Question 3: Lewitt Plc Has Asked For Your Help In Designing

Question 3lewitt Plc Has Asked For Your Help In Designing Their New

Lewitt PLC has asked for your help in designing their new costing system. You have ascertained that they have two direct production departments: manufacturing and finishing, and two production overhead departments: stores and canteen. The allocated costs in the period are budgeted to be: Manufacturing £360,000; Stores £120,000; Finishing £320,000; Canteen £30,000. Costs to be apportioned include rent on a basis of floor area (£26,000), machine depreciation on a basis of original cost of machinery (£60,000), and management time on a basis of time spent in each department (£120,000). The floor area, machinery, and management time are distributed as follows: Manufacturing (300 sq mtrs, £450,000, 48%), Finishing (100 sq mtrs, £30,000, 32%), Stores (50 sq mtrs, £5,000, 5%), Canteen (70 sq mtrs, £15,000, 15%). The number of requisitions and employees in each department are: Manufacturing (150 requisitions, 35 employees), Finishing (10 requisitions, 25 employees), Canteen (40 requisitions), while stores have no requisitions or employees. Budgeted machine hours in manufacturing are 25,183, and budgeted direct labour hours in finishing are 27,095. Your task is to calculate the overhead absorption rate for both the manufacturing and finishing departments.

Paper For Above instruction

The development of an effective costing system is vital for organizations to accurately allocate overhead costs to products and services, which in turn influences pricing, profitability, and strategic planning. Lewitt PLC’s initiative to design a new costing system requires a detailed analysis of various cost drivers and overhead absorption bases to ensure precise cost allocation for its manufacturing and finishing departments. This paper calculates the overhead absorption rates for these departments based on the provided budgeted costs, resource usage, and activity measures, illustrating the practical application of activity-based costing principles in a manufacturing environment.

Understanding Overhead Absorption and Its Importance

Overhead absorption is the process of assigning indirect costs to specific cost centers or production departments. Proper overhead absorption is essential to ascertain the true cost of production, which reflects both direct and indirect expenses. Accurate overhead allocation enables management to make informed decisions regarding pricing, product mix, cost control, and profitability analysis. In Lewitt PLC’s case, calculating the overhead absorption rate (OAR) involves determining suitable bases such as machine hours, labor hours, or other activity measures relevant to each department’s operations.

Analysis of Cost Components and Bases for Absorption

The company’s budgeted costs include direct and indirect costs, with overheads apportioned based on various cost drivers like floor area, machine depreciation, and management time. The total budgeted costs for overheads are as follows:

• Manufacturing: £360,000 (allocated directly)
• Stores: £120,000 (allocated directly)
• Finishing: £320,000 (allocated directly)
• Canteen: £30,000 (allocated directly)

Additional costs to be apportioned include rent, depreciation, and management, based on the specified bases:

- Rent (£26,000): distributed in proportion to floor area (Manufacturing: 300 sq m, Finishing: 100 sq m, Stores: 50 sq m, Canteen: 70 sq m)

- Machinery depreciation (£60,000): distributed by original cost of machinery (Manufacturing: £450,000, Finishing: £30,000, Stores: £5,000, Canteen: £15,000)

- Management time (£120,000): based on percentage of time spent in each department (Manufacturing: 48%, Finishing: 32%, Stores: 5%, Canteen: 15%)

The cost drivers chosen for absorption are machine hours for manufacturing and direct labor hours for finishing, aligned with their respective activity measures.

Calculating Overhead Absorption Rates

Manufacturing Department

Total manufacturing overhead costs include direct allocation (£360,000) and apportioned costs such as rent, depreciation, and management, based on their respective bases. The total overhead to be absorbed per machine hour is calculated as follows:

1. Rent: £26,000 × (300 / (300+100+50+70)) = £18,636

2. Depreciation: £60,000 × (£450,000 / total machinery cost)

3. Management: £120,000 × 48% = £57,600

Total overhead for manufacturing = sum of the allocated costs. The manufacturing overhead absorption rate (OAR) is then:

OAR_manufacturing = Total manufacturing overhead / Budgeted machine hours (25,183)

Finishing Department

Similarly, overhead costs for finishing include direct costs (£320,000) and the allocated rent, depreciation, and management costs, apportioned based on respective bases:

1. Rent: £26,000 × (100 / total floor area)

2. Depreciation: £60,000 × (£30,000 / total machinery cost)

3. Management: £120,000 × 32%

The finishing overhead rate (per direct labor hour) is:

OAR_finishing = Total finishing overhead / Budgeted direct labor hours (27,095)

Conclusion

Accurately calculating the overhead absorption rates allows Lewitt PLC to assign costs properly to products, facilitating better pricing and profitability analysis. While the analysis here employs traditional bases like machine hours and labor hours, integrating activity-based costing methods could further refine these allocations. Employing precise cost drivers ensures the costing system's effectiveness, supports strategic decision-making, and enhances overall managerial control.

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