Salem Corp. contracted for a specialized production machine from Quindo Industries, a tool company. The contract specified a price equal to “production cost plus 15% of production cost.” A sales executive at Quindo told Salem’s management that the machine’s approximate price would be $1,725,000 based on the following estimates:
Direct material cost ..................... $500,000
Direct labor cost ....................... 400,000
Manufacturing overhead (applied based on machine time) ...... 600,000
Markup .......................... 225,000
Estimated price to Salem ................. $1,725,000
Two months later, Quindo Industries delivered the completed machinery, configured and manufactured as per the contract. However, the accompanying invoice caught Salem’s executives by surprise. The invoice provided the following:
Direct material cost ...................... $658,000
Direct labor cost .................... .. 625,000
Manufacturing overhead (applied based on machine time) ....... 640,000
Markup ......................... 288,450
Estimated price to Salem ................... $2,211,450
Upon receiving the invoice, Salem executives requested an audit of the direct material charges because they were more than 30 percent higher than the original estimate. Quindo Industries granted the request and Salem hired your firm to conduct the audit.
a. Describe your strategy for validating the $658,000 charge for direct material and discuss specific documents you will request from Quindo Industries as part of the audit.
b. Describe your strategy for validating the $625,000 charge for direct labor and discuss specific documents you will request from Quindo Industries as part of the audit.
c. How might Quindo Industries have manipulated the predetermined overhead rate?
d. Even if all of the charges are validated, do you perceive the tool company’s behavior in this case as ethical? Explain.