In today’s very competitive business environment, it is imperative that organizations choose the most appropriate and effective overhead rate, particularly, because it guides management in its tasks of product pricing, job costing, and budgeting. Businesses can use the single company-wide method or can opt for the departmental method. Auerbach Enterprises manufactures air conditioners for many makes of both automobiles and trucks. The two main products are MaxiFlow and Alaska. Currently, the company uses a company-wide predetermined overhead (OH) rate but is considering using departmental OH rates in the upcoming year. Company-wide OH rates allocate expenses across the entire enterprise. This rate is figured by dividing the total cost of overhead by cost drivers common throughout each department. According to Schneider (2012), “Department OH rates are calculated for each separate department by dividing the total department overhead budgeted by the budgeted amount of common cost drivers within the department” (p. 3.3).
Moreover, Auerbach Enterprises is trying to make a determination as to whether it would be more appropriate to use the company-wide predetermined overhead rates, or whether it would be more appropriate to switch to using departmental overhead rates. As such, this paper will be making calculations to determine the most appropriate overhead costing rate method; according to Brunton (1998): The easiest method is to apply the plant-wide, or blanket rate. Parts are valued at a proportionate share of indirect costs according to some predetermined base. One disadvantage of this method rises when production processes differ significantly for different parts. Parts processed in departments that have low overhead expenses are valued and priced proportionately the same as parts produced in departments with high overhead expenses.
A second disadvantage is that all parts do not necessarily carry a portion of indirect cost as part of their value because one base is used in the allocation process (p. 22). Further, a determination should be made concerning whether one product is affected more than the other by using departmental rates rather than a company-wide rate. Computation of departmental OH rates using machine hours as the cost driver. Department OH Costs / Machine Hours = Department OH Rate Radiator parts fabrication $80,000 /10,000 = 800% Radiator assembly, weld, and test 100,000 /20,000 = 500% Compressor parts fabrication 120,000 /5,000 = 2400% Compressor assembly and test 180,000 /45,000 = 400% Total 480,000 80,000 4100%
Computation of company-wide overhead rate using machine hours as the cost driver. Company-wide OH cost = 480,000 Total machine hours =80,000 Company-wide OH rate 480,000/80,000 = 6.00
AUERBACH ENTERPRISES 4 Computation of the overhead costs per batch of MaxiFlow and Alaska assuming: (a) The company-wide rate (b) The departmental rates. Maxiflow 6.00 x 116 = 696Alaska 6 x 164 = 984
a) MaxiFlow 696/20 = 34.8Alaska 984/20 = 49.2
b) MaxiFlow 1246/20 = 62.3Alaska 954/20 = 47.7
Departmen MaxiFlow hours Department OH rate Department cost Radiator parts fabrication 28 x 8.00 = $ 224.00 Radiator assembly weld and test 30 x 5.00 =
150.00 Compressor parts fabrication 32 x 24.00 = 768.00 Compressor assembly and test 26 x 4.00 = 104.00 Total 116 41.00 1,246.00
Department Alaska hours Department OH rate Department cost Radiator parts fabrication 16 x 8.00 = $ 128.00 Radiator assembly weld and test 74 x 5.00 = 370.00 Compressor parts fabrication 8 x 24.00 = 192.00
Compressor assembly and test 6 x 4.00 = 264.00 Total 164 41.00 954.00
Computation of the OH costs per unit of MaxiFlow and Alaska assuming: (a) The company-wide rate & b) departmental rate. MaxiFlow Departmental Rate Company-wide Rate Direct materials $ 135.00 $ 135.00 Direct labor $ 75.00 $ 75.00 Overhead 62.30 34.80 Total unit costs 272.30 244.80
Alaska Departmental Rate Company-wide rate Direct materials $ 110.00 $ 110.00 Direct labor 95.00 95.00 Overhead 47.70 49.20 Total unit costs 252.70 254.20
Is one product affected more than the other by use of departmental rates rather than a company-wide rate? Why or why not? Indeed, the ability to remain competitive lies in how well a company implements cost-cutting solutions within its organization. Accordingly, based on the total unit cost, MaxiFlow appears to be affected more than Alaska by using the departmental rate. Using a company-wide OH rate is better suited for an enterprise that manufactures a single product. Since Auerbach has multiple departments and manufacturing sections, a more accurate overhead rate can be calculated using the departmental OH rate method.
Additionally, it is very interesting, and no less compelling that company such as this uses machine hours instead of direct labor as the cost driver to assign overhead cost; this, in and of itself strongly suggest that it is a company which the majority of its manufacturing is done by machine and not by physical labor. This is expressed by Novin (1992) in the following excerpt; he states: Direct labor no longer may be the most effective base for applying factory overhead costs to various jobs and products. With today’s highly automated systems, labor-related costs constitute only a small portion of total manufacturing costs, and overhead costs now correlate more with factors such as machine hours and material quantities. Accordingly, many companies are beginning to identity application bases that better reflect the causes of overhead costs in their unique manufacturing environments (p. 40).
Indeed, regardless of whether a company opts to use the company-wide overhead rate, or the departmental overhead rates, the effectiveness of those various systems, to a large extent, depends on the type of organization that utilizes them. This is expressed by Boer & Jeter (1993), wherein they state, “…manufacturing cost structures have been changing slowly over time, but sufficient variation across industries exists in the extent and nature of the changes to suggest that no single approach to structuring cost accounting systems is likely to be optimal for all industrial organizations or sectors” (pp. 5, 61).
In conclusion, Auerbach compiled planning information in an attempt to determine if it would be beneficial to change from a company-wide predetermined overhead rate to a departmental overhead rate. This is important because choosing the most appropriate rate helps management in the budgeting, job costing, and product pricing process. Essentially, it all amounts to the bottom line of a company choosing the method that provides the most accurate results for its business success.
Boer, G., & Jeter, D. (1993). What’s new about modern manufacturing? empirical evidence on manufacturing cost changes. Journal of Management Accounting Research, 5, 61. Retrieved from http://search.proquest.com/docview/210171196?accountid=32521 Brunton, N. M. (1988). Evaluation of overhead allocations. Management Accounting, 70(1), 22. Retrieved from http://search.proquest.com/docview/229737200?accountid=32521 Novin, A. M. (1992). Applying overhead: How to find the right bases and rates. Management Accounting, 73(9), 40. Retrieved from http://search.proquest.com/docview/229742735?accountid=32521 Schneider, A. (2012). Managerial Accounting: Decision Making for the Service and Manufacturing Sectors. Bridgepoint Education: San Diego, CA.