Sam Edwards has been the accounting manager for Jade Manufacturing in a highly competitive international market for ten years. Jade Manufacturing produces heavy equipment for two major customers: Camberta and Gantz. In the present costing system, Jade uses the percentage of direct material dollar value as the basis for cost allocations in the Materials Receiving and Handling Department. The administrative departments including Personnel, Sales, IT and Accounting use the services of the Materials Receiving and Handling Department on a limited basis. However, in the past none of the materials receiving and handling costs have been allocated to the administrative departments.
Traditionally production has been greater for Gantz relative to Camberta, although Camberta's purchases are for low-dollar high-volume items. Recently sales to Gantz decreased significantly as a percentage of total sales. In investigation of possible causes for the decrease it was discovered that Gantz is not happy with the material handling costs and they state these costs are higher than what they perceive is necessary. Gantz indicates they can purchase the heavy equipment elsewhere at a lower cost and is considering changing to another supplier.
The CEO, John Paz, has many questions for Sam in regard to accounting for costs in the Materials Receiving and Handling Department to prevent the loss of this customer. Sam is convinced that implementing a change in the accounting system where allocations are based on the number of purchase orders, plus any direct costs related to purchases, would improve costing at Jade Manufacturing. He discusses the change with the CEO, but needs to collect further information. Sam reviews the records and notes that a significant portion of the Gantz purchases are for Material A, a high-dollar low-volume material that is purchased only for Gantz production.
Subsequent to the review, Sam develops estimates for the number of purchase orders for Gantz in 2011 as 120,000 (not including the Material A purchases) and for Camberta as 234,000. The number of purchase orders to be processed total 364,400, which includes a further 4,050 for Accounting, 750 for Personnel, 3,700 for the Sales Department and 1,900 for IT. Jade's IT department is relatively sophisticated with a leading-edge system that is used for computer integrated manufacturing.
Sam and his team develop an estimate of the operating costs for the Materials Receiving and Handling Department in 2011, where direct materials costs for Gantz are $3,009,000 (including Material A) and for Camberta are $1,311,000. Other department costs include indirect materials of $9,000, communication costs of $57,000, salaries of $270,000, lubricants and coolants $54,000, equipment depreciation of $9,000 and other costs of $33,000. Within the above costs are all the purchase order costs solely related to the Gantz high-cost low-volume Material A purchases as follows: $54,000 for salaries, $2,800 for related communication costs and $10,800 for other costs.
The CEO requests that Sam develop a three-year budget and Sam agrees that it would be useful. He collects information and develops estimates. He estimates the extra costs for the Gantz high-cost low-volume Material A purchases will remain the same each year, as does the ratio of material handling costs to direct material cost. However, direct material costs will increase by 5% per year and there will be an increase in the number of purchase orders by 10% per year. The ratio of Gantz purchase orders to the total will be 40% each year after 2011, and the cost of Gantz's material in the future will be 60% of total material cost after 2011.
Jade Manufacturing also has two additional costs:
(1) CEO salary $250,000 per year and
(2) Headquarters housekeeping costs per year
These two costs listed above are not included by Jade in the costs allocated to the Materials Receiving and Handling Department.
a. Describe the current overhead cost allocation system used by the Material Receiving and Handling Department and identify its weaknesses.
b. Compute the budgeted material handling rate presently used at Jade Manufacturing.
2. Changing from the previous cost driver (percentage of direct material dollar value) to a per purchase order cost driver is Sam's first step to adopting Activity Based Costing (ABC). Sam would like to implement ABC for the company in all cost areas, where this first change in cost drivers illustrates the effects. In order to present a logical argument to the CEO for changing the cost driver, Sam asks you to assist with the following:
a. Compute the material handling costs to be allocated on a per purchase order basis for Jade Manufacturing.
b. For Gantz, compute the difference in using the new method of allocating material handling costs compared to the prior method, which was based on percentage of direct material dollar value.
c. For Gantz, prepare a forecast for 2011, 2012 and 2013 to calculate the cumulative dollar effect from using the cost per purchase order allocation method compared to the percentage of direct material dollar value method.