A consumer durables company intends to launch a luxury air conditioner. The company is evaluating a make-or-buy decision for some of the parts. The procurement division has provided the planning engineer with the standard rate so that the planning department can estimate the indirect cost. The

Question

A consumer durables company intends to launch a luxury air conditioner. The company is evaluating a make-or-buy decision for some of the parts. The procurement division has provided the planning engineer with the standard rate so that the planning department can estimate the indirect cost.

Machine	Indirect cost rate
Hydraulic press for bending	₹ 300 per labor rupees
Vertical milling machine	₹ 1,000 per labor hour
Brazing machine	₹ 100 per material rupees

The planning division intends to apply a single basket rate per direct labor hour until the procurement division provided it with the wide ranging rates given above and the bases and the usage data given in the following table. Elaborate how the indirect cost rates were estimated.

Table 15.3 Indirect cost bases and activity
Machine	Indirect cost basis	Expected annual activity	Annual indirect budgeted costing
Hydraulic press for bending	Direct labor cost	₹ 4,50,000	₹ 1,500
Vertical milling machine	Direct labor hour	250 hours	₹ 2,50,000
Brazing machine	Material cost	₹ 15,000	₹ 1,50,000

Accepted Answer

The rates would be determined at the beginning of the year using the total indirect costs budgeted for each machine. Equation (15.13) is used to determine the rates provided to the company.

Hydraulic press for bending: Rate = ₹ 4,50,000/₹ 1,500 = ₹ 300 per direct labor rupees

Vertical milling machine: ₹ 2,50,000/250 = ₹ 1,000 per direct labor hour

Brazing machine: Rate = ₹ 1,50,000/₹ 15,000 = ₹ 100 per material rupees

[latex] ext { indirect/overhead cost rate }=\frac{ ext { estimated total indirect cost }}{ ext { estimated basis level }}[/latex] (15.13)

It is a general practice to determine a blanket rate of indirect cost using a common base for allocating the indirect costs to multiple projects. For example, a blanket rate of indirect cost for multiple projects based on the material cost can be computed as given in Equation (15.14).

[latex]\frac{ ext { Blanket indirect }}{ ext { Overhead cost rate }}=\frac{ ext { Expected indirect costs of all projects }}{ ext { Estimated material cost of all projects }}[/latex] (15.14)

It can be realized that it is easy to calculate and apply blanket indirect cost rates. However, they do not account for the different accomplishments and functions of assets or people in the same department. For example, consider a production system which comprises of few automated and few manually operated machines. If a blanket rate of indirect costs is determined for this system, it will unnecessarily over-accumulate indirect costs for manually operated machines. Therefore, more than one basis should be normally used to allocate overhead. This has led to the development of Activity Based Costing (ABC) method. For economic evaluation of projects, it is essential to correctly estimate their indirect costs along with their direct costs and both should be considered in the evaluation process. Example 15.8 illustrates this concept for a make or buy evaluation.

Question 15.7: A consumer durables company intends to launch a luxury air c...

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