ETO Case Study Analysis 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| | | =| 4. 713982,0/3. 60. 015,0*100| =| 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. 0 | 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 Exhibit 6)| $917| $2,051| $1,094| $525| $519| $5,106| administrative and technical functions cost (21%)| $192. 57| $430. 71| $229. 74| $110. 25| $108. 99| $1,072. 26| Machine hours needed in hours (info found in exhibit 6)| 18. 5| 40| 7. 5| 5| 12| 83| Burden testing rooms ($80 per machine hour) | $1,480| $3,200| $600| $400| $960| $6,640| Total Cost| $2,589. 57| $5,681. 71| $1,923. 4| $1,035. 25| $1,587. 99| $12,818. 26| Burden rate for first cost pool (information found in Exhibit 5)| Total Burden (administrating and technical functions)| $684,603| Total Direct labor hours | $3,260,015| Effective Rate for 1st cost pool*| 21%| *Effective Rate = total burden/ total direct labor hours multiplied by 100 | | Burden rate for second cost pool (information found in Exhibit 5)| Total burden (testing rooms) | $4,029,379| Total machine hours | 50,304| Effective rate for 2nd cost pool*| $80| *Effective Rate = Total burden/ total machine hours| | Total Cost = direct labor costs + administrative and technical costs + burden testing room c. Cost System proposed by the consultant The consultant proposed a plan that would trace burden to three cost pools. The first pool would include burden related to the administrative and technical functions and would allocate costs per direct labor dollar. The second pool would contain burden assigned to the main test room and would be based on machine hours. The third pool would contain the burden allocated to the mechanical test room and would also be allocated based on machine hours.
Burden rate for first cost pool (information found in Exhibit 5) *same as burden rate proposed by accounting manager | Total Burden (administrating and technical functions)| $684,603| Total Direct labor hours | $3,260,015| Effective Rate for 1st cost pool*| 21%| *Effective Rate = total burden/ total direct labor hours multiplied by 100 Burden rate for 2nd and 3rd cost pools (information found in Exhibit 5)| | | | Main Test Room | $2,103,116 | | Mechanical test room| $1,926,263 | | Machine hours in the main test room | 33,201| | Machine hours in the mechanical test room | 17,103| | | | Burden rate for main test room | $63 | 2nd cost pool| (2,103,116/33,201)| | | Burden rate for mechanical test room | $113 | 3rd cost pool| (1,926,263/17,103)| | | Product | ICA | ICB | Capacitor | Amplifier | Diode | Total | Direct Labor | $917 | $2,051 | $1,094 | $525 | $519 | $5,106 | administrating and technical functions cost (21%)| $192. 57 | $430. 71 | $229. 74 | $110. 25 | $108. 99 | $1,072. 26 | machine hours needed in main test room| 8. 5| 14| 3| 4| 7| 36. 5| machine hours needed in mechanical test room | 10| 26| 4. 5| 1| 5| 46. | Burden main test room ($63/hour)*| $535. 50 | $882. 00 | $189. 00 | $252. 00 | $441. 00 | $2,299. 50 | * (machine hours needed in main room * $63)| | | | | | | Burden mechanical test room ($113/hour)*| $1,130. 00 | $2,938. 00 | $508. 50 | $113. 00 | $565. 00 | $5,254. 50 | *(machine hours needed in mechanical test room * $113)| | | | | | | Total Cost*| $2,775. 07 | $6,301. 71 | $2,021. 24 | $1,000. 25 | $1,633. 99 | $13,732. 26 | * total cost = DL + administrative and technical costs + burden in main test room + burden mechanical test room
Which Cost System is preferable? Why? First let’s compare the total cost with the three different methods calculated above: 1. Existing cost system | ICB | Amplifier | Machine Hours | 40| 5| Total Cost | $5,024. 95 | $1,286. 25 | | | | 2. Cost system proposed by accounting manager | ICB | Amplifier | Machine Hours | 40| 5| Total Cost | $5,681. 71 | $1,035. 25 | | | | | | | 3. Cost system proposed by outside consultant | ICB | Amplifier | Machine Hours needed in main test room | 14| 4| Machine hours needed in mechanical test room | 26| 1| Total Cost | $6,301. 71 | $1,000. 25 |
If we compare the existing cost system with the cost system proposed by the accounting manager we can see that ICA and ICB consumer a greater amount of machine hours per direct labor dollars in comparison with the Capacitor and the Amplifier. ICA consumer 18. 5 machine hours total and ICB consumer 40 hours compared with the Capacitor which consumer 7. 5 machine hours total and the Amplifier which only consumer 5 machine hour’s total. By switching cost systems and allocating costs based partly on machine hours ICB and ICA’s costs will go up and costs for the Capacitor and Amplifier decrease because they use substantially less machine hours.
If we compare the cost system proposed by the accounting manager with the cost system proposed by the consultant we will notice slight differences depending on if the product used more hours in the main test room or the mechanical test room. The mechanical room burden rate is $113 per machine hour compared to the main test room burden rate, which is only $63 per machine hour. This type of costing system will cause the total cost for ICB, ICA, Capacitor and the diode to increase and the total cost for the Amplifier will decrease since it only requires 1 machine hour in the mechanical testing room.
The costing system proposed by the consultant is the most preferable because it takes into account that each product does not consume both testing rooms in the same proportion. This is especially important since the effective rates of the two rooms differ considerably ($113 for the mechanical room and $63 in the main testing room). The system proposed by the consultant is more accurate and also makes it easier to trace costs. Would you recommend any changes to the system that you prefer? Why?
A possible change that could be made to the cost system proposed by the consultant would be to add a fourth cost pool that will separate administrative and technical costs. Administrative and technical functions are very different in nature and consumption of resources varies among products. Treating these costs as two distinct cost pools may provide better accuracy than if they are grouped together as one. Would you treat the new machine as a separate cost center or as part of the main testing room? The initial burden rate from the cost system proposed by the consultant, which traced burden to three cost pools is $63 ($2,103,116/33,201).
If we wanted to treat the new machine as part of the main testing room we can calculate the new burden from information found in Exhibit 7 and Exhibit 5. The depreciation method used on the new machine is double declining balance. The First year’s depreciation cost is $500,000. We will use the depreciation expense calculated in years 1 and 4 to compute the estimated machine hour burden rate. Year| Book Value| Depreciation| Depreciation| Accumulated| Book Value| | Year Start| Percent| Expense| Depreciation| Year End| 1| $2,000,000 | 25. 00%| $500,000 | $500,000 | $1,500,000 | 2| $1,500,000 | 25. 0%| $375,000 | $875,000 | $1,125,000 | 3| $1,125,000 | 25. 00%| $281,250 | $1,156,250 | $843,750 | 4| $843,750 | 25. 00%| $210,938 | $1,367,188 | $632,813 | The following chart shows depreciation from year 1 through year 4: First year’s burden rate: | Hours | Variable | Depreciation| Other Costs | Total | Old Machine | 33,201| 887,379| 88,779| 1,126,958| 2,103,116| New Machine | 400(10% of 4,000) | 100,000| 500,000| 225,000(Fixed cost + installation costs)| 825,000| Total | 33,601| 987,379| 588,779| 1,351,958| 2,928,116| Machine Hour MOH rate in year 1: $87 (2,928,116/33,601)
Year 4: | Hours| Variable| Depreciation| Other Costs | Total| Old Machine | 33,201| 887,379| 88,779| 1,126,958| 2,103,116| New Machine | 2,400(60% of 4,000)| 100,000| 210,938| 150,000(fixed costs)| 460,938| Total| 35,601| 987,379| 299,717| 1,276,958| 2,564,054| Machine Hour MOH rate for Year 4 : $72 (2,564,054/35,601) The burden rate drastically increases in year 1 from the initial burden rate of $63 and increases overall in total throughout the remaining years if the new machine is treated as part of the main test room.
Because the new machine will only be used for just a couple of customers in the “foreseeable future”, the new machine should be treated as a separate cost. If the new machine was treated as part of the main testing room it will affect the accuracy of the allocation of costs for all the products tested because it will be used so sparingly. Generally speaking, when should a more “refined” costing system be implemented?
A more “refined” costing system should be used when: * A company produces heterogeneous products such as airplanes or buildings * When a company has a large amount of overhead costs with numerous product lines * High complexity in the manufacturing environment. Companies that manufacture complex products need a more detailed costing system that traditional costing systems are unable to manage. * A more accurate view of product cost is required