Sharpton Fabricators Corporation manufactures a variety of parts for the
automotive industry. The company uses a job-order costing system with a
plantwide predetermined overhead rate based on direct labour-hours. On
December 10, 2015, the company’s controller made a preliminary estimate
of the predetermined overhead rate for 2016. The new rate was based on
the estimated total manufacturing overhead cost of $3,402,000 and the
estimated 63,000 total direct labour-hours for 2016:
$54 per direct labour hour
This new predetermined overhead rate was communicated to top managers
in a meeting on December 11. The rate did not cause any comment because
it was within a few cents of the overhead rate that had been used during
2015. One of the subjects discussed at the meeting was a proposal by the
production manager to purchase an automated milling machine centre built
by Central Robotics. The president of Sharpton Fabricators, Kevin Reynolds,
agreed to meet with the regional sales representative from Central Robotics
to discuss the proposal.
On the day following the meeting, Reynolds met with Jay Warner, Central
Robotics’ sales representative. The following discussion took place:
Reynolds: Lisa Winter, our production manager, asked me to meet with you
since she’s interested in installing an automated milling machine centre.
Frankly, I’m skeptical. You’re going to have to show me this isn’t just
another expensive toy for Lisa’s people to play with.
Warner: That shouldn’t be too difficult, Kevin. The automated milling
machine centre has three major advantages. First, it’s much faster than the
manual methods you’re using. It can process about twice as many parts per
hour as your current milling machines. Second, it’s much more flexible.
There are some up-front programming costs, but once those have been
incurred, almost no setup is required on the machines for standard
operations. You just punch in the code of the standard operation, load the
machine’s hopper with raw material, and the machine does the rest.
Reynolds: Yeah, but what about cost? Having twice the capacity in the
milling machine area won’t do us much good. That centre is idle much of the
Warner: I was getting there. The third advantage of the automated milling
machine centre is lower cost. Winters and I looked over your present
operations, and we estimated that the automated equipment would
eliminate the need for about 6,000 direct labour-hours a year. What is your
direct labour cost per hour?
Reynolds: The wage rate in the milling area averages about $32 per hour.
Fringe benefits raise that figure to about $41 per hour.
Warner: Don’t forget your overhead.
Reynolds: Next year the overhead rate will be about $54 per direct labourhour.
Warner: So including fringe benefits and overhead, the cost per direct
labour-hour is about $95.
Reynolds: That’s right.
Warner: Since you can save 6,000 direct labour-hours per year, the cost
savings would amount to about $570,000 a year, and our 60-month lease
plan would require payments of only $348,000 per year.
Reynolds: Sold! When can you install the equipment?
Shortly after this meeting, Reynolds informed the company’s controller of
the decision to lease the new equipment, which would be installed over the
Christmas vacation period. The controller realized that this decision would
require a recomputation of the predetermined overhead rate for 2016, since
the decision would affect both the manufacturing overhead and the direct
labour-hours for the year. After talking with both the production manager
and the sales representative from Central Robotics, the controller discovered
that in addition to the annual lease cost of $348,000, the new machine
would also require a skilled technician/programmer who would have to be
hired at a cost of $50,000 per year to maintain and program the equipment.
Both of these costs would be included in factory overhead. There would be
no other changes in total manufacturing overhead cost, which is almost
entirely fixed. The controller assumed that the new machine would result in
a reduction of 6,000 direct labour-hours for the year from the levels that had
initially been planned.
When the revised predetermined overhead rate for 2016 was circulated
among the company’s top managers, there was considerable dismay.
1. Recompute the predetermined rate assuming that the new machine
will be installed. Explain why the new predetermined overhead rate is
higher (or lower) than the rate that was originally estimated for 2016.
2. What effect (if any) would this new rate have on the cost of jobs that
do not use the new automated milling machine?
3. Why would managers be concerned about the new overhead rate?
4. After seeing the new predetermined overhead rate, the production
manager admitted that he probably wouldn’t be able to eliminate all of
the 6,000 direct labour-hours. He had been hoping to accomplish the
reduction by not replacing workers who retire or quit, but that would
not be possible. As a result, the real labour savings would only be
about 2,000 hours—one worker. In the light of this additional
information, evaluate the original decision to acquire the automated
milling machine from Central Robotics.