Kelvin Aerospace, Inc., manufactures parts such as rudder hinges for the
aerospace industry. The company uses a job-order costing system with a
predetermined plantwide overhead rate based on direct labor-hours. On
December 16, 2008, the company's controller made a preliminary estimate
of the predetermined overhead rate for the year 2009. The new rate was
based on the estimated total manufacturing overhead cost of $3,402,000
and the estimated 63,000 total direct labor-hours for 2009:
Predetermined overhead rate =3,402,000
63,000 hours
= $54 per direct labor – hour
This new predetermined overhead rate was communicated to top managers
in a meeting on December 19. The rate did not cause any comment because
it was within a few pennies of the overhead rate that had been used
during 2008. One of the subjects discussed at the meeting was a proposal
by the production manager to purchase an automated milling machine
built by Sunghi Industries. The president of Kelvin Aerospace, Harry
Arcany, agreed to meet with the sales representative from Sunghi
Industries to discuss the proposal.
On the day following the meeting, Mr. Arcany met with Jasmine Chang,
Sunghi Industries' sales representative. The following discussion took
place:
Arcany: Wally, our production manager, asked me to meet with you
because he is interested in installing an automated milling machine.
Frankly, I'm skeptical. You're going to have to show me this isn't just
another expensive toy for Wally's people to play with.
Chang: This is a great machine with direct bottom-line benefits. The
automated milling machine has three major advantages. First, it is much
faster than the manual methods you are using. It can process about twice
as many parts per hour as your present milling machines. Second, it is
much more flexible. There are some up-front programming costs, but once
those have been incurred, almost no setup is required to run a standard
operation. You just punch in the code for the standard operation, load
the machine's hopper with raw material, and the machine does the rest.
Arcany: What about cost? Having twice the capacity in the milling
machine area won't do us much good. That center is idle much of the time
anyway.
Chang: I was getting there. The third advantage of the automated
milling machine is lower cost. Wally and I looked over your present
operations, and we estimated that the automated equipment would
eliminate the need for about 6,000 direct labor-hours a year. What is
your direct labor cost per hour?
Arcany: The wage rate in the milling area averages about $32 per hour. Fringe benefits raise that figure to about $41 per hour.
Chang: Don't forget your overhead.
Arcany: Next year the overhead rate will be $54 per hour.
Chang: So including fringe benefits and overhead, the cost per direct labor-hour is about $95.
Arcany: That's right.
Chang: Since you can save 6,000 direct labor-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.
Arcany: That sounds like a no-brainer. When can you install the equipment?
Shortly after this meeting, Mr. Arcany 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 the year 2009 because the decision would affect both
the manufacturing overhead and the direct labor-hours for the year.
After talking with both the production manager and the sales
representative from Sunghi Industries, 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 labor-hours for the year from the
levels that had initially been planned.
When the revised predetermined overhead rate for the year 2009 was
circulated among the company's top managers, there was considerable
dismay.
Requirement 1:Recompute the predetermined rate assuming that the new
machine will be installed. (Round your answer to 2 decimal places.
Requirement 2:What effect (if any) would this new rate have on the cost
of jobs that do not use the new automated milling machine?
Requirement 3:Why would managers be concerned about the new overhead rate?
Requirement 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 labor-hours. He had been hoping to
accomplish the reduction by not replacing workers who retire or quit,
but that had not been possible. As a result, the real labor savings
would be only about 2,000 hours—one worker. Compute the net increase or
decrease in annual manufacturing overhead cost considering 2,000 hours
saving.
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