Manufacturing Overhead And Cost Allocation In Borealis Manuf

Manufacturing Overhead and Cost Allocation in Borealis Manufacturing

Borealis Manufacturing recently implemented a significant upgrade to its quality control (QC) process by replacing manual inspection with a computerized video QC system. This transition involved substantial capital investment and a shift in cost structure concerning quality control activities. The company's management faces questions about the impact of this change on manufacturing overhead, cost allocation, and overall financial performance. This paper aims to clarify key concepts related to manufacturing overhead, elaborate on the use of predetermined overhead rates, analyze the implications of the increased overhead rate, suggest improvements in cost allocation systems, and explore the potential benefits of adopting activity-based costing (ABC) in Borealis Manufacturing.

Definition of Manufacturing Overhead

Manufacturing overhead encompasses all indirect manufacturing costs that are incurred during the production process but cannot be directly traced to specific products. These expenses are essential for the manufacturing operation to occur, yet they do not directly become part of the product's physical components. Overhead costs are allocated to products through various cost assignment methods, usually based on a predetermined overhead rate established prior to production.

Examples of Manufacturing Overhead

  1. Factory Utilities: Expenses related to electricity, water, and heating necessary to operate the manufacturing facilities.
  2. Depreciation on Manufacturing Equipment: The allocated cost of equipment used in production, representing wear and tear over time.
  3. Maintenance and Repairs: Costs incurred for upkeep and repairs of machinery and equipment to ensure smooth operation.

Reasons for Developing Predetermined Overhead Rates

Manufacturing companies develop predetermined overhead rates primarily to allocate indirect costs systematically and consistently to products during the production process. These rates are set before the production period begins based on estimated costs and activity levels. The main reasons include:

  • Cost Control and Planning: Predetermined rates facilitate budgeting and control by providing a standardized method for assigning overhead costs to products throughout the year.
  • Accurate Pricing Decisions: They enable management to estimate product costs accurately, which is critical for setting competitive prices.
  • Efficient Cost Allocation: Using a predetermined rate allows for continuous cost assignment without waiting until actual expenses are incurred, thus supporting timely financial reporting.

Impact of Increased Overhead Rate on Borealis Manufacturing

Although the new QC system has enhanced efficiency by reducing manual inspectors from ten to two, the company's overhead rate has risen from 190% to 300%. This apparent increase often raises concerns about profitability and cost competitiveness. However, this situation does not necessarily carry negative financial consequences. The key is understanding that the increase results mainly from capital expenditure on the new system and the manner of allocating these costs. Since the new system's operating costs are treated as factory overhead, capital costs like the $250,000 investment are spread over production volumes, increasing the overhead base and thus raising the percentage rate.

Moreover, the higher overhead rate reflects a shift toward more automation and indirect costs rather than increased total costs. If total costs are controlled and productivity improves, the overall profitability may not be adversely impacted. Essentially, the rise in the overhead rate is a bookkeeping and allocation phenomenon rather than a direct indicator of increased production costs or reduced profitability.

Adjusting the Overhead Allocation System at Borealis Manufacturing

To reduce confusion and improve accuracy in product costing, Borealis Manufacturing could adopt several strategies. Firstly, implementing more precise cost tracking mechanisms that distinguish between different types of overhead costs can improve the allocation process. Transitioning from a single plant-wide overhead rate to multiple departmental or activity-specific rates can reflect the actual consumption of overhead resources more accurately.

Secondly, using operational data to adjust the course of overhead assignment regularly ensures that cost allocations remain relevant as production processes evolve. This may involve adopting a systematic review of cost drivers and updating overhead rates quarterly or semi-annually instead of relying solely on annual estimates. Such measures will enhance transparency and help management make more informed decisions based on more accurate cost data.

The Benefits of Activity-Based Costing for Borealis Manufacturing

Adopting activity-based costing (ABC) could significantly enhance Borealis Manufacturing’s cost management. ABC assigns overhead costs based on specific activities that drive costs, such as machine setups, quality inspections, or material handling. This finer granularity allows for more precise product cost calculation, enabling management to identify high-cost activities and target them for process improvements.

In the context of Borealis Manufacturing, where quality control has shifted from manual inspection to automated video systems, ABC can help distinguish between costs associated with different quality processes and identify inefficiencies. For instance, the costs of maintaining the video QC system can be allocated based on actual usage patterns rather than broad activity pools, providing insights into the true cost drivers. Consequently, ABC enhances decision-making related to product pricing, process improvements, and resource allocation, eventually leading to cost reductions and improved profitability.

Furthermore, ABC supports strategic initiatives such as product line profitability analysis and customer profitability analysis, equipping Borealis Manufacturing to make data-driven decisions in competitive markets.

Conclusion

Understanding and managing manufacturing overhead is vital for accurate product costing and financial decision-making. Borealis Manufacturing’s adoption of a new QC system has shifted the nature and scale of overhead costs, leading to an increased overhead rate that might seem alarming but is primarily an accounting phenomenon. Carefully designing overhead application systems, potentially moving to activity-based costing, can provide more accurate insights into product costs, supporting strategic and operational improvements. Ultimately, these measures can enhance the company’s competitiveness and profitability in a demanding manufacturing environment.

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