Quarterly and Annual Overhead Application The Mansfield Machine Shop is a family-owned busi- ness with 25 employees. The founding brothers, Steve and George, started the business in 1974 with a single milling machine, a grinder, and a lathe. The brothers now own a business with 27 machines, and operating revenues of more than $5 million per year. The brothers have noticed that they are losing business to new competitors and they have heard from some of their customers that their com- petitors have better prices. So they have asked you to study their operations and summary financial reports for the prior year and to make recommendations.
The information available to you includes:
The business is very seasonal, as it reflects the seasonality of the businesses of its major customers in the manufacturing and construction industries. The first and third quarters of the year have relatively low demand, while their busiest periods are the second and fourth quarters. George and Steve measure the volume of their business in machine-hours, since they charge by the machine-hour and the materials costs are negligible. The machine-hours demand for last year was 5,000 hours in the first quarter, 12,500 in the second quarter, 7,500 in the third quarter, and 11,250 in the fourth quarter.
Mansfield has 27 machines in the plant, and while some are newer and more technologically advanced than others, the differences are not great. Because of this, the brothers charge the same price for machin- ing on each of the machines. George and Steve realize that their business is very seasonal and that their machines and operators will be busier at times, but to keep the machines in good shape and operators rested, they try to limit the work to approximately 150 hours per month per machine.
Because of the seasonality of the business, George and Steve have always recalculated the overhead rate for each quarter. The overhead rate is determined at the end of each quarter based on actual total over- head costs for the quarter (which are $450,000 per quarter) and the actual machine-hours for that quarter. This machine-hours-based rate is then used in the following quarter, and is revised accordingly at the end of each quarter.
Mansfield’s variable costs are $45 per machine-hour. The firm charges a 50 percent markup over full cost, the sum of variable costs and overhead charges per unit. Mansfield uses $85 full cost in pricing for the first quarter.
In addition to $450,000 fixed operating costs per quarter, Mansfield has $25,000 administrative fixed costs per quarter. Required
Calculate the overhead rates and machine-hour pricing rates using the quarterly overhead system now used by the firm.
Recalculate the overhead rates and machine-hour pricing rates using an annual overhead rate.
Calculate total contribution and operating income for the year and for each quarter under both the quar- terly and annual rates.
Interpret your findings in parts 1 through 3. How does the choice of a quarterly overhead rate affect pricing for Mansfield? Which overhead rate, quarterly or annual, do you think Mansfield should use and why? What are the strategic implications of the choice of overhead rates for the company?