Lowry Locomotion produces toy cars. Its engineering manager is considering installing an automated packaging machine on one production line located in its Chicago facility that makes toy fire trucks. Doing so will require an investment in new machinery that will add $50,000 of depreciation to overhead, and will eliminate $1.50 per unit of direct labor. The company currently allocates overhead based on the amount of direct labor consumed.
After the installation is complete, the total amount of overhead has increased from $450,000 to $500,000, while the total amount of direct labor consumed by a toy fire truck has declined from $6.00 to $4.50. The total direct labor used throughout the Chicago facility has declined from $400,000 to $350,000. The calculation of its overhead allo cation before and after the installation of automated equipment is:
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Overhead Per Dollar of Direct Labor Calculation |
|
|
Before automation |
$450,000 overhead / $400,000 labor = $1.13 per $ of direct labor |
|
After automation |
$500,000 overhead / $350,000 labor = $1.43 per $ of direct labor |
Before automation, the toy fire truck consumed $6.00 of direct labor, so the amount of overhead assigned to each truck was $6.78 ($6.00 direct labor x $1.13 overhead allocation). After automation, the toy fire truck consumes $4.50 of direct labor, so the amount of overhead assigned to each truck declines to $6.44 ($4.50 direct labor x $1.43 overhead allocation). Consequently, the method of overhead allocation drives down the full cost of the fire truck.
After automation, the entire Chicago facility still uses $350,000 of direct labor, of which $250,000 is used on anoth er production line that manufactures toy racing cars. Prior to the automation, the racing car line had a total overhead allocation of $282,500 ($250,000 direct labor x $1.13 overhead allocation). Following automation, the racing car line still uses the same amount of labor, but its overhead allocation has increased to $357,500 ($250,000 direct labor x $1.43 overhead allocation).
Thus, the overhead allocation to the fire truck has declined, because its allocation base has declined, while the addition al overhead has now shifted to the racing car product, simply because its allocation base did not decline. The shift in al location between the two product lines is so extreme that the racing car line is now absorbing an additional $75,000 of overhead, even though the total amount of overhead only increased by $50,000; this is because the racing car line has proportionally more of the allocation base than it did before the automation project was completed.