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Finance - Overhead Allocation

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Fabricator Inc., a specialized equipment manufacturer, uses a job order costing system. The overhead is allocated to jobs on the basis of direct labor hours. The overhead rate is now $ 3,000 per direct labor hour. The design engineer thinks that this is illogical. The design engineer has stated the following: Our accounting system doesn't make any sense to me. It tells me that every labor hour carries an additional burden of $3,000. This means that while direct labor makes up only 5% of our total product cost, it drives all our costs. In addition, these rates give my design engineers incentives to "design out" direct labor by using machine technology. Yet, over the past years as we have had less and less direct labor, the overhead rate keeps going up and up. I won't be surprised if next year the rate is $4,000 per direct labor hour. I'm also concerned because small errors in our estimates of the direct labor content can have a large impact on our estimated costs. Just a 30-minute error in our estimate of assembly time is worth $1,500. Small mistakes in our direct labor time estimates really swing our bids around. I think this puts us at a disadvantage when we are going after business.

1. What is the engineer's concern about the overhead rate going "up and up"?

2. What did the engineer mean about the large overhead rate being a disadvantage when placing bids and seeking new business?

3. What do you think is a possible solution?

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Solution Summary

This post gives an overview of why using direct labor hours to allocate overhead costs might not be appropriate anymore for manufacturing firms.

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I will give you some conceptual information to get you started and some ideas on how to approach the questions. If you require further explanation, please let me know and I can update the posting.

In the past, direct labor hours were highly correlated with overhead costs. Each additional hour of labor translated to more supervisor hours, more machines, more overhead in general. All in all, because direct labor was highly correlated with overhead costs, using direct labor hours to estimate overhead costs was appropriate. ...

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