Based upon our calculations, we noted that the payback period for the new equipment would be 1.8 years. In most firms, the investment would be approved on that basis alone. But now consider the investment from a purely departmental perspective if the amount of overhead allocated to the department is adjusted based on the reduced labor content of the products produced. Using the Standard Cost System calculations, the department would be charged $42,000 less overhead per year. The department manager would have every incentive to lobby hard for approval of this investment. Considering both direct labor and overhead costs, the standard cost approach would likely calculate the total annual cost savings for the department at $57,000 per year. This implies a payback period of less than 6 months. Based on this, the purchase of the new stamping machine would most likely be approved.
A More Realistic Appraisal
We now need to consider how the realities of the manufacturing environment might impact this decision. It’s important to consider three important issues before a final purchasing decision is made. These issues are the capacity requirements of the stamping operation, the actual reduction in direct labor, and the allocation of overhead costs. So let’s look at each of these issues in more detail.
Capacity Requirements: One of the key considerations in the stamping machine case study is whether or not the new stamping machine is actually needed. We must ask questions like, is the old machine fully utilized? Or, is there a need to increase the production capacity in the stamping process. Or maybe even, is the old stamping machine inadequate to meet the demand placed on it. Let’s try to answer these questions.
We know that the old stamping machine is available 2,000 hours per year, so based on the stated capacity of 100 units per hour, the old stamping machine should theoretically be able to produce 200,000 units per year. Since the current annual output is 150,000 units per year, the old stamping machine is only utilized 75 percent of the time. So based upon this fact alone, the decision to purchase the new machine is probably not supported. If there is an increased demand or the need for lead time reductions to remain competitive, then maybe there would be a justification to purchase the new stamping machine. Bu keep in mind, these type of considerations are not relevant in the standard cost system.
Reduction of Direct Labor: If the standard procedure to justify this investment decision, then the question that must be answered is whether or not the labor cost was actually reduced, even if the labor hours required on the new machine was significantly less. In most companies, if the labor cost of the operation is to be reduced, then one or more workers must be removed from the process. Unless there is a serious downturn in profitability, most companies will not lay-off the workers. In this case, both the old machine and the new machine still requires one operator to run them. The conclusion here is that the projected $15,000 savings in direct labor cost will never materialize. In other words, from a global perspective, there will not be any savings in labor costs.
Allocation of Overhead Costs: The final issue raised in the decision as to whether or not a new stamping machine should be purchased is the proper allocation of overhead costs. The standard cost analysis would indicate that the costs of products being processed through the stamping machine would be reduced by a total amount of $57,000. When divided by the number of units processed annually (150,000), it is concluded that the unit cost would be reduced by $0.38 per unit. But is such a reduction in product cost actually realized? The answer is absolutely not!
Part of the reason for this is that the total labor cost is actually unchanged. But the primary reason is that the procedures used to allocate overhead costs are highly questionable. The important point is that the overhead costs don’t go away. The $42,000 of overhead costs which are no longer allocated to the stamping operation still exist and will simply be reallocated to other operations. As a result, the product costs for all products not processed through the stamping operation will go up. Think about this…..even though these products are produced exactly as they were, their calculated costs will increase.
Not only are the $42,000 savings in overhead costs for the stamping operation a mirage, but the costs for other products will “appear” to increase. This is the inevitable result of using cost procedures that do not consider the big picture for the whole company. That is, instead of system optimization, these cost procedures favor local optimization.
In my next post, we will begin a new discussion on the difference between local optimums versus global optimum. As always, if you have any questions or comments about any of my posts, leave me a message and I will respond.
Until next time.
 L. Srikanth and Michael Umble,Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One – 1997, The Spectrum Publishing Company, Wallingford, CT
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