Tonya Martin, CMA and controller of the Parts Division of Gunderson, Inc., was meeting with Doug Adams, manager of the division. The topic of discussion was the assignment of overhead costs to jobs and their impact on the division's pricing decisions. Their conversation is presented below.
Tonya: Doug, as you know, about 25% of our business is based on government contracts, with the other 75% based on jobs from private sources won through bidding. During the last several years, our private business has declined. We have been losing more bids than usual. After some careful investigation, I have concluded that we are overpricing some jobs because of improper assignment of overhead costs. Some jobs are being underpriced. Unfortunately, the jobs being overpriced are coming from our higher-volume, labor-intensive products; thus we are losing business.
Doug: I think I understand. Jobs associated with our high volume products are being assigned more overhead than they should be receiving. Then, when we add our standard 40% mark-up, we end up with a higher price than our competitors, who assign costs more accurately.
Tonya: Exactly. We have two producing departments, one labor intensive and the other machine intensive. The labor-intensive department generates much less overhead than the machine-intensive department. Further, virtually all of our high-volume jobs are labor intensive. We have been using a plantwide rate based on direct-labor hours to assign overhead to all jobs. As a result, the high-volume, labor-intensive jobs receive a greater share of the machine-intensive department's overhead than they deserve. This problem can be greatly alleviated by switching to departmental overhead rates. For example, an average high-volume job would be assigned $100,000 of overhead using a plantwide rate and only $70,000 using departmental rates. The change would lower our bidding price on high-volume jobs by an average of $42,000 per job. By increasing the accuracy of our product costing, we can make better pricing decisions and win back much of our private-sector business.
Doug: Hold it. I just thought of a possible complication. As I recall, most of our new government contract work is done in the labor-intensive department. This new overhead assignment scheme will push down the costs on our government jobs. The government pays us full cost plus our standard mark-up. This business is not threatened by our current costing procedures, but we can't switch our rates only for the private business. Government auditors would question the lack of consistency in our costing procedures. Officially, let's keep our plantwide overhead rate. All of the official records will reflect this overhead costing approach for both our private-sector and government business. Unofficially, I want you to develop a separate set of books that can be used to generate the information we need to prepare competitive bids for our private sector business.
1. Do you believe that the solution proposed by Doug Adams is ethical? Explain.
2. Suppose that, despite Tonya's objections, Doug insists strongly on implementing the action. What should Tonya do?