Kingsport Containers Ltd Of The Bahamas Experiences Wide Var

Kingsport Containers Ltd Of The Bahamas Experiences Wide Variation I

Kingsport Containers, Ltd, of the Bahamas experiences wide variation in demand for the 200-liter steel drums it fabricates. The leakproof, rustproof steel drums have a variety of uses from storing liquids and bulk materials to serving as makeshift musical instruments. The drums are made to order and are painted according to the customer's specifications—often in bright patterns and de-signs. The company is well known for the artwork that appears on its drums. Unit product costs are computed on a quarterly basis by dividing each quarter's manufacturing costs (materials, labor, and overhead) by the quarter's production in units.

The company's estimated costs, by quarter, for the coming year follow: Quarter Direct materials $240,000, $120,000, $64,000, $60,000, $32,000; Manufacturing overhead for each quarter totals $668,000. Number of units to be produced: 40,000, 20,000, 60,000, 40,000. Estimated unit product costs vary significantly between quarters, creating confusion. The company has noted that overhead costs are mostly fixed and sought a better method to assign manufacturing overhead to units, considering their fixed nature.

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In addressing the problem of wide variation in unit costs faced by Kingsport Containers Ltd., it is crucial to analyze the company's cost structure—particularly its manufacturing overhead—and recommend an appropriate costing method that reflects the fixed nature of these costs. The main issue stems from the current practice of applying overhead based on actual production levels, which leads to significant fluctuations in per-unit costs due to the fixed component of overhead.

Understanding the Nature of Manufacturing Overhead

Manufacturing overhead includes all indirect costs associated with production, such as utilities, depreciation, salaries of manufacturing supervisors, and maintenance costs. Based on the information provided, most of these costs are fixed, meaning they do not vary significantly with the level of production within the relevant range. Fixed costs, when allocated based on actual production, cause per-unit costs to fluctuate inversely with changes in output. For example, when production volume decreases, the fixed overhead is spread over fewer units, increasing per-unit costs; conversely, higher production levels reduce the per-unit overhead cost.

This fluctuation presents a challenge for managerial decision-making, costing accuracy, and pricing strategies. Therefore, a more appropriate method of assigning overhead should acknowledge the fixed nature of these costs, aiming to allocate them more consistently over the levels of activity.

Recommended Overhead Allocation Method

Given that the overheads are predominantly fixed, I recommend shifting from an actual cost-based or activity-based overhead allocation to a predetermined overhead rate based on a budgeted activity level. Specifically, the company should adopt a standard or predetermined overhead rate applied uniformly across all units produced, using a level of activity that approximates normal or expected production. This approach is consistent with normal costing systems, which recognize fixed costs as period expenses and allocate overhead based on a budgeted or normal activity level.

By using a predetermined overhead rate calculated at the beginning of the period based on estimated total overhead and estimated activity levels, the company establishes a consistent cost per unit, reducing the impact of fluctuations in actual production. The rate is then applied to actual or budgeted units to compute overhead costs allocated to products.

Computations of Predetermined Overhead Rate

To demonstrate, suppose the company estimates total manufacturing overhead at $668,000 for the upcoming year and predicts a total production volume of 160,000 units (sum of the quarterly units: 40,000 + 20,000 + 60,000 + 40,000). The predetermined overhead rate (POHR) would be:

POHR = Total estimated manufacturing overhead / Total estimated activity


= $668,000 / 160,000 units


= $4.175 per unit

This rate signifies that for each unit produced, $4.175 of overhead is allocated, irrespective of the actual quarterly production variation.

Advantages of the Predetermined Rate Approach

This method offers several benefits:

- Cost stability: Consistent per-unit overhead costs facilitate better budgeting, control, and decision-making.

- Reduced fluctuations: Eliminates the wide variation caused by fluctuating activity levels affecting overhead application.

- Enhanced comparability: Units produced in different quarters can be compared more reliably when allocated overheads are based on a fixed rate.

Implementation Considerations

The company must choose an appropriate level of activity for calculating the predetermined overhead rate—preferably a normal or expected production level that reflects average activity. It should update the rate periodically if production forecasts change significantly. Additionally, any over- or under-applied overhead at the end of the period should be adjusted to ensure accurate product costing.

Recalculation of Unit Product Costs

Using the recommended method, the company’s unit costs for each quarter can be recalculated based on the fixed rate:

- For the first quarter with 40,000 units:

Overhead per unit = $4.175

Material costs per unit = $240,000 / 40,000 = $6.00

Labour costs per unit (assuming a proportionate allocation) are to be recalculated, but since detailed labour costs are not provided, focus remains on overhead.

- Similar calculations apply to other quarters, maintaining the overhead allocation at $4.175 per unit, thus stabilizing unit costs across periods.

Conclusion

The primary cause of the observed variation in unit costs is the method of overhead application that allocates costs based on actual production, which varies significantly due to the fixed overhead component. By adopting a predetermined overhead rate derived from estimated annual overhead and normal activity levels, Kingsport Containers Ltd. can achieve more stable, predictable, and meaningful product costs. This approach aligns with managerial accounting principles for fixed cost behavior, enhances decision-making, and facilitates better cost control and profitability analysis.

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