Product Costing Macquarie Electronics

This case highlights the deficiencies of traditional methods of product costing which employ single volume drivers of overhead cost allocation. It provides the opportunity to apply other costing methods in order to demonstrate differences in cost and price outcomes.

Background

Macquarie Electronics has been at the forefront of engine products in Australia since the information technology explosion of the 1970s. From modest premises in the Melbourne suburbs, founder and now Chief Executive, Barry Martin has driven the company to a respected position among leaders in the market, with a reputation for meeting consumer needs. Barrys genius has always been in providing products in anticipation of the market and in bringing those products in ahead of competitors. Costing and pricing have always been much lower on his priorities because new, well- marketed products have always been successful.

The management at Macquarie is now worried. The companys bottom line displays a disconcerting downturn for the second successive year the first time this has happened in a 20 year history. This relatively poor performance is largely attributable to a lack of sales revenue stemming from an inexplicable failure to win orders in competitive tenders. The Chief Executive feels that the pricing policies must be wrong and has called for a full investigation of current procedures in order to identify deficiencies.

Problem: Macquarie Electronics manufactures specialised engines to customers' specifications and operates a job costing system. Manufacturing overhead cost is applied to jobs on the basis of direct labour cost. The following estimates were made at the beginning of the year:

Jobs require varying amounts of work in the three departments. The Hastings job (private sector business), for example, would have required manufacturing costs in the three departments as follows:

The company uses a plant-wide overhead rate to apply manufacturing overhead cost to jobs.

Tonya Donovan, the management accountant of Macquarie Electronics, was meeting with Adam Williams, the manager of the production division, who is also a member of CPA. The topic of discussion was the assignment of overhead costs to jobs and their impact on the divisions pricing decisions. Their conversations is reproduced below.

Tonya: Adam, as you know, about 25% of our business is based on government contracts, with the other 75% based on jobs from private sources won through bidding. During the last several years, our private business has declined. We have been losing more bids than usual. After some careful investigation, I have concluded that we are overpricing some jobs because of improper assignment of overhead costs.

Adam: I think I understand. We have three production departments. The labour-intensive department Assembly generates much less overhead than the machine-intensive departments Cutting and Machining. However, we have been using plant-wide rate based on direct labour costs to assign overhead costs to all jobs. As a result, labour-intensive jobs receive a greater share of the machine- intensive departments overhead than they deserve. This problem actually can be greatly alleviated by switching to departmental overhead rates. The change would lower our bidding price for those jobs which were overestimated due to the application of a plant-wide rate. By increasing the accuracy of our product costing, we can make better pricing decisions and win back much of our private-sector business.

Tonya: Sounds good. When can you implement the change in overhead rates?

Adam: It wont take long. I can have the new system working within four to six weeks, certainly by the start of the new financial year.

Tonya: Hold it. I just thought of a possible complication. As I recall, most of our government contract work is mainly done in the labour-intensive department. This new overhead assignment scheme will push down the cost on the government jobs, and we will lose revenues. They pay us full cost plus our standard mark-up. This business is not threatened by our current costing procedures, but we cant switch our rates for only the private business. Government auditors would question the lack of consistency in our costing procedures.

Adam: I thought of this issue too. According to my estimates, we will gain more revenues from the private sector than we will lose from our government contracts. Besides, the costs of our government jobs are distorted. In effect, we are overcharging the government. However, they dont know that, and never would, unless we switch our overhead assignment procedures. I think I have the solution. Officially, lets keep our plant-wide overhead rate. All of the official records will reflect this overhead costing approach for both our private and government business. Unofficially, I want you to develop a separate set of books that can be used to generate the information we need to prepare competitive bids for our private-sector business.

Question:

Analyse the problems with the current costing systems and how it can be improved. (Hint: Using the Hastings job as an example explain what has been happening as a result of using the businesss current costing system. Assume that it is customary in the industry to bid jobs at 150% of total manufacturing cost, compare the current Hastings job price with the new price if separate predetermined overhead rate is applied within each department).

Department Cutting Machining Assembly Total Plant S300,000 $200,000 $400,000 $900,000 Direct labour Manufacturing overhead $540,000S800,000S100,000 $1,440,000 - Department Cutting Machining Assembly Total Plant S300,000 $200,000 $400,000 $900,000 Direct labour Manufacturing overhead $540,000S800,000S100,000 $1,440,000