INTERNATIONAL ACCOUNTING AND FINANCE

International Accounting and Finance

International Accounting and Finance

Part 1

The case study deals with the controversial and addresses a subject where the beliefs run counter to common practice. Overhead and overhead-cost recovery is the main concern in the case study.

Two principles are important when deciding how to account for and manage overhead costs associated with running an equipment fleet(Mitchell 1994 261-77).

Overhead cost must be reduced to the absolute minimum. Every cost should be assigned to direct codes whenever possible. Fuel trucks can form a part of the direct cost of fueling, and lowboys can be charged to jobs benefiting from their service. Classifying cost as overhead should be seen as an absolute last resort.

Mechanisms for generating overhead cost recoveries must be tied to easily identified, measurable and desired outputs. An output such as shop labor makes sense for a dealer's shop where labor sold is the output. It doesn't make sense in a contractor's shop where labor is an input. Contractor shops should instead tie overhead recovery to outputs such as total equipment revenue so that improvements in utilization, availability and reliability result in corresponding improvements in overhead cost recovery.

The difference between tying overhead cost recovery to either labor or equipment revenue is best explained by the example in the accompanying table. Total annual cost for owning and operating the fleet is $5.6 million with an anticipated gain of $70,000 based on the assumption that the fleet will work 95,000 hours at an average rate of $65 per hour. Labor cost is based on 16,200 labor hours at a rate of $47.54. The $320,000 in overhead covers rent, facilities utilities, indirect labor and miscellaneous supplies(Cooper 1990 pp.34-39).

Recovering overhead as a percentage of labor, as is done in dealer shops and in many contractor shops, is a simple process. Overhead costs is recovered at a rate of $19.75 per labor hour ($320,000 ÷ 16,200), which when added to the $47.54 labor rate, results in a rate of $67.29 per hour.

Tying overhead to equipment revenues can be done in a number of ways. For our purposes, let's calculate overhead cost recovery at a flat rate of $3.37 per machine hour ($320,000 ÷ 95,000) with the balance of $61.63 ($65 - $3.37) available to recover the direct owning and operating costs.

In the labor scenario, let's assume that training and technology have enabled the company to improve labor efficiency and to reduce the required labor hours from 16,200 to 14,200. There will be an immediate gain of $95,080 (2,000 hours saved at $47.54 per hour) in direct labor, but the overhead budget will be short by $39,500 (2,000 hours saved at $19.75 overhead recovery per hour). It is counter-intuitive to have an improvement in training and technology result in a negative impact on overhead recovery. Not the situation you want to encourage.

Question 2

Activity Based System costs of standard and specialist products

Product costs include direct materials, direct labor, and overhead. It's easy to determine the direct costs for an individual ...