Seligram Case Study

1. What caused the existing system at ETO to fail?

As we learned in chapter 7 initially,”… cost systems designs were simple…“(Brewster et.al, p. 236). The goal of the allocation process is to assign overhead in a manner that most appropriately reflects the cause /effect relationship of incurred costs. These cost systems were based on belief that there was a high correlation between direct labor hours and units produced (Brewster et. al, p. 237). ETO’s current cost system only factors in two of their cost components;” direct labor and burden” (Seligram, 1993 p.2 ) Burden is grouped into a single cost pool that includes costs associated with each of the testing rooms, engineering burden costs related to software and tooling development as well as administrative costs for the division.

The major assumption that caused ETO’s existing system to fail is that all costs are divided equally among direct labor costs and burden despite the variety of services. As described in the case study, components significantly varied in number and type of electrical and mechanical testing required. For example, some components required six different flows through the facility while others only required electrical testing at room temperature (Seligram 1993 p 2).

Therefore, ETO’s flaw is to assume that dividing costs equally will give them an accurate breakdown of their costs. As direct labors hours decreased and ETO is testing smaller samplings, some products needed more direct labor while others do not require as much. In addition, ETO’s has lower market prices in contract to their competition for testing complex parts. Their prices are higher for elementary testing and engineering support is increasing. This leads to increased burden costs, which also varied from part to part. Most importantly, the high-technology components are tested using more automated test equipment.

These tests do not require as many hours of direct labor. As the case implies, trends point toward the obsolescence of the labor-based burden allocation system because technology advances require less direct labor, so overhead costs will actually increase. When conditions change the percentage of total cost, direct labor costs decreases and overhead costs increase.

Therefore, relying on a single cost pool by using the traditional allocation base would be misleading when reporting on unit product costs (Brewster et.al, p 237). This is the reason ETO’s cost system has become obsolete. Continued use of their single cost system would also increase prices to customer, a fear which ETO realizes would likely cause them to lose customers.

2.Calculate the reported costs of the five components described in: a.The existing system

Current Cost System
ProductDirect Labor $Burden RateBurdenTotal
ICA917145%13302247
ICB2051145%29745025
Capacitor1094145%15862680
Amplifier525145%7611286
Diode519145%7531272

b.The system proposed by the accounting manager:

Accounting Manager Proposal

ProductDirect Labor$Burden Rate Given 21%Burden $Total Machine Hours givenMachine Hour Rate $80.10 GivenTotal Cost $
ICA91721%19318.514822592
ICB205121%4314032045686
Capacitor109421%2307.56011925
Amplifier52521%1105.04011036
Diode51921%10912.09611589

c. The system proposed by the consultants:
•Direct labor hours = 21% burden rate
• Machine Room per hour rate: 2,106,116 / 33,201 = $63.56 •Mechanical Test Room per hour rate: 1,926,263/17,103 = $112.63 Consultant Proposal
ProductDirect Labor$Burden Rate Burden $Main Room HrsMain Rm $63.56 Per Hr RateMechanical Room Hrs Mechanical Rm $112.63 Per Hr rateTotal Costs $ ICA91721%1938.554010.0 11262776

ICB205121%43114.0 89026.029286300
Capacitor109421%2303.01914.55072022
Amplifier52521%1104.02541.01131002
Diode51921%1097.04455.05631636

3. Which system is preferable? Why?

Out of all the costs system, the one that is most preferable is the consultants. While there is an expense to change the system, it will allow ETO to better account for actual costs. The original cost system assumes that the allocation base of direct labor hours accounts for all overhead. This would be appropriate if direct labor constitutes a significant part of the product costs and there was a high correlation between direct labor and changes to overhead. However, this is not the case for ETO. Their system does not allocate machine hours or actual costs variation between products; rather it spreads all costs equally.

This results in product cost distortion and all customers end up sharing equal costs despite the different cost in product testing. The cost system recommended by ETO’s accounting managers is better than the original one in use, because it addresses some of the problem by creating an additional cost pool. . Adding in the allocation base of Machine hours to the direct labor hours, will allow them to have a better sense of where costs are incurred. However it still does not provide the breakdown of the test room’s expenses.

As seen in the breakdown of the consultant proposal, the cost per hour for each room is significantly different. The ability to see this breakdown will allow ETO to allocate costs more accurately. The consultants three costs system breakdown provides more accurate cost information by allowing ETO to capture the differences in the way overhead is really used for different product processes. Moving forward, this will help ETO understand which processes are profitable and what costs should be charged to customer to be more competitive and in line with their market.

4. Would you recommend any changes to the system you prefer? I would recommend that ETO separate direct product costs out more, such as tooling and software development from administrative general overhead costs. Adding additional, cost pools, especially ones that are relevant to the cost drivers and one that is easily traced to product testing will provide more accurate cost information.

Having a more detailed cost breakdown will allow ETO’s management to set more accurate prices for their testing services to reach desired profit levels. Having this knowledge and understanding the breakdown of their costs will help ETO make decisions about future investments. Such as, should invest in the equipment required to test the next generation of components.

Testing on this equipment would be more automated, so there would be less direct labor costs but more overhead costs. Based on this, having a breakdown of additional costs is important. However, implementing costs systems are expensive and more complex than traditional costing systems. ETO will have to decide if the benefits outweigh the investment of time and resources required to break down these costs further.