Develop a cost allocation method for materials overhead
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The questions that I have are as follows:
1. Using assumed numbers, develop a cost allocation method for materials overhead (MOH) to quantify and communicate the strategy of parts standardization.
2. Explain how use of your method would support the strategy.
3. Is any method which applies the entire MOH cost pool on the basis of one cost driver sufficiently accurate for product decisions in the highly competitive portable scope markets? Explain.
4. Are MOH product costing rates developed for management reporting appropriate for inventory valuation for external reporting? Why or why not?
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Here is a sample of what you will find in this solution:
"3) This is a good start as it might be the largest bang for the effort. However, the situation is too competitive to stop here. Material costs can be driven down by many methods besides this one. "
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Active since 2012
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Tektronix, Inc. headquartered in Portland, Oregon, is a world leader in the production of electronic
test and measurement instruments. The company's principal product since its founding in 1946 has been
the oscilloscope (scope), an instrument that measures and graphically displays electronic signals. The two
divisions of the Portables Group produce and market high and medium-performance portable scopes.
Tektronix experienced almost uninterrupted growth through the 1970s based on a successful
strategy of providing technical excellence in the scope market and continually improving its products in
terms of both functionality and performance for the dollar. In the early 1980s, however, the lower priced
end of the division's medium-performance line of scopes was challenged by an aggressive low-price
strategy of several Japanese competitors. Moving in from the low-price, low-performance market
segment in which Tektronix had decided not to compete, these companies set prices 25 percent below
the U.S. firm's prevailing prices. Rather than moving up the scale to more highly differentiated products,
the group management decided to block the move.
The first step was to reduce the prices of higher-performance, higher-cast scopes to the prices of
the competitors' scopes of lower performance. This short-term strategy resulted in reported losses for
those instruments. The second step was to put in place a new management team whose objective was to
turn the business around. These managers concluded that, contrary to conventional wisdom, the
Portables Group divisions could compete successfully with foreign competition on a cost basis. To do so,
the divisions would have to reduce costs and increase customer value by increasing operational
PRODUCTION PROCESS CHANGES
The production process in the Portables Group divisions consisted of many functional islands,
including etched circuit board (ECB) insertion, ECB assembly, ECB testing, ECB repair, final assembly,
test, thermal cycle, test/QC, cabinet fitting, finishing, boxing for shipment, and shipment. The new
management team consolidated these functionally oriented activities into integrated production lines in
open work spaces that allow visual control of the entire production area. Parts inventory areas were also
placed parallel to production lines so that at each work station operators would be able to pull their own
parts. This in essence created an early warning system that nearly eliminated line stoppages due to
Additional steps that were taken in the early to mid 1980s to solve managerial and technical
problems include implementation of just-in-time (JIT) delivery and scheduling techniques and total quality
control (TQC), movement of manufacturing support departments into the production area, and
implementation of people involvement (PI) techniques to move responsibility for problem solving down to
the operating level of the divisions. The results of these changes were impressive: substantial reductions
in cycle time, direct labor hours per unit, and inventory, and increases in output dollars per person per
day and operating income. The cost accounting group had dutifully measured these improvements, but
had not effectively supported the strategic direction of the divisions.
COST ACCOUNTING SYSTEM
DIRECT MATERIALS AND DIRECT LABOR
The total manufacturing cost of the newest portable scopes produced with the latest technologies
has 75% direct materials, 3% direct labor, and 22% factory overhead. In most cases, direct materials
and direct labor are easily traced to specific products for costing purposes. Prior to the mid 1980s,
however, the divisions' attempts to control direct labor had been a resource drain that actually decreased
There were approximately twenty-five production cost centers in the Portable Instruments Plant.
Very detailed labor efficiency reports were prepared monthly for each cost center and each major step in
the production process. In addition, an efficiency rating for each individual employee was computed daily.
Employees reported the quantity of units produced and the time required to produce them, often
overestimating the quantity produced to show improved efficiency against continually updated standards.
The poor quality of collected data resulted in semi-annual inventory-downs when physical and book
quantities were compared.
"The inadequacy of our efficiency reporting system became clear when we analyzed one of our new
AT production lines," commented Michael Wright, Financial Systems Application Manager. "On a AT
manufacturing line, once the excess inventory has been flushed out, it is essentially impossible for any
person to work faster or slower than the line moves. However, if one person on the line is having a
problem, it immediately becomes apparent because the product flow on the line stops. Corrective action
is then taken, and the line is started up again.
"On that line, the system told us that the efficiency of each of the workers was decreasing.
However, stepping back from the detail of the situation allowed us to look at the overall picture. We
found that the costs incurred on the line were gang down and its product output was going up.
Obviously, it was becoming more, not less, efficient."
The quantity of direct labor data collected and processed also was a problem. Production employees
often spent twenty minutes per day completing required reports when they could have been producing
output. Additionally, the accounting staff was processing 35,000 labor transactions per month to account
for what amounted to 3 percent of total manufacturing cost.
"Transactions cost money," observed John Jonez, Group Cost Accounting Manager, "and lots of
transactions cost lots of money."
In response to these problems, the group accounting staff greatly simplified its procedures. It
abandoned the measurement of labor performance for each operation, and greatly reduced the number
of variances reported. The number of monthly labor transactions fell to less than 70, allowing the staff to
spend more time on factory overhead allocation and other pressing issues.
The product costing system allocated all factory overhead costs to products based on standard direct
labor hours. A separate rate was computed for each manufacturing cost center. This system led to rapidly
increasing rates: the direct labor content of the group's products had been continually decreasing for
years, while factory overhead costs were increasing in absolute terms.
"Because the costing system correlated overhead to labor, our engineers concluded that the way to
reduce overhead costs was to reduce labor," commented Jonez. "The focus of cost reduction programs
therefore had been the elimination of direct labor. However, most of this effort was misdirected, because
there was almost no correlation between overhead cost incurrence and direct labor hours worked. Our
system penalized products with proportionately higher direct labor, but it wasn't those products that
caused overhead costs. We proved that. We attacked direct labor and it went down, but at the same time
overhead went up.
"We therefore knew that we needed a new way to allocate overhead. More fundamentally, we
needed a way for the cost accounting system to support the manufacturing strategy of our group. The
objective was clear-to provide management with accounting information that would be useful in
identifying cost reduction opportunities in its operating decisions as well as provide a basis for effective
reporting of accomplishments."
A PPROACH TO METHOD CHANGE
T he first step taken by Wright and Jonez in developing a new overhead allocation method was to
establish a set of desirable characteristics for the method. They decided that it must accurately assign
costs to products, thus providing better support for management decisions than the old method. It must
support the AT manufacturing strategy of the Portables Group. It also must be intuitively logical and easily
understandable by management. And finally, it must provide information that is accessible by decision
The next step was to interview the engineering and manufacturing managers who were the primary
users of product cost information. These users were asked, "What is it that makes your job more difficult?
What is it that makes certain products more difficult to manufacture? What causes the production line to
slow down? What is it that causes overhead?" The answers to these questions were remarkably
consistent-there were too many unique part numbers in the system. This finding revealed a major flaw in
the ability of the direct labor-based costing method to communicate information critical for cost-related
decisions. Manufacturing managers realized there were substantial cost reduction opportunities through
the standardization of component parts, but there was no direct method to communicate this idea to design
and cost-reduction engineers who made part selection decisions.
Although difficult to quantify, some costs are associated with just carrying a part number i n the
d atabase. Each part number must be originally set up in the system, built into the structure of a bill of
materials, and maintained until it is no longer used. Moreover, each part must be planned, scheduled,
negotiated with vendors, purchased, received, stored, moved, and paid for. Having two parts similar
enough that one could be used for both application requires unnecessary duplication of these activities,
and therefore unnecessary costs. Standardizing parts results in several indirect benefits. Fewer unique
part numbers usually means fewer vendors and greater quality of delivered parts. It also means smoother
JIT production, fewer shutdowns of manufacturing lines, and greater field reliability. These observations
led to a preliminary consensus on the need to develop a product costing method that would quantify and
communicate the value of parts standardization.
" To confirm our assessment," stated Jonez, "we segmented the total manufacturing overhead cost
pool. The costs of all cost centers comprising the pool were categorized as either materials-related or
conversion-related based upon rules developed in conjunction with operating managers.(See T-1)
"Material-related costs pertain to procurement, scheduling, receiving, incoming inspection, stockroom
personnel, cost-reduction engineering, and information systems. Conversion-related costs are associated
with direct labor, manufacturing supervision, and process-related engineering. Application of the rules
resulted in an approximately 55/45 split between materials overhead (MOH) and conversion overhead
(COH). This finding further confirmed the inadequacy of the existing method, which applied all overhead
based on direct labor."
The accounting analysts decided to focus their initial efforts on the MOH pool. To improve their
understanding of the composition of the pool and thus assist them in developing a method for its
allocation, Wright and Jonez consulted operating managers and further segmented it into:
1. Costs due to the value of parts,
2. Costs due to the absolute number of parts used,
3. Costs due to the maintenance and handling of each different part number and
4. Costs due to each use of a different part number.
The managers believed that the majority of MOH costs were of type (3). The costs due to the value of parts
(1) and the frequency of the use of parts (2 and 4) categories were considered quite small by comparison.
The analysts therefore concluded that the material-related costs of the Portables Group would decrease if a
smaller number of different part numbers were used in its products. This cost reduction would result from two
factors. First, greater volume discounts would be realized by purchasing larger volum es of f ewer unique
par ts. Second, material overhead costs would be lower. "It was the latter point that we wanted our new
allocation method to focus on," commented Wright.
"Our goal," continued Jonez, "was to increase customer value by reducing overhead costs. Our strategy
was parts standardization. We needed a tactic to operationalize the strategy."