Explain How Borealis Manufacturing Could Change Its Overhead

Explain how Borealis Manufacturing could change its overhead application system to

Borealis Manufacturing has recently implemented a new computerized video quality control (QC) system that has significantly altered its approach to manufacturing overhead allocation. This change has brought about confusion regarding the high overhead rate despite apparent improvements in operational efficiency. To address these issues, it is essential to understand the concept of manufacturing overhead, why companies develop predetermined overhead rates, and how modifications to the overhead allocation system—and the potential application of activity-based costing—could benefit Borealis Manufacturing.

Definition of Manufacturing Overhead and Examples

Manufacturing overhead refers to all manufacturing costs that are not directly traceable to specific products or jobs, but are necessary for the production process. These costs include indirect materials, indirect labor, and other factory-related expenses that support manufacturing activities but are not directly tied to any one unit of production. Examples of typical manufacturing overhead costs include:

• Depreciation on factory equipment and facilities
• Factory utility expenses, such as electricity and water used in manufacturing operations
• Factory maintenance and repairs, including costs associated with equipment upkeep and facility repairs

These costs collectively contribute to the overall manufacturing expenses that are allocated to products based on a predetermined rate or activity-based costs, rather than direct labor or direct materials costs alone.

Why Companies Develop Predetermined Overhead Rates

Companies develop predetermined overhead rates to facilitate consistent and probable cost allocation during a specific period, typically a fiscal year. The primary reasons include:

• Budgeting and planning: Predetermined rates allow companies to estimate production costs accurately and set appropriate selling prices.
• Cost control: By establishing a standard rate upfront, management can compare actual overhead incurred with the predicted rate to assess operational efficiency.
• Simplified accounting: Using a fixed rate simplifies bookkeeping and cost accumulation, especially when actual overhead fluctuates throughout the period.

These rates essentially serve as a standard or benchmark, enabling businesses to allocate overhead costs systematically and consistently across products and departments (Cokins, 2010).

Impact of Overhead Rate Increase on Borealis Manufacturing's Financials

Though Borealis Manufacturing's overhead rate has increased from 190% to 300%, this does not necessarily indicate a negative financial impact. The notable increase in the rate results from the allocation of higher overhead costs, primarily driven by the capital investment in the new QC system and its associated costs, which have been included in factory overhead. The rise in the overhead rate should not directly translate to higher product costs if the allocation system is accurate and reflects true resource consumption.

Moreover, the new system's efficiencies—such as reduced labor costs for QC inspectors—may offset the higher overhead allocation. It is crucial to understand that the overhead rate is a budgeting and allocation tool, not a direct measure of profitability or cost per unit. Proper cost management, analysis, and pricing strategies ensure that the higher rate does not adversely affect competitiveness or profitability (Drury, 2013).

Changing Borealis Manufacturing's Overhead Allocation System

To eliminate confusion over product costs and enhance cost accuracy, Borealis Manufacturing could adopt a more refined overhead application system. This can involve:

• Implementing a departmental or activity-based costing (ABC) system to better trace overhead costs to products based on actual consumption of activities.
• Segmenting overhead costs into different activity pools, such as machine setups, quality inspections, or maintenance, and allocating costs based on relevant cost drivers.
• Collecting detailed data on the activities contributing to overhead costs and using these to assign costs proportionally to products, leading to more accurate product costing.

Such approaches help in aligning overhead costs more closely with actual resource utilization, minimizing cross-subsidization, and providing clearer insights into product profitability (Cooper & Kaplan, 1991).

The Potential Benefits of Activity-Based Costing for Borealis Manufacturing

Adopting an activity-based costing (ABC) system could offer several significant advantages for Borealis Manufacturing. ABC provides a more precise method of allocating overhead costs by focusing on the activities that drive expenses rather than broad-based rates. The benefits include:

• Enhanced cost accuracy: ABC identifies cost drivers linked to specific activities, leading to more accurate product costing and profitability analysis (Kaplan & Anderson, 2004).
• Better resource management: By understanding which activities consume the most resources, management can target process improvements and cost reduction initiatives more effectively.
• Improved pricing decisions: Accurate product costs allow for more informed pricing strategies, ensuring products are competitively priced while maintaining profitability.
• Identifying non-value-added activities: ABC highlights processes that do not add value, enabling organizations to streamline operations and eliminate waste.
• Facilitating strategic decisions: ABC can support decisions related to product mix, outsourcing, and process improvements by providing detailed cost insights.

Overall, transitioning to ABC could help Borealis Manufacturing better understand its cost structure, optimize resource utilization, and strengthen its competitive position in the marketplace.

Conclusion

In conclusion, Borealis Manufacturing's recent implementation of a computerized video QC system and subsequent change in overhead costs and rates underscore the importance of accurate and strategic overhead management. Understanding that manufacturing overhead encompasses indirect costs such as depreciation, utilities, and repairs clarifies the nature of the costs involved. Developing predetermined overhead rates facilitates operational planning but must be carefully managed to ensure accurate cost allocations. The apparent increase in overhead rate should not negatively impact the company's finances if correctly interpreted and managed.

Furthermore, shifting toward a more refined overhead allocation system, such as activity-based costing, can significantly improve cost accuracy, provide actionable insights, and support better decision-making. By adopting ABC, Borealis Manufacturing can achieve a more precise understanding of product costs, leading to improved pricing, profitability, and competitiveness in the dynamic manufacturing landscape.

References

• Cooper, R., & Kaplan, R. S. (1991). The Design of Cost Management Systems: Text, Cases, and Readings. Prentice Hall.
• Cokins, G. (2010). Cost Management: Strategies for Business Decisions. Pearson Education.
• Drury, C. (2013). Management and Cost Accounting. Cengage Learning.
• Kaplan, R. S., & Anderson, S. R. (2004). Time-Driven Activity-Based Costing. Harvard Business Review, 82(11), 131-138.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting. McGraw-Hill Education.
• Horngren, C. T., Datar, S. M., & Rajan, M. (2015). Cost Accounting: A Managerial Emphasis. Pearson Education.
• Blocher, E., Stout, D., Juras, P., & Cokins, G. (2019). Cost Management: A Strategic Emphasis. McGraw-Hill Education.
• Anthony, R., & Govindarajan, V. (2014). Management Control Systems. McGraw-Hill Education.
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• Kaplan, R. S., & Anderson, S. R. (2007). The Integrated Cost System. Harvard Business School Publishing.