Question

A company signs a contract to sell items at a “cost-plus”, meaning the payments per item is based on the actual production costs plus a profit markup. The company manufactures multiple products and to collect more money on the contract they manipulate the allocation of overhead costs from other jobs to the “cost-plus” jobs. They figured nobody would catch the changes in the workers’ timesheets.

Identify the cost system the company is using and why you selected it. Explain what cost driver(s) the company was using to allocate the costs to the various jobs. Identify what the benefit to the company is in the above scenario.

Based on the cost system you chose above, explain the benefits and issues if the company used the other cost system studied.

Answer 1

The company is using the absorption method(i.e, traditional method) to allocate the overheads to the products.

In the question they clearly stated that "They figured nobody would catch the changes in the worker's time sheets."

This means, the company was using "direct labor hours" as the basis or cost driver to allocate the overheads. This is only possible if the company uses the traditional(or absorption) costing method.

The benefit in absorption method is, to each product, appropriate amount of overhead costs get apportioned, which plays an important role in determining the cost of the product.

And the main drawback of absorption method is, it uses a single rate to distribute the overhead costs among different products. This is not logical at all if the company is producing different products which requires different area of functionalities.