Case Study - Valdosta Vinyl Company (VVC)
John Patrick has recently been hired as controller of Valdosta Vinyl Company (VVC), a manufacturer of vinyl siding, used in residential construction. VVC has been in the vinyl siding business for many years and is currently investigating ways to modernise its manufacturing process. At the first staff meeting Patrick attended, Jack Kielshesky, chief engineer, presented a proposal for automating the Moulding Department. Kielshesky recommended that the company purchase two robots that would have the capability of replacing the eight direct labour employees in the department. The cost savings outlined in the proposal include the elimination of direct labour costs in the Moulding Department plus a reduction of manufacturing overhead cost in the department to zero because VVC charges manufacturing overhead on the basis of direct labour dollars using a plantwide rate. The president of VVC was puzzled by Kielshesky's explanation: 'This just doesn't make any sense. How can a department's overhead rate drop to zero by adding expensive, high tech manufacturing equipment? If anything, it seems like the rate ought to go up.'
Kielshesky responded by saying 'I'm an engineer, not an accountant. But if we're charging overhead on the basis of direct labour, and we eliminate the labour, then we eliminate the overhead.'
Patrick agreed with the president. He explained that as firms become more automated, they should rethink their product costing systems. The president then asked Patrick to look into the matter and prepare a report for the next staff meeting. Patrick gathered the following data on the manufacturing overhead rates experienced by VVC over the years. Patrick also wanted to have some departmental data to present at the meeting, and by using VVC's accounting records, he was able to estimate the following annual averages for each manufacturing department over the five decades since VVC's formation.
|
Decade
|
Average annual manufacturing overhead cost
|
Average annual direct labour cost
|
Average manufacturing overhead application rate
|
|
1st
|
$2 200 000
|
$2 000 000
|
110%
|
|
2nd
|
$6 240 000
|
$2 400 000
|
260%
|
|
3rd
|
$13 600 000
|
$4 000 000
|
340%
|
|
4th
|
$24 600 000
|
$6 000 000
|
410%
|
|
5th
|
$38 710 000
|
$7 900 000
|
490%
|
|
Annual average costs during recent years
|
|
Cutting department
|
Finishing department
|
Moulding department
|
|
Manufacturing
|
$22 000 000
|
$14 000 000
|
$4 000 000
|
|
overhead
|
|
|
|
|
Direct labour
|
$4 000 000
|
$3 500 000
|
$500 000
|
Reference: Langfield-Smith, K., H. Thorne and R. Hilton (2015). Management Accounting: Information for creating and managing value, 7th edition. McGraw Hill Education (Australia) North Ryde NSw
Question -
1. Limitations/shortcomings of traditional approaches to overhead cost allocation (200 words).
2. Contemporary approach to overhead cost allocation (Activity Based Costing) (200 words).