Byp17 2: Ideal Manufacturing Company Of Sycamore Illinois

Byp17 2 Ideal Manufacturing Company Of Sycamore Illinois Has Support

Ideal Manufacturing Company of Sycamore, Illinois, has historically relied on its research and development (R&D) department as the sole contributor to its new farm machinery products. The R&D activity is an overhead cost center that exclusively provides services to in-house manufacturing departments, encompassing four different product lines that produce agricultural, farm, and ranch-related machinery. Although the department has never sold its services externally, larger agricultural equipment manufacturers have recently approached Ideal seeking to hire the R&D department for special projects. With R&D operating costs spiraling uncontrollably, management is considering offering these services to outside clients to offset costs. However, management faces two key issues: first, a lack of a cost basis to appropriately charge outsiders, and second, a need to better control and understand R&D expenses.

To address these issues, management has decided to implement an activity-based costing (ABC) system to accurately allocate R&D costs to both internal and external users. The ABC approach involves identifying the specific activities that incur costs and assigning these costs based on the actual consumption of resources, which provides a more precise cost allocation compared to traditional methods.

Paper For Above instruction

The adoption of activity-based costing (ABC) by Ideal Manufacturing Company represents a strategic move aimed at improving cost management and establishing a fair pricing structure for both internal and external R&D services. ABC is an approach that assigns overhead costs to activities based on their consumption of resources and subsequently allocates these costs to products or clients based on their actual usage of those activities. This methodology is particularly valuable in service departments like R&D, where overhead costs are a significant component and where activities are diverse and complex.

Initially, the R&D department’s costs are broken into four activity pools: market analysis, product design, product development, and prototype testing. Each activity pool has an associated total annual cost: $1,050,000 for market analysis, $2,350,000 for product design, $3,600,000 for product development, and $1,400,000 for prototype testing. To effectively allocate these costs, activity analysis identifies the appropriate cost drivers and estimated usage for each activity: hours of analysis for market analysis, number of designs for product design, number of products for product development, and number of tests for prototype testing.

Calculation of Activity-Based Overhead Rates

To facilitate cost allocation, the activity-based overhead rate for each activity pool is computed by dividing the total activity cost by its estimated driver volume:

• Market analysis rate = $1,050,000 / 15,000 hours = $70 per analysis hour
• Product design rate = $2,350,000 / 2,500 designs = $940 per design
• Product development rate = $3,600,000 / 90 products = $40,000 per product
• Prototype testing rate = $1,400,000 / 500 tests = $2,800 per test

These rates serve as the basis to calculate the costs allocated to specific projects or departments according to their consumption of each activity.

Cost Allocation for In-House Manufacturing Department

Suppose an in-house manufacturing department consumes 1,800 hours of market analysis, 280 designs relating to 10 products, and requests 92 engineering tests. The total activity costs allocated are calculated by multiplying the activity rate by the respective activity usage:

• Market analysis cost = 1,800 hours x $70/hour = $126,000
• Product design cost = 280 designs x $940/design = $263,200
• Product development cost = 10 products x $40,000/product = $400,000
• Prototype testing cost = 92 tests x $2,800/test = $257,600

The total cost allocated to the internal department sums to $1,046,000, which reflects a fair and precise allocation based on actual activity consumption.

Cost Basis for External R&D Bid

Similarly, for an external company engaging the R&D department, suppose the project consumes 800 hours of analysis, involves 178 designs related to 3 products, and requires 70 tests. The allocated costs are:

• Market analysis = 800 hours x $70/hour = $56,000
• Design costs = 178 designs x $940/design = $167,320
• Product development = 3 products x $40,000/product = $120,000
• Prototype testing = 70 tests x $2,800/test = $196,000

The total bid price, reflecting the costs incurred, would be $539,320. This provides a transparent and justifiable basis for pricing external projects while covering costs and generating potentially profit.

Benefits of Applying Activity-Based Costing

The implementation of ABC offers numerous advantages for Ideal Manufacturing. Foremost, it enhances the accuracy of cost allocation by linking indirect costs to specific activities, thereby providing a clearer picture of where resources are consumed. This detailed understanding enables management to identify cost-saving opportunities and improve operational efficiency. Moreover, ABC facilitates more accurate pricing strategies for both internal and external projects, reducing the risk of under or overpricing services. It also supports decision-making related to process improvements by highlighting high-cost activities and areas for potential redesign.

By precisely allocating R&D costs, Ideal Manufacturing can establish fair and competitive charges for external clients, ensuring the sustainability of the department while controlling internal costs. The transparency of ABC encourages better management of resource utilization and can lead to innovations in process efficiencies, ultimately reducing total R&D expenditure. In addition, ABC allows the company to evaluate the profitability of different projects, guiding strategic decisions about resource investment.

Furthermore, the insights gained from activity analysis enable the company to develop cost-saving initiatives and prioritize projects that align with strategic goals. The ability to link costs directly to activities also improves accountability across departments. Overall, implementing activity-based costing fosters a culture of cost consciousness and continuous improvement, vital for long-term competitiveness in the industry.

Conclusion

In conclusion, the adoption of activity-based costing by Ideal Manufacturing provides a robust framework for accurately allocating R&D overhead costs. This method supports fair pricing for external projects, enhances internal cost control, and offers valuable insights for strategic decision-making. Transitioning to ABC positions Ideal Manufacturing to better manage its resources, optimize operational efficiency, and sustain its competitive advantage in the agricultural machinery sector.

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