Aerospace, Inc., manufactures parts such as rudder hinges for the aerospace industry. The company uses a job- order costing system with a predetermined plantwide overhead rate based on direct labor hours. On December 10, 2017, the company’s controller made a preliminary estimate of the predetermined overhead rate for the year 2018. The new rate was $75 per direct labor hour, based on the estimated total manufacturing overhead cost of $3,750,000 ($3,250,000 fixed; $500,000 variable) and the estimated 50,000 total direct labor hours for 2018. This new predetermined overhead rate was communicated to top managers in a meeting on December 20. The rate did not cause any comment because it was within a few pennies of the overhead rate that had been used during 2017. One of the subjects discussed at the meeting was a proposal by the production manager to lease an automated milling machine built by Sunghi Industries. The president of Kelvin Aerospace, Harry Arcany, agreed to meet with the sales representative from Sunghi Industries to discuss the proposal. On the day following the meeting, Mr. Arcany met with Jasmine Chang, Sunghi Industries’ sales representative. The following discussion took place:
Arcany: Wally, our production manager, asked me to meet with you because he is interested in installing an automated milling machine. Frankly, I’m skeptical. You’re going to have to show me this isn’t just another expensive toy for Wally’s people to play with.
Chang: This is a great machine with direct bottom-line benefits. The automated milling machine has three major advantages. First, it is much faster than the manual methods you are using. It can process about twice as many parts per hour as your present milling machines. Second, it is much more flexible. There are some up-front programming costs, but once those have been incurred, almost no setup is required to run a standard operation. You just punch in the code for the standard operation, load the machine’s hopper with raw material, and the machine does the rest.
Arcany: What about cost? Having twice the capacity in the milling machine area won’t do us much good. That center is idle much of the time anyway.
Chang: I was getting there. The third advantage of the automated milling machine is lower cost. Wally and I looked over your present operations, and we estimated that the automated equipment would eliminate the need for about 12,000 direct labor hours a year. What is your direct labor cost per hour?
Arcany: The wage rate in the milling area averages about $30 per hour. Fringe benefits raise that figure to about $40 per hour.
Chang: Don’t forget your overhead.
Arcany: Next year the overhead rate will be $75 per hour.
Chang: So including fringe benefits and overhead, the cost per direct labor hour is about $115.
Arcany: That’s right.
Chang: Since you can save 12,000 direct labor hours per year, the cost savings would amount to about $1,380,000 a year. And our 60-month lease plan would require payments of only $500,000 per year.
Shortly after this meeting, Mr. Arcany asked the company’s controller for a recommendation on whether the new machine should be leased. The controller realized that if the machine is leased a recomputation of the overhead rate for the year 2018 would be required because the decision would affect both the manufacturing overhead and the direct labor hours for the year. After talking with both the production manager and the sales representative from Sunghi Industries, the controller discovered that in addition to the annual lease cost of $500,000, the new machine would also require a skilled technician/programmer who would have to be hired at a cost of $70,000 per year to maintain and program the equipment. Both of these costs would be included in factory overhead. The controller assumed that the new machine would result in a reduction of 12,000 direct labor hours for the year from the levels that had initially been planned. The reduction in direct labor hours is expected to mainly result from attrition, but some layoffs would likely be necessary. When the revised predetermined overhead rate for the year 2018 was circulated among the company’s top managers, there was considerable dismay.
Required:
Provide a recommendation as to whether the lease of the new machine should be approved and show how you came to the conclusion.