Answer Key for Seligram, Inc.

Answer Key for Seligram, Inc. page 1 1. What business decisions at Seligram does the cost system support? In this context, what caused the existing cost system at Seligram (ETO) to fail? In general, a cost system supports the pricing decisions of the firm. ETO’s existing cost system contains only one cost center (the entire facility). All overhead is collected into a single cost pool, and the total overhead cost is divided by the total number of direct labor dollars consumed to give a single direct labor dollar burden rate. The major flaw in ETO’s existing system is that it assumes that all products consume direct labor and overhead in the same proportion. However, some products are produced on simple labor intensive equipment while others require very expensive automated equipment. Therefore, it is extremely unlikely that all products consume direct labor and overhead in the same proportion. As testing processes become more complicated, they require more expensive equipment and less labor-intensive equipment, which means that the proportion of costs due to overhead is increasing while the proportion of costs due to direct labor is decreasing. This caused the existing cost system to fail. 2. Calculate the reported costs of the five components described in Exhibit 6 under the three systems. 2a. Costs Under The Existing System: One Center System Product ICA ICB Capacitor Amplifier Diode Direct Labor $ 917 2051 1094 525 519 Overhead @ 145% 1330 2974 1586 761 753 Total 2247 5025 2680 1286 1272 2b. Costs Under The Proposed System from the Accounting Manager: Two Center System Product ICA ICB Capacitor Amplifier Diode Direct Labor $ Overhead $ 917 2051 1094 525 519 1480 3200 600 400 960 Overhead (Machine Hrs.) (18.5) (40.0) (7.5) (5.0) (12.0) Overhead (Direct Labor $) 183 410 219 105 104 Total 2580 5661 1913 1030 1583 Answer Key for Seligram, Inc. 2c. Costs Under The Proposed System from the Consultant: Three Center System Overhead Mech Overhead Main Product Direct Overhead (DL$) (M/C (M/C (M/C (M/C Labor Hours) $ Hours) Hours) $ Hours) $ Hours (Hours) ICA 917 535 8.5 1130 10.0 183 ICB 2051 882 14.0 2938 26.0 410 Capacitor 1094 184 3.0 509 4.5 219 Amplifier 525 252 4.0 113 1.0 105 Diode 519 441 7.0 565 5.0 104 page 2 Total 2765 6281 2011 995 1629 3. Explain conceptually (and briefly) the dynamics that cause the movements you see in the costs calculated above. For example, why do costs for certain components increase when moving from alternative (a) to (b) but decrease from (b) to (c), while other costs increase from (a) to (b) to (c)? First, let’s compare (a) to (b). ICA, ICB, and the diode all consume a relatively large number of machine hours per direct labor dollar compared to the capacitor and the amplifier (ratio of direct labor dollars per machine hour for the five products are 50, 51, 146, 105, and 43, respectively). Thus, switching to machine hours in the test room causes more costs to be allocated to these products. Their reported costs therefore go up. The reported costs of the other two products in contrast decrease, since they consume a relatively low umber of direct labor dollars per machine hour. Now let’s compare (a) and (b) to (c). For system 2(c), the mechanical burden rate is $113 per machine hour compared to $64 for the main test room. Therefore, components that consume relatively more mechanical machine hours compared to main machine hours will have higher reported product costs. These are the ICA, ICB, capacitor, and the diode. For some products, the results under system 2(b) and 2(c) reinforce each other, whereas for other, they counteract. For example, the reported cost of ICB goes up 13% with the introduction of the cost center for 2(b) and up an additional 10% with the introduction of the cost center for 2(c). In contrast, the reported cost of the amplifier goes down with the introduction of the center 2(b) and up with the introduction of the center 2(c). 4. Which of the three cost systems do you think is most appropriate? Why? What are some potential disadvantages of the system that you recommend? The three-center system is the most appropriate cost system because it provides the most accurate cost information. The increased number of cost centers under the three-center system enables the cost system to capture differences in the way overhead is consumed in different parts of the production process. Answer Key for Seligram, Inc. page 3 The potential disadvantage of the system is that the cost of system redesign may be high. The selection of an optimal cost system is based on trade-offs between increased accuracy and the cost of system redesign. 5. Would you treat the new machine as a separate cost center or as part of the main room? Why? If you were to treat it separately, how would you allocate its costs? We can use the data provided in Exhibit 5 of the case to determine the burden rate of the machine. The burden rate for the first year will be much higher than for the Nth year because of start-up costs and depreciation. Burden rate for new machine Burden Variable st 1 year Machine cost $100,000 Machine hours 400 hours $250 Burden rate/machine hour Nth year Machine cost $100,000 Machine hours 2,400 hours $41.67 Burden rate/machine hour *Approximate depreciation charge for year 6. Depreciation Other $500,000 $225,000 Total $825,000 $1,250 $562.50 $2,062.50 $120,000* $150,000 $370,000 $50 $62.50 $154.17 If the new machine is not treated as a separate cost center, then the new burden rates for the main test become: Main test room burden rates with machine included Variable Depreciation Other Total 1st year Existing costs $887,379 $88,779 $1,126,958 $2,103,116 Machine costs $100,000 $500,000 $225,000 $825,000 Total costs 987,379 $588,779 $1,351,958 $2,928,116 Machine hours 33,000+400 Burden rate/ $29.56 $17.63 $40.48 $87.67 machine hour Nth year Existing costs $887,379 $88,779 $1,126,958 $2,103,116 Machine costs $100,000 $125,000 $150,000 $375,000 Total costs $987,379 $203,779 $1,276,958 $2,478,116 Machine hours 33,000+2,400 Burden rate/ $27.89 $8.49 $36.07 $70.03 machine hour As can be seen, failing to treat the new machine as a separate cost center seriously distorts the burden rates.