Assume you recently accepted a job with a company that designs and builds helicopters for commercial and military use. The company has numerous contracts with the U.S. military that require the use of cost-plus pricing. In other words, the contracted price for each helicopter is calculated at a certain percentage of the total cost to produce it. Unlike the cost-plus pricing approach used for military contracts, the prices for civilian helicopters are based on the amount that individuals and corporations are willing to pay for a state-of-the-art helicopter.
As your first assignment, the company controller has asked you to reevaluate the costing system currently used to determine the cost of producing helicopters. The company assigns manufacturing overhead based on the number of units produced. The result is that every helicopter is assigned the same amount of overhead regardless of whether it is for military or civilian use.
As part of your assignment, you collected the following information about two other potential allocation bases (direct labor hour
the company produces an equal number of military and civilian helicopters (1,000 of each), they require a different amount of direct labor and machine hours. In particular, civilian helicopters require relatively more direct labor hours (60 percent of the total), perhaps because of the labor required to install all of the %u201Cbells and whistles%u201D that wealthy consumers expect on a luxury helicopter. However, military helicopters require more machine time (70 percent of the total) due to the precise machining and intensive instrument testing required to comply with the military contracts. Further analysis revealed that some of the manufacturing overhead items are logically related to labor hours (such as supervision and use of indirect materials) while other overhead items (such as machine depreciation and power) are more highly related to machine hours.
When you presented these data to the controller, you recommended that the company move to an allocation system whereby part of the overhead would be allocated based on direct labor hours and part of it based on machine hours. He responded that he wanted you to choose the system that would assign the highest percentage of the total overhead cost to the military contracts. His reasoning was that the cost-plus agreement with the U.S. government would result in a higher contract price for military helicopters without affecting the price of civilian helicopters, which are set by the market.
Required:
1.Explain how changing the allocation base can impact the profitability of the two types of products.
2.Which allocation base(s) do you think the company should use to apply manufacturing overhead to the two types of products?
3.Identify the ethical issues involved in this scenario. What are your potential courses of action for responding to the controller's request? What are the potential personal, professional, and legal implications of the alternative courses of action you considered? How would you ultimately respond to this situation?