Air Dream Products has contracted with you to analyze and update its costing and pricing practices. The company's product line has changed over time from general air conditioning units to customizable mini-split units. Although some large orders are received, the majority of business is now generated from products designed and produced in small lots in order to meet specific detailed environmental and technical standards. The company has experienced increased overhead growth, including costs in customer service, production scheduling, inventory control and laboratory work. Overhead has doubled since the shift in product lines and management believes that the larger orders are being penalized, while smaller orders are receiving favorable cost and selling price treatment.Required:1. Why

Question

would the shift in product lines have caused such major increases in overhead?2. Is it possible that management is correct in its belief about the costs of the large and small orders and, if so, why?3. Write a memo to management suggesting how it might change the cost accounting system to reflect the changes in the business.

What will be an ideal response?

Answer 1

1. It is possible that as variety in products increases, costs will also increase. Therefore, the shift to small special orders will increase costs in purchasing (more orders, more calls to get prices, more space required for catalogs, etc.), receiving (more orders and receipts to handle and account for), storage (different products must be grouped together and differentiated from other products for easy accessibility), accounting (more inventory to account for, potentially more suppliers to pay), customer service (new larger catalogs, possible complaints from customers receiving wrong or slightly wrong orders, more time for sales calls), production scheduling (variety in setups, increase in movement of materials depending on production run), and laboratory work (research and development tests incurred to make certain that the products meet the appropriate environmental and technical requirements).

2. It is definitely possible that management is correct because total overhead costs are typically allocated to products based on some single allocation base such as direct labor hours or machine hours. These single allocation bases do not reflect the actual cause-and-effect relationships between cost drivers and overhead costs.

3. Student submissions will vary. However, the memo should suggest that management consider the use of multiple overhead allocation bases and activity-based costing. This method of overhead allocation attempts to more fairly attach costs to the products and/or services that actually caused the costs to be incurred.