Q1.

The overhead allocation rate used in the 1987 model year strategy study at the ACF was 435% of
direct labor cost. Calculate the overhead allocation rate using the 1987 model year budget. Why do you
get different numbers?

1987 model year budget:

Total direct labor costs: 24,682,000
Total overhead costs: 107,956,000
Overhead allocation rate: 107,956,000/24,682,000 = 437.38%

Because the overhead costs may be pessimistic during the budget or some of the direct costs may be
classified as overhead costs.

Q2. Calculate the overhead allocation rate for each of the model years, 1988 through 1990. Are the
changes since 1987 in overhead allocation rates significant? Why have these changes occurred?

Yes, the overhead allocation rates are higher in 89 and 90.

Some products were outsourced, which reduced both the dirt labor costs as well as overhead costs as due
to loss of 60 direct labor and 30 indirect labors. This shows that the remaining product groups Fuel tanks,
manifolds, and oil pans have more overhead costs than doors and muffler/exhausts.

Q3. Calculate the expected gross margins as a % of selling price on each product based on the 88 and 90
model year budgets, assuming selling price and material and labor cost do not change from standard.

Item P1 P2
Selling price 62$ 54$
Standard material cost 16$ 27$
Standard labor cost 6$ 3$
Overhead in 88 26.04 13.02
… in 89 34.62 17.32
… in 90 33.78 16.39
Total expenses in 88 48.04 43.02
… in 89 56.62 47.32
… in 90 55.78 46.39
Gross profit in 88 13.96 10.98
… in 89 5.38 6.68
… in 90 6.22 7.61
Gross margin/sales in 88 22.51% 17.7%
… in 89 8.67% 12.3%
… in 90 10.03% 14.09%
Direct costs/total costs in 88 12.48% 6.9%
… in 89 10.6% 6.3%
… in 90 10.75% 6.46%

Q4. Are the product costs reported by the cost system appropriate for use in the strategic analysis?

The direct costs for product 1 were a little more than 10% but for product 2 they were less than 10%.
Since the direct costs were a small percentage of the total costs, the cost system is not appropriate to use
direct costs as the allocation is distorting the product costs.

Q5. Assume that the selling prices, volumes, and material costs for the 91 model year will not change for
fuel tanks and doors produced by the ACF of Bridgeton Industries. Assume also that if manifolds are
produced, their selling prices, volume, and material costs will not change either.
a. Prepare an estimated model year budget for the ACF in 91
1) If no additional products are dropped.
The budget for the ACF in model year 91 is estimated. The total sales, direct labor and direct materials
costs remain same as of the year 90.
Assumptions: The product lines of ACF remains the same: fuel tanks, manifolds, and doors. The selling
prices, volume and material costs are not changed.
2) If the manifold product line is dropped.
Similarly, the budget for ACF in model year 91 is also estimated with little changes in assumptions.
Assumptions: One of three product lines dropped, i.e., Manifolds. The selling prices, volume, and
material costs of fuel tanks and doors do not change.

Explain any additional assumptions you make in preparing your estimated model year budgets.
The direct labor costs are increased in both the models by 4% of the preceding year direct labor costs.
This assumption is made based on the increase in direct labor costs in years from 87 to 90.
Similarly, the increase in the overhead costs in the model year budget estimation when there is no product
is dropped; overhead costs are increased in the year 91 based on % change in overhead from 89 to 90.
However, the % increase in the overhead costs in the model year budget estimation when product line of
manifolds is dropped, overhead costs are increased in the year 91 based on percentage change in overhead
from 88 to 89. The reason behind this assumption is that in the year 89 the dropping in the two product
lines approximately decrease the sales, materials, and labor cost at a same average rate as the decrease in
sales, materials and labor cost after the dropping of manifolds.

% Share of product line in total sales 88

Muffler Oil pans both
Sales 19% 23% 42%
Direct materials 23% 26% 50%
Direct labor 23% 26% 49%
Average 46.57%

% Share of manifold in total sales 90

Manifold
Sales 41%
Direct materials 51%
Direct labor 46%
Average 46%

As the average proportion is quite similar, it is assumed that dropping either two product lines or
manifolds will generate same affect in overhead costs.

b. Under Scenario 1 (no changes to product line), which assumes selling prices, volumes, material, and
direct labor costs remain unchanged, the overhead was kept burden at the 90 level of 563% of direct
labor, which assumes that no new efficiencies in overhead costs are achieved in 91. Under this scenario, if
Bridgeton continues internal production of its manifold line at the ACF plant, total revenue will remain at
$226,542, direct materials cost at $69,546, and direct labor costs at $14,102. In 91, factory profit would
be $63,501 with a gross margin of 28%.
Under Scenario 2, where manifold production is outsourced, we assume selling prices, volumes, and
material cost for fuel tanks and doors remain the same. Direct material and labor costs for manifolds
would no longer be incurred. Outsourcing the production of the manifold line would result in total
revenue of $133,422, direct material costs at $33,821, and direct labor costs at $7,562.
The first step in determining factory profit and gross margin under Scenario 2 was to account for
overhead costs account changes. Overhead is applied as a % of direct labor costs. Direct labor costs
decreased by 46% from 88 to 89 from outsourcing muffler systems and oil pans. Under scenario 2,
outsourcing manifolds from 90 to 91 would also decrease direct labor costs by 46%.
The changes were estimated in overhead accounts from 88 to 89 (when direct labor decreased by 46%). It
is assumed that if the change in an overhead account is close to 46% (the change in direct labor costs
from outsourcing) then it may be considered a variable account. Where the change is not close to 46%, it
is assumed that the overhead account is fixed. Given these budget assumptions, it is possible to observe
that overhead accounts 2000, 3000, and 12000 are highly variable and decrease by about 46% with
outsourcing.
Under Scenario 2, where overhead is fixed (see analysis above), Bridgeton should use the same 90
overhead
cost. Where overhead is variable, Bridgeton should multiply their 90 overhead account balances by direct
labor ratio (total direct labor costs in 91/total direct labor costs in 90) to get the budgeted overhead costs
in 91. If manifolds were outsourced in 91, the overhead allocation rate based on direct labor costs would
be 855.7%; overhead costs would total $64,710; and factory profit would be $27, 329.
Using these overhead costs in our analysis, we determined that the total profit would be $27,329 in 91 if
manifolds were outsourced. If the ACF continues production of manifolds, its profit would be $63,501. If
the ACF continues producing manifolds, its overhead allocation rate would be 563%, which is the same
as the 90 rates, in contrast, the allocation rate would increase to 855.7% if the facility outsourced its
production of manifolds.

Q6. Personally, I would not outsource manifolds in 91, as this would make ACF less profitable, factory
profit would decrease. Even if manifold production is outsourced, ACF possesses a fixed overhead that
will transfer to the other product lines (fuel tanks and doors), making them less profitable. I think AFC
should apply diverse cost drivers, including machine hours, to few cost pools. This would provide a more
accurate estimate of manifold’s profitability and costs and allow for a more accurate identification of
product lines contributing the most to variable overhead costs. It would also allow for the development of
more competitive pricing among products. Lastly, when applying overhead, the cost of unused capacity
should be considered.