Was the existing system adequate in the past? Why or why not? Why is it no longer adequate?
The existing system was adequate in the past due to heavy reliance on direct labor hours. The ETO served as a central cost center, and transferred the costs to other divisions at direct costs plus allocated burden. Being in the late 1970s and early 1980s, technology testing of components required fewer cycles, and less complicated structures. Hence, such testing on products could be carried out by direct labor. The products included Integrated circuits, capacitor resistors, transistors and similar components. The testing center would handle about 500 components per month, and close to 3,000 per year. In addition, the main components tested were defense related, and hence they had a single client with a large share of the business. The previous accounting system focused on two variables: direct labor and burden. For the latter, costs were grouped into a single cost pool that included burden costs associated with of the testing rooms i.e. mechanical and electrical; as well as engineering burden costs related to software and tooling development alongside administrative costs of the division. As the case mentions, total burden costs are then divided by the sum of testing and engineer labor dollars to arrive at burden rate per direct labor hour. Furthermore, the division would cost each lot of components, as burden was calculated for each lot from the product of actual direct labor dollars and 145% of the burden rate.
In this case, the system is adequate, however it is temporary. Due to the method of calculating the burden rate we saw minor flaws. The formula is hinged on the number of direct labor dollars of testing and engineering. As technology progressed, it is obvious that the number of direct labor will be forced out with new machines. Much like the way auto assembly lines workers were phased out, the same would apply to ETO’s testing and engineering segment. Hence, through the arithmetical relationship between the burden rate and direct labor hours, as the denominator decreases, the associated burden rate per direct labor dollar will increase. The adequacy of the system began to deteriorate as direct labor hours per lot tested were declining.
The obsolete nature of the system is further compounded by additional dependence on vendor certification. In other words Seligram’s ETO were slowly drifting away from their objective. True they carried out statistical sampling to test the claim of the vendor, but it was not as vigorous as previous testing tasks. Time is of the essence for ETO as they have adopted Just in Time inventory practices, and this approach is complemented by a larger dependence on vendor certifications. As mentioned in the case: “Early indications were JIT deliveries would account for 30% of Seligram’s shipments within the next five years.” The impact of this, with the existing cost system, would decrease the direct labor input as it relates to statistical sampling.
In combination, the fewer direct labor hours available alongside decreased lot sizes have left costs increasing and customers unsatisfied. Low-tech external vendors were able to provide cheaper services especially on large lots. Such lots would still be carried out locally, however, the technology available in ETO’s testing centers were far over qualified for most lots received. Finally, the advancement of technology in components required less direct labor hours and more automated processes that can carry out 10,000 condition verification. Hence, the needed dependence on equipment caused a decrease in the labor requirements; hence having a smaller base to absorb the depreciation costs of new equipment only amplified the problem further. Calculate the reported costs of the five components for each of the following (explain each step)? Based on the case, ETO’s measured costs based on two components of direct labor dollar and burden. Burden...
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