Coficnozv. WMMCWM mm lm The Beta Company Peter clerks, University |t'tollagtar Dublin Key topics: Relevant costs including overhead prediction Dave Barry, an electrical engineer, is the manager of the Beta company which manufactures special elecbonic components to order. He took up his present position some years ago alter obtaining an MBA degree. The company has been relatively protable in recent years although sales1 in volume terms, have shown little increase. He has recently been approached, by a potential new customer, to produce a special component. Barry is unsure 'rfthe proposal would enable him to make any money on the project. One of his problems is that his rm's weekly production overhead has uctuated widely in recent weeks. These fluctuations have made it difcult to estimate the level of production overhead that will be incurred for any single week. The proposal which Elany is considering is for the production of 5,l]D electrical components which can be produced using the nn's existing highly skilled labour force and machine-time capabilities. Each electrical component would require an input of 1 direct labour hour and 1t] minutes of machine time. Since the company was already operating a near Ilpacity Bany realised that the necessary work would have to be performed on an overtime basis. Workers in such circumstances were paid at time and a hall. Elany estimates that. on an overtime basis, the entire job would take about 12 weeks to complete and should be nished by midDecember. The production manager and shop steward were enthusiastic about the proposal since it would boost employees earnings prior to the Christmas holidays. Currently production workers were paid about 9 euros per hour which provided them with gross earnings of about EDD euros per week. However taxes and social insurance deductions resulted in take home pay of about 160 euros. For his part Elarry saw the distinct possibility of purchasing additional plant and equipment next year if this special order situation translated itself into a regular and frequent commitment to purchase by the customer. After all the cunent price offer of 50 euros per unit represented an initial contract of 250,000 euros. That kind of money was not to be frowned upon1 rather it was to be encouraged. From a costing point of view1 the estimating department provided an analysis of raw materials required. Each unit produced requires three different types of raw materials designated A, El and C. IQuantities required and additional information is as follows: Raw Material Kilos required Current stock Historic Cost Replacement Net Realisable per unit level {kilos} Cost Value A 1 EDEI 2 euros 4 euros 1 euros El 1i2 9,000 3 euors 5 euros 2 euros B 2 NIL NIL 6 euros NIL Material A is used regularly by the company in the production of other electrical components. However, material E is in excess of the company's requirements and unless used in the production of these units would be sold. The required amount of material (3, since none are in stock, would be specially purchased. However, the estimating department were reluctant to provide even 'guesstimates' of production overheads which could be attributed to this iob. The sales manager of the rm, Jack Russell1 argued that they were irrelevant for pricing purposes because1 by de nition1 they couldn't be attributed to an individual product. He argued that if only direct labour and materials were included in the costing it would enable a very competitive contract price to be quoted. A keen price would virtually guarantee the contract this time prots could then be generated on subsequent business. if overheads were included in the quotation the company could end up pricing itself out of the market. not just in the short term but also in the long term! Dave Barry was not convinced by the argument of the 'irrelevancy" of production overheads in such circumstances. Rather he believed that an accurate classication of overheads was essential in both planning and oontroling the operations of the rm. The rst thing Barry had to do was to relate production overheads to some type of activity within the rm. However, he is unsure whether to use direct labour hours or machine hours as the best measure of activity. Ultimately a choice would have to be n'ade between these two bases in order to determine a cost behaviour pattern. A trade association publication to which he subscribes indicates that, for companies manufacturing electrical components, overheads tend to vary with direct labour hours. On the other hand he realised that in his company a large proportion of production overheads represented depreciation of factory equipment and energy costs which were also lated on a usage i.e. a machine usage basis. The rst place to startI David reasoned1 would be an analysis of historical data. The following data on total production overheads, direct labour hours and machine hours for the most recent 12 week period are collected and Barry noted that they showed sufcient variability in activity levels and to provide a useful start for prediction purposes: [Exhibit 1} M D'rect Labour Hours lvlachine Hours Total Production Overheads jeurosi 1 1,259 111 29,999 2 1,49? 132 34,599 3 1 ,194 121 29,999 4 1,499 14?I 34,399 5 1,355 154 32,499 9 1,399 125 31,299 i" 1,222 122 29,?99 9 1,259 131 29,499 9 1,199 129 2?,999 1 9 1,435 144 33,499 11 1,121 112 2?,T99 1 2 1 ,433 1 45 34,1 99 Bany was condent that the above observations were representative of the current production process and that the relationships would be valid for the forthcoming year. There had not been any signicant technologiI-I change in the production process in recent times and there was noexperience or learning curve phenomenon in the production process. Certainly no signicant cost variances relating to labour efciency had appeared on the monthly production report. General or specic price changes in relation to overheads during the past few months had been insignicant and no price changes were anticipated in the immediate future. Having quickly revised a basic management accounting text dealing with cost prediction, Barty understood the various methods proposed for determining a cost behaviour pattern. These methods included the scatter diagram method, the high - low method and simple linear regression. He could not make up his mind on which was the best method to use since each had its own advantages and disadvantages. Perhaps he should use all three1 Bany thought to himself? Then he realised that each would probably provide a different gure and he would be virtually back where he started! Requirement 1. Determine the historical cost behaviour pattern of the production overhead costs using the scatter diagram method, the high lcrw method and simple linear regression. Justify your choice of independent i.e. explanatory variable. 2. 0f the three proposed methods, which one should Elany use to determine the historical cost behaviour pattern of production overhead. Explain your choice indicating the reasons why the other methods are less desirable. Include reference to various criteria which can be used in choosing between alternative cost prediction models. 3. Would you recommend that Barry accept the proposal? How did you arrive at your conclusion? Would your recommendation change if the company was operating at considerably below maximum capacity? 4. Assume the following results were obtained from two simple linear regressions. Simple Regression Analysis Results (y = a + b x) Regression No. 1 Regression No. 2 Dependent variable (y) Production overhead Production overhead costs costs Independent variable (x) Direct labour hours Machine hours Computed values: y - intercept Euros 5,519 Euros 11,682 Coefficient of independent variable 19.49 147.96 Coefficient of correlation (R) 0.99 0.77 Standard error of estimate 448 1800 Standard error of regression coefficient for the 0.98 38.00 independent variable Coefficient of determination (R2) 0.97 0.59 No. of observations 12 12 t-statistic required for a 95% confidence interval: 12 degrees of freedom 2.179 2.179 10 degrees of freedom 2.228 2.228 i. Apply two tests to assess the linearity of both regressions. Which regression would you recommend to use? Why?ii. Calculate a 95% confidence interval for the variable production overhead per unit based on your preferred regression equation. To what extent could this confidence interval influence your recommendation of accepting or rejecting the order? Explain