Kelvin Aerospace, Inc. manufactures parts, such as rudder hinges, for the aerospace industry. The company uses a job-order costing system with a plantwide predetermined overhead rate based on direct labourhours. On December 16, 2015, the company?s controller made a preliminary estimate of the predetermined overhead rate for 2016. The new rate was based on the estimated total manufacturing overhead cost of $3,402,000 and the estimated 63,000 total direct labour-hours for 2016:

This new predetermined overhead rate was communicated to top managers in a meeting on December 19. The rate did not cause any comment because it was within a few pennies of the overhead rate that had been used during 2015. One of the subjects discussed at the meeting was a proposal by the production manager to purchase an automated milling machine built by Sunghi Industries. The president of Kelvin Aerospace, Harry Arcany, agreed to meet with the sales representative from Sunghi Industries to discuss the proposal.

On the day after the meeting, Harry Arcany met with Jasmine Chang, Sunghi Industries? sales representative.

The following discussion took place:

Arcany: Wally, our production manager, asked me to meet with you, since he is interested in installing an automated milling machine. Frankly, I?m skeptical. You?re going to have to show me that this isn?t just another expensive toy for Wally?s people to play with.

Chang: This is a great machine with direct bottom-line benefits. The automated milling machine has three major advantages. First, it is much faster than the manual methods you are using. It can process about twice as many parts per hour as your present milling machines. Second, it is much more flexible. There are some upfront programming costs, but once those have been incurred, almost no setup is required to run a standard operation. You just punch in the code for the standard operation, load the machine?s hopper with raw material, and the machine does the rest.

Arcany: What about cost? Having twice the capacity in the milling machine area won?t do us much good. That centre is idle much of the time anyway.

Chang: I was getting there. The third advantage of the automated milling machine is lower cost.

Wally and I looked over your present operations, and we estimated that the automated equipment would eliminate the need for about 6,000 direct labour-hours a year. What is your direct labour cost per hour?

Arcany: The wage rate in the milling area averages about $32 per hour. Fringe benefits raise that figure to about $41 per hour.

Chang: Don?t forget your overhead.

Arcany: Next year, the overhead rate will be $54 per hour.

Chang: So, including fringe benefits and overhead, the cost per direct labour-hour is about $95.

Arcany: That?s right.

Chang: Since you can save 6,000 direct labour-hours per year, the cost savings would amount to about $570,000 a year. And our 60-month lease plan would require payments of only $348,000 per year.

Arcany: That sounds like a no-brainer. When can you install the equipment?

Shortly after this meeting, Harry Arcany informed the company?s controller of the decision to lease the new equipment, which would be installed over the Christmas vacation period. The controller realized that this decision would require a recomputation of the predetermined overhead rate for 2016, since the decision would affect both the manufacturing overhead and the direct labour-hours for the year. After talking with both the production manager and the sales representative from Sunghi Industries, the controller discovered that in addition to the annual lease cost of $348,000, the new machine would also require a skilled technician/programmer who would have to be hired at a cost of $50,000 per year to maintain and program the equipment. Both of these costs would be included in factory overhead. There would be no other changes in total manufacturing overhead cost, which is almost entirely fixed. The controller assumed that the new machine would result in a reduction of 6,000 direct labour-hours for the year from the levels that had initially been planned.

When the revised predetermined overhead rate for 2016 was circulated among the company?s top managers, there was considerable dismay.

Required:

1. Recompute the predetermined rate assuming that the new machine will be installed. Explain why the new predetermined overhead rate is higher (or lower) than the rate that was originally estimated for 2016.

2. What effect (if any) would this new rate have on the cost of jobs that do not use the new automated milling machine?

3. Why would managers be concerned about the new overhead rate?

4. After seeing the new predetermined overhead rate, the production manager admitted that he probably would not be able to eliminate all of the 6,000 direct labour hours. He had been hoping to accomplish the reduction by not replacing workers who retired or quit, but that had not been possible. As a result, the real labour savings would be only about 2,000 hours?one worker. In the light of this additional information, evaluate the original decision to acquire the automated milling machine from Sunghi Industries.

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Predetermined overhead rate $3,402,000 63,000 direct labour-hours $54 per direct labour-hour