Step-Down Method versus Direct Method“I can't understand what's happening here,” s...

Step-Down Method versus Direct Method

“I can't understand what's happening here,” said Mike Holt, president of Severson Products, Inc. “We always seem to bid too high on jobs that require a lot of labor time in the Finishing Department, and we always seem to get every job we bid on that requires a lot of machine time in the Milling Department. Yet we don't seem to be making much money on those Milling Department jobs. I wonder if the problem is in our overhead rates.”

Severson Products manufactures high-quality wood products to customers' specifications. Some jobs take a large amount of machine work in the Milling Department, and other jobs take a large amount of hand finishing work in the Finishing Department. In addition to the Milling and Finishing departments, the company has three service departments. The costs of these service departments are allocated to other departments in the order listed on the following page. (For each service department, use the most appropriate allocation base.)

Budgeted overhead costs in each department for the current year are as follows:

“This represents the amount of cost subsidized by the company.

Because of its simplicity, the company has always used the direct method to allocate service department costs to the two operating departments.

Required:

1. Using the step-down method, allocate service department costs to the consuming departments. Then compute predetermined overhead rates in the operating departments for the current year using machine-hours as the allocation base in the Milling Department and direct labor-hours as the allocation base in the Finishing Department.

2. Repeat (1) above, this time using the direct method. Again compute predetermined overhead rates in the Milling and Finishing Departments.

3. Assume that during the current year the company bids on a job that requires machine and labor time as follows:

a. Determine the amount of overhead that would be assigned to the job if the company used the overhead rates developed in (1) above. Then determine the amount of overhead that would be assigned to the job if the company used the overhead rates developed in (2) above.

b. Explain to the president why the step-down method provides a better basis for computing predetermined overhead rates than the direct method.

Although sales have remained unchanged at Si00.000. the sales mix is exactly the reverse of what it was in Exhibit 5–4. with the bulk of the sales now coming from the less profitable Le Louvre DVD. Notice that this shift in the sales mix has caused both the overall CM ratio and total profits to drop sharply from the prior month even though total sales are the same. The overall CM ratio has dropped from 45% in September to only 30% in October, and net operating income has dropped from $18,000 to only S3.000. In addition, with the drop in the overall CM ratio, the company's break-even point is no longer $60,000 in sales. Because the company is now realizing less average contribution margin per dollar of sales, it takes more sales to cover the same amount of fixed costs. Thus, the break-even point has increased from $60,000 to $90,000 in sales per year.

In preparing a break-even analysis, an assumption must be made concerning the sales mix. Usually the assumption is that it will not change. However, if the sales mix is expected to change, then this must be explicitly considered in any CVP computations.