Seligram Incorporation, Electric Testing Operations (ETO) previously measured two components of cost: direct labor and manufacturing overhead. The existing cost system is very simple. Burden was grouped into a single cost pool that was combined with each of the testing rooms as well as the engineering burden costs related to software and tooling development and the administrating costs of the department. The total burden costs was then divided by the sum of testing and engineering labor dollars to obtain the burden rate per direct labor dollar. Burden was then calculated by multiplying 145% of the burden rate by the actual direct labor hours related with the lots. ETO added the computed burden to the actual direct labor costs to determine the lot’s total cost.
According to the calculations provided by ETO, the burden rate is equal to: (total burden $/ direct labor $)*100 = Effective Rate Calculation of Burden Rate | | | |
Total burden costs| $4.713.982,0| | |
Total direct labor dollars| $3.260.015,0| | |
=| 144,6%| | |
Effective rate =| 145%| | |
The current cost system was satisfactory in the past because ETO used much more direct labor hours and therefore the burden rate was more valid than it is currently, although it was still not the best choice. ETO’s current cost system assumes that all products absorb direct labor and overhead in comparable ratios. In reality, some products require costly automated equipment while others are produced on labor-intensive equipment. Three primary reasons will show why the current cost system is no longer adequate for Electronic Testing Operations and that it needs to implement a new cost system to account for the changes that ETO is experiencing. 1. Because of the implantation of vendor certification, Seligram’s suppliers are doing the main testing on products and they do not require more testing once ETO receives them. This has decreased the amount of tests being performed and has resulted in less direct labor hours being used. Therefore, the application of direct labor as an input in computing burden is no longer useful. 2. Although ETO was cheaper than outside resources on complex parts, it faces outsourcing on products that only require basic testing. Due to lower costs this has caused in increase in indirect costs and a decrease in direct costs. 3. ETO discovered a need for more high-technology tests because of new components that are much more complex. The equipment needed to test these new components are mostly automated and use much less direct labor. The proportion of costs due to overhead is increasing while the proportion of costs due to direct labor is decreasing resulting in a continuous increase in the burden rate. This is evidence that the current costing system is no longer acceptable.
Calculation of the reported costs of the five components described in the case: Product | ICA | ICB | Capacitor | Amplifier | Diode | Total | Direct Labor $ (from exhibit 6)| 917| 2051| 1094| 525| 519| 5106| Burden (145%) | $1,329.65 | $2,973.95 | $1,586.30 | $761.25 | $752.55 | $7,403.70 | Total Cost | $2,246.65 | $5,024.95 | $2,680.30 | $1,286.25 | $1,271.55 | $12,509.70 | a. Existing cost system
*Burden = direct labor costs * 145%
b. Cost system proposed by accounting manager
The accounting manager for ETO suggested a new cost system in an attempt to alleviate the problem at hand. His proposition included a plan that would trace burden directly to two cost pools. The first cost pool would include burden connected to the technical and administrative functions and would be charged on a rate per direct labor hour. The second cost pool would include all other burden costs and would be allocated based on machine hours. Product | ICA | ICB | Capacitor | Amplifier | Diode | Total | Direct Labor $ (from...