Problem - Overhead application

Last June, Lacy Dalton had just been appointed CFO of Garland & Wreath when she received some interesting reports about the profitability of the company's three most important product lines. One of the products, GW1, was produced in a very labor-intensive production process; another product, GW7, was produced in a very machine-intensive production process; and the third product, GW4, was produced in a manner that was equally labor and machine intensive. Dalton observed that all three products were produced in high volume and were priced to compete with similar products of other manufacturers. Prior to receiving the profit report, Dalton had expected the three products to be roughly equally profitable. How- ever, according to the profit report, GW1 was actually losing a significant amount of money and GW7 was generating an impressively high profit. In the middle, GW4 was producing an average profit. After viewing the profit data, Dalton developed a theory that the ''real'' profitability of each product was substantially different from the reported profits. To test her theory, Dalton gathered cost data from the firm's account- ing records. Dalton was quickly satisfied that the direct material and direct labor costs were charged to products properly; however, she surmised that the manufacturing overhead allocation was distorting product costs. To further investigate, she gathered the following information:

GW1 GW4 GW7

Monthly direct labor hours 8,000 1,600 400

Monthly machine hours 800 2,400 12,800

Monthly allocated overhead cost $80,000 $16,000 $4,000

Dalton noted that the current cost accounting system assigned all overhead to products based on direct labor hours using a predetermined overhead rate.

a. Using the data gathered by Dalton, calculate the predetermined OH rate based on direct labor hours.

b. Find the predetermined OH rate per machine hour that would allocate the current total overhead ($100,000) to the three product lines.

c. Dalton believes the current overhead allocation is distorting the profitability of the product lines. Determine the amount of overhead that would be allocated to each product line if machine hours were the basis of overhead allocation.

d. Why are the overhead allocations using direct labor hours and machine hours so dif- ferent? Which is the better allocation?