Question

“Our costs are out of control, our accounting system is messed up, or both!” screamed Mickey, the sales manager. “We are simply non-competitive on a great many of the jobs we bid on. Just last week we lost a customer when a competitor underbid us by 25%! And I bid that job at cost because the customer has been with us for years and has been complaining about our prices.”

This problem raised at the weekly management meeting, has been getting worse over the years. The Pluto Tool Company produces parts for specific customer orders. When the firm first became successful 25 years ago , it employed nearly 500 skilled machinists. Over the years, the firm has become increasingly automated, and it now uses a number of different robotic machines. The firm currently employs only 75 production workers but output has quadrupled.

The problems raised by the sales manager can be seen in the portions of two bid sheets brought to the meeting. The bids are from the cutting department, but the relative size of these three types of manufacturing costs is similar from other departments.

The cutting department charges overhead to products based on direct labour hours. For the current period, the department expects to use 4000 direct labour hours. Departmental overhead, consisting mostly of amortization on the robotic equipment, is expected to be $1,480,000.

An employee can typically set up any job on the appropriate equipment in about 15 minutes. Once machines are operating, an employee oversees five to eight machines simultaneously. All that is required is to load or unload materials and monitor calibrations. The department’s robotic machines will log a total of 25,000 hours of run time in the current period.

Mickey knows you are a smart accounting student at the Hill School of Business and thinks maybe you can help the company.    Mickey acknowledges that the company hasn’t looked at their accounting policies for a while. Their accountant left to join the circus 5 years ago and really nothing has been done since then other than filing corporate tax returns.

Mickey asks you if you can help him figure out

1. what could be adjusted in their bidding system and
2. why you think those adjustments are needed,
3. what the adjustments mean and
4. any other explanations that you think would help him. Mickey has always relied on his old accountant because in Mickey’s word – “numbers are just not my thing”.

To help you out, Mickey provides the bid sheets from the last two jobs.  

Beside the bid sheets Mickey had written these notes – “For Bid 74683, we were substantially underbid by a competitor. Got job for Bid 74687 but these size jobs are hard to find. figure out why we rarely get the small jobs – we get to bid on these all the time”.

Bid	Bid 74683	Bid 74687
Machine run time	3 hours	11 hours
Materials - steel sheeting	$280.25	$2440.50
Direct labour - equipment set up @ 0.25 hrs * $12.50	$3.13	$3.13
Equipment tending @1.25 hrs * $12.50	$12.50	$15.63
Overhead 1.25 hrs * $370.00	$462.50	$555.00
Total Costs	$758.38	$3,014.26

                                                                                                            Small job

Answer 1

For Pluto Tools Company

Issue raised in the management meeting:

The company is heavily automated and could not attain the jobs which are small and looses job from long term customers , due to underbidding by the competitors.

Real problem in the given case:

The actual problem in the given case is the inappropriate costing policy of the company, due to which they could not find the actual Cost, leading them to overbid for the job and subsequently loosing the job to the competitors.

How to solve the Issue?

1.The company presently follows Overhead absorption rate on the basis of labor hours bringing its Overhead rate to $370($1480000÷4000labor hours).

2.The company has to change its costing policy, in order for it to be able to compute overheads on the basis of total machine hours, to give the correct and actual cost in the given case.

3.It has to change its Overhead absorption rate based on machine hours worked, which is more appropiate basis of measurement as the factory is heavily automated and is based on machines to work,(this is proved as the overheads are mostly amortization on equipment) not on the labor.

So, Overhead absorption rate

=Total Overheads÷Total Machine hours

=$1480000÷25000 machine hours

=$59.2

3.This will lead to company costing only $59.2, instead of $370,which reduces overhead rate by $310.8 when compared with previous costing policy of using Direct labor hours as base for overhead absorption.

Conclusion:

The above steps when followed should help the company to make more competitive bids and earn larger market share, and get back at it tracks and even get into profits.