You are the controller for Minuteman Enterprises, a manufacturer of rocket booster engines and various aerospace products. Though there are many commercial customers for most of the company’s products, the federal government is the only buyer of your rocket booster engines. Because you are the only provider for the engines, the government has agreed to buy these engines at a price equal to your cost plus a 10% markup.
As the controller, you have recently been studying the accuracy of your product costs. Traditionally, manufacturing overhead has been allocated on the basis of direct labor hours. Using this method, rocket boosters have borne a high percentage of manufacturing overhead because they take many more direct labor hours than do the other products.
You have just been presented an analysis by one of your staff members that shows that direct labor hours is not a very relevant base for allocating manufacturing overhead costs. Rather, she has made a very convincing case that manufacturing overhead should be allocated using activity-based costing with multiple cost drivers. Using her suggested approach, however, you discover that the rocket boosters bear a much smaller portion of manufacturing overhead costs, and therefore, the total cost of the boosters is considerably less than the amount you have been using to determine the price charged to the government.
You know that her calculations using ABC are likely to be more accurate than the current cost allocation method and that the commercial products should bear a larger amount of manufacturing overhead costs. Yet, you also know that by using ABC and the more accurate cost drivers, your profits from both the boosters and the commercial products will be reduced.
1. What should you do?
2. Is it ethical to continue to allocate manufacturing overhead costs on the basis of direct labor hours?
3. Would it be ethical to use direct labor hours if that were the basis used by other government contractors?
4. If you decide to switch to ABC, should you inform the government that you have overcharged it and return the excess profits?