00 M$6.00 M$3.00 1,000 M$8.00 Direct labor 3.00 2.50 2.00 5.00 5.00 2.00 Overhead Section 1: 291% direct labor 8.73 14.55 Section 2: 124% direct labor 3.10 6.20 Section 3: 313% direct labor Total Fabrication Department M$16.73 M$ 7.60 6.25 M$12.25 6.25 M$25.55 M$14.20 M$16.25 Finished Goods Department Direct material Direct labor Area 1 M$ 1.00 M$ 1.50 .50 1.00 Overhead Area 1: 75% direct labor Direct labor Area 2 Overhead Area 2: 171% direct labor Total Finished Goods Department Total Direct Factory Cost *PS-portable/shower .37 .75 .25 .25 .43 M$ 2.55 .43 M$ 3.93 PS* PM PW SS SM SW M$35.65 M$26.52 M$31.17 M$67.61 M$56.26 M$58.31 PM-portable/metal PW-portable/wood SS=shelf/shower SM-shelf/metal SW-shelf/wood Exhibit 3 (continued) SHUN ELECTRONICS COMPANY Explanatory Notes The overhead totals for each section and area shown in Exhibit 2 were allocated to the radios going through the sections and areas on the basis of direct labor dollars. For example, the MS25,000 overhead allocated to Section 1 in the Assembly Department was 156% of the M$16,000 budgeted direct labor costs for the department (4,000 units times M$1.00 plus 3,000 units times M$4.00 equals M$16,000). The overhead to be charged to each unit was therefore 156% of the standard direct labor cost. Other sections and departments were handled in like manner. Direct labor alone was used by Manjit as a base for allocation in the Assembly Department since he thought inclusion of direct material costs in the overhead allocation process introduced a slight distortion. If direct labor alone had been used in the division's present system, the cost of the portable radios in the Assembly Department would come out M$1.38 lower, and the shelf radios M$1.85 higher. This would have resulted in total direct factory costs as follows: PS M$33.12 PM M$28.62 PW M$29.12 SS M$62.85 SM M$59.85 SW M$55.85 D Question 1 3 pts 1. How is total direct factory cost of product SS in exhibit 1 calculated? Show your calculations. Edit View Insert Format Tools Table 12pt P Paragraph BIUA 22: k D Question 2 3 pts 2. How are the overhead rates for Assembly department in exhibit 3 calculated? Show your calculations. Edit View Insert Format Tools Table 12pt Paragraph BIUAT D Question 3 endance ry 3. How are the overhead rates for fabrication department and Finished goods department in exhibit 3 calculated? Show your calculations. Edit View Insert Format Tools Table 12pt Paragraph BIUATv ings 4 pts