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DHS Inc

Executive Memo

 

To:  Zizi Zou, VP for Finance

 

From:   Tony Amato

           

Re: Developing a Strategy to Combat Loss of Basic Jobs to Swedish Competitor

 

DHS has long been a leading provider of waste recovery systems, and during2003 industry sales have increased by 10% over projections due to an improving economy.  However, DHS sales declined, because  a  a Swedish firm entered the US market with aggressive pricing that undercut DHS bid particularly on jobs that are relatively simple and that call for less skilled workers.

 

After comparing the figures you elicited from the accounting department for jobs 258 (a simple job) and 265 (a more complex job) (see Appendix item A), I noticed that each job required similar amounts of labor (210 and 200 hrs respectively) and each was charged approximately the same amount of overhead ($21,000 and $20,000 respectively) based on an overhead allocation of $100 for every DLH. 

 

Overall overhead costs are four times the cost of labor and represent 50% of DHS’s total cost,  (see Appendix item B), but for Job 258 $5 of overhead is charged for every $ spent on labor, but for job 265 only $2.5 of overhead is applied for every $ in labor cost.  As 258 is a relatively simple job the workers are less skilled and are paid at the lower end of the pay scale which starts at $15 and runs up to $50 per hour. In general jobs that require more highly skilled workers are more complex and demand more support costs such as set up time for equipment.  Our current allocation method, however is allocating more overhead costs to low complexity jobs and less to more complex jobs (again see Appendix item A).  Therefore this allocation reverses the actual incurrence of overhead resulting in overpricing low skill jobs, which do not require much overhead and under-pricing the more complex jobs which incur greater overhead costs.  We are loosing a lot of revenue if we give up this business and as $35 million of overhead costs are fixed (see Appendix item B), they will remain even if we lay off the low skilled workers and save $2 million.

 

I therefore propose that we change the overhead allocation basis to direct labor cost (DL$), of $4 per DL$ (see Appendix item C for computations).  This allocation basis reflects the complexity of the work on various jobs and better matches the overhead costs with the jobs that cause overhead costs to increase.  The new cost computation will result in lower bids ($61,000 rather than $66,000) for less complex jobs like 256, as shown in Appendix item D.  It also suggests that we are probably under bidding for the more complex jobs, for example in job 265 as costs increase  from $88,000 to $100,000 (also see Appendix D)

 

 

Alternative Course of Action

 

I am still concerned that we might not get the work even using DL$ as the overhead allocation basis.  As most of the overhead is fixed and therefore will not change in the short run, we might use variable costing to make sure that we get the work which is essential to our financial health.  On a variable cost basis the overhead per direct labor hour is only $12.50 (see Appendix item E) and total cost is only $46,825 a lot less than $61,000 (see Appendix item F).  Any price in excess of $ 46,825 is still worth having as it will cover all out of pocket costs and some of some of the fixed costs.  

 

Appendix item A 

 

Job 258                                   Ratio of           Job 265                                   Ratio of           

                                                OH Applied                                                    OH Applied

                                                 to DL$                                                            to DL$

                                   

Direct Material             $40,000                       Direct Material $60,000

Direct Labor                                                     Direct Labor

     210hrs@$20               4,200                                200hrs@$40           8,000

Overhead                                                         Overhead

     210hrs@$100           21,000           5x                 200hrs@$100       20,000      2.5

           

Total                              65,000                       Total                              88,000

 

Appendix item B

 

At the start of 2003 the company estimated that it would incur the following costs:

                                                                        $ million            %

Direct labor                                          $10                  12.5

Direct material                                      $30                  37.5

Manufacturing overhead                        $40                  50

 ($5 mill variable $35 mill fixed*). 

            Total                                                    $80                  100

 

*Although these costs are fixed in the short run, in the long run more complex jobs caused us to take on more design engineers, more indirect labor for machine set up and more complex equipment to manufacture the jobs.  We need to cover these costs. 

 

Appendix item C 

 

Overhead Allocation Rate based on DL$

 

Estimated 2003 Overhead  =  $40 mill  = 400%

Estimated 2003 DL$                $10 mill 

 

 

Appendix item D 

 

Job 258                                   Ratio of           Job 265                                   Ratio of           

                                                OH Applied                                                    OH Applied

                                                 to DL$                                                            to DL$

                                   

Direct Material             $40,000                       Direct Material $60,000

Direct Labor                                                     Direct Labor

     210hrs@$20               4,200                                200hrs@$40           8,000

Overhead                                                         Overhead

     $4,200@400%         16,800     4x                      $8,000@ 400%     32,000      4x

           

Total                              61,000                       Total                            100,000

 

Appendix item E 

 

Overhead Allocation Rate based on DL$

 

Estimated 2003 Overhead VC =  $5 mill  = $12.50

Estimated 2003 DLH                    400,000 

 

Appendix item F 

 

Job 258                                                                                                                                 

Direct Material             $40,000                      

Direct Labor

     210hrs@$20               4,200                              

Overhead                                                        

     $210hrs@400%           2,625                

           

Total                              46,825