Allocating Overhead versus Direct Tracing Nixon & Ross, a law firm, is about to install a new accounting system that will allow the firm to track more of the overhead costs to individual cases. Overheads are currently allocated to individual client cases based on billable professional staff salaries. Attorneys working on client cases charge their time to "billable professional staff salaries." Attorney time spent in training, law firm administrative meetings, and the like is charged to an overhead account titled "unbilled staff salaries." The following is a summary of the costs for the current year: \[\begin{array} { | l | r | } \hline \text { Billable professional staff salaries } & \$ 4,000,000 \\ \hline \text { Overhead } & 8,000,000 \\ \hline \text { Total costs } & \$ 12,000,000 \\ \hline \end{array}\] The overhead costs were as follows: \[\begin{array} { | l | r | } \hline \text { Secretarial costs } & \$ 1,500,000 \\ \hline \text { Staff benefits } & 2,750,000 \\ \hline \text { Office rent } & 1,250,000 \\ \hline \text { Telephone and mailing costs } & 1,500,000 \\ \hline \text { Unbilled staff salaries } & 1,000,000 \\ \hline \text { Total costs } & \$ 8,000,000 \\ \hline \end{array}\] Under the new accounting system, the firm will be able to trace secretarial costs, staff benefits, and telephone and mailing costs to specific clients. The following are the costs incurred on the Lawson Company case: \[\begin{array} { | l | r | } \hline \text { Billable professional staff salaries } & \$ 150,000 \\ \hline \text { Secretarial costs } & 25,000 \\ \hline \text { Staff benefits } & 13,500 \\ \hline \text { Telephone and mailing costs } & 8,000 \\ \hline \text { Total costs } & \$ 196,500 \\ \hline \end{array}\] Required: a. Calculate the current year's overhead application rate under the old cost accounting system. b. How would this application rate change if the secretarial costs, staff benefits, and telephone and mailing costs were reclassified as direct costs instead of overhead, and overhead was assigned based on direct costs (instead of staff salaries)? Direct costs are defined as billable staff salaries plus secretarial costs, staff benefits, and telephone and mailing costs. c. Use the overhead application rates from (a) and (b) to compute the cost of the Lawson case. d. Nixon & Ross bills clients 150 percent of the total costs of the job. What will be the total billings to the Lawson Co. if the old overhead application scheme is replaced with the new overhead scheme? e. Steve Nixon, managing partner, has commented that replacing the old allocation system with the direct charge method of the new accounting system will result in more accurate costing and pricing of cases. Evaluate the new system.

a. c. i. The Lawson Company case (usi

Five departments of National Training Institute, a nonprofit organization, share a rented building. Four of the departments provide services to educational agencies and have little or no competition for their services. The fifth department, Technical Training, provides educational services to the business community in a competitive market with other nonprofit and private organizations. Each department is a cost center. Revenues received by Technical Training are based on a fee for services, identified as tuition. All five departments have dedicated space as listed in the accompanying table. Common shared space, including hallways, restrooms, meeting rooms, and dining areas, is not included in these allocations. National Training Institute rents space at $10 per square foot. $\begin{array}{c} \text { Allocation Table }\\ \begin{array}{|l|r|r|r|} \hline \text { Department } & \text { Square } & \text { Percentage } & \text { Revenue } \\ & \text { Footage } & \text { of Space } \\ \hline \text { Administration } & 13.500 & 9.0 \% & \$ 3.600,000 \\ \hline \begin{array}{l} \text { Support } \\ \text { services } \end{array} & 46,500 & 31.0 & 11,000,000 \\ \hline \begin{array}{l} \text { Computer } \\ \text { services } \end{array} & 12,000 & 8.0 & 8.800,000 \\ \hline \begin{array}{l} \text { Technical } \\ \text { training } \end{array} & 6,000 & 4.0 & 1,900,000 \\ \hline \text { Transportation } & 72,000 & 48.0 & 4,700,000 \\ \hline \begin{array}{l} \text { Total } \\ \text { allocated } \end{array} & 150,000 & 100.0 \% & \$ 30,000,000 \\ \hline \begin{array}{l} \text { Common } \\ \text { space } \end{array} & 50,000 & & \\ \hline \end{array}\end{array}$ In addition to its assigned space, the technical training department offers training during off-hours using many of the areas allocated to other departments. Technical Training also uses off-site facilities for the same purpose. About 50 percent of its training activities are in off-site facilities, which have excess capacity, charge no rent, and are available only during off-hours. John Daniels, the administration department's business manager, proposed a rental allocation plan based on each department's percentage of dedicated square footage plus the same percentage of the common space. The technical training department would be charged an additional amount for the space it uses during off-hours that is dedicated to other departments. This additional amount would be based on planned usage per year. Jane Richards, director of technical training, claims this allocation method will cause her to increase the price of services. As a result, she will lose business to competition. She would rather see the allocation method use the percentage of department revenue in relation to total revenue. Required: Comment on Daniels's and Richards's proposed rent allocation plans. Make appropriate recommendations.

Off-TimeUsage The square footage allocat

Cost Allocations Can Distort Pricing Decisions Kraft Foods Group used to sponsor a car in the NASCAR races. Like other major corporations that sponsor sports events, Kraft believes that the public's awareness of its products is enhanced by sponsoring a NASCAR. For the right to have "Kraft" displayed prominently on the automobile, Kraft pays the racing team an annual fee. Kraft is organized around a number of business units that are profit centers. Senior management at Kraft believes that since the various business units at Kraft receive the benefits of the NASCAR exposure through greater name recognition, and hence greater sales, the costs of the program should be allocated back to the business units and ultimately to all Kraft products. The cost of the NASCAR program is allocated back to the Kraft business units based on sales revenue. Suppose the allocation is 10 percent of revenues. That is, for every $1 of revenue, the business unit is allocated $0.10 of cost from the NASCAR car. One of Kraft's business units sells Velveeta processed cheese in cartons containing 200 32 ounce packages. The following table summarizes possible pricing levels, cartons sold at that price, and costs for the various number of cartons. \[\begin{array} { | c | c | c | } \hline \text { Price } & \text { Number of Cartons Sold } & \text { Total Cost } \\ \hline \$ 564 & 218 & \$ 71,800 \\ \hline 562 & 219 & 71,900 \\ \hline 560 & 220 & 72,000 \\ \hline 558 & 221 & 72,100 \\ \hline 556 & 222 & 72,200 \\ \hline 554 & 223 & 72,300 \\ \hline 552 & 224 & 72,400 \\ \hline 550 & 225 & 72,500 \\ \hline 548 & 226 & 72,600 \\ \hline \end{array}\] Required: a. What price-quantity combination maximizes the profits of the Velvetta, ignoring the allocation of NASCAR? b. If $0.10 of the NASCAR is allocated for every dollar of Velvetta revenue, what price-quantity combination of Velvetta maximizes profits after allocating NASCAR costs? c. What price-quantity combination of Velvetta maximizes profits after allocating NASCAR costs using total costs (instead of revenues), where for every dollar of total costs, $0.20 of NASCAR costs are allocated? d. Instead of allocating the NASCAR based on revenues, it is allocated based on profits before allocated costs. For every $1.00 of profits before allocated costs, $0.30 of NASCAR costs are allocated. Now what price-quantity combination maximizes Velvetta profits after allocating NASCAR costs? e. Should NASCAR costs be allocated to the business units, and if so, what allocation scheme should be used (revenues, costs, or profits)?

a. Profit maximizing price-quantity comb

Exam 7: Cost Allocation: Theory

The maintenance department's costs are allocated to other departments based on the number of hours of maintenance use by each department. The maintenance department has fixed costs of $500,000 and variable costs of $30 per hour of maintenance provided. The variable costs include the salaries of the maintenance workers. More maintenance workers can be added if greater maintenance is demanded by the other departments without affecting the fixed costs of the maintenance department. The maintenance department expects to provide 10,000 hours of maintenance. Required: a. What is the application rate for the maintenance department? b. What is the additional cost to the maintenance department of providing another hour of maintenance? c. What problem exists if the managers of other departments can choose how much maintenance to be performed? d. What problem exists if the other departments are allowed to go outside the organization to buy maintenance services?

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a. Total expected costs are $500,000 + ($30/hour) (10,000 hours) = $800,000
The application rate is $800,000/10,000 hours = $80/hour
b. The additional cost to the maintenance department of providing another hour of maintenance is the variable cost of $30/hour.
c. The other departments will under-use the maintenance department because the application rate of $80/hour is much greater than the additional costs of providing maintenance.
d. If departments are allowed to go outside the organization to buy maintenance services, fewer in-house maintenance hours will be used. This will cause the application rate to become even higher if the fixed cost is included.

The Independent Underwriters Insurance Co. (IUI) established a systems department two years ago to implement and operate its information technology system. IUI believed that its own system would be more cost-effective than the service bureau it had been using. IUI's three departments - claims, records, and finance - have different requirements with respect to hardware and other capacity-related resources and operating resources. The system was designed to recognize these differing demands. It was also designed to meet IUI's long-term capacity. The excess capacity designed into the system is being sold to outside users until IUI needs it. The estimated resource requirements used to design and implement the system are shown in the following schedule. Hardware and Other Capacity- Related Resources Dperating Resources Records 30\% 60\% Claims 50 20 Finance 15 15 Expansion (outside use) 5 5 Total 100\% 100\% IUI currently sells the equivalent of its expansion capacity to a few outside clients. When the system became operational, management decided to redistribute total expenses of the systems department to the user departments based upon actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows: Department Percentage Utilization Amount Records 60\% \ 330,000 Claims 20 110,000 Finance 15 82,500 Outside 5 27,500 Total 100\% \ 550,000 The three user departments have complained about the cost distribution since the systems department was established. The records department's monthly costs have been as much as three times the costs experienced with the service bureau. The finance department is concerned about the costs distributed to the outside user category, because these allocated costs form the basis for the fees billed to outside clients. James Dale, IUI's controller, decided to review the distribution method by which the systems department's costs have been allocated for the past two years. The additional information he gathered for his review is reported in Tables 1, 2, and 3. Dale has concluded that the method of cost distribution should be changed to reflect more directly the actual benefits received by the departments. He believes that hardware and capacity-related costs should be allocated to the user departments in proportion to their planned, long-term needs. Any difference between actual and budgeted hardware costs should remain with the systems department. The remaining costs for software development and operations would be charged to the user departments based upon actual hours used. A predetermined hourly rate based upon the annual budget data would be used. The hourly rates proposed for the current fiscal year are as follows: Function Hourly Rate Software development \ 30 Operations Computer related \ 200 Input/output related \ 10 Dale plans to use first-quarter activity and cost data to illustrate his recommendations. The recommendations will be presented to the systems department and the user departments for their comments and reactions. He then expects to present his recommendations to management for approval. Required: a. Prepare a schedule to show how the actual first-quarter costs of the systems department will be charged to the users if James Dale's recommended method is adopted. b. Explain whether James Dale's recommended system for charging costs to the user departments will (i) Improve cost control in the systems department. (ii) Improve planning and cost control in the user departments. (iii) Be a more equitable basis for charging costs to user departments. Table1 SystemsDepartmentCostsandActivityLevels $The Independent Underwriters Insurance Co. (IUI) established a systems department two years ago to implement and operate its information technology system. IUI believed that its own system would be more cost-effective than the service bureau it had been using. IUI's three departments - claims, records, and finance - have different requirements with respect to hardware and other capacity-related resources and operating resources. The system was designed to recognize these differing demands. It was also designed to meet IUI's long-term capacity. The excess capacity designed into the system is being sold to outside users until IUI needs it. The estimated resource requirements used to design and implement the system are shown in the following schedule. \begin{array} { | l | r | r | } \hline & \begin{array} { r } \text { Hardware and } \\ \text { Other Capacity- } \\ \text { Related Resources } \end{array} & \begin{array} { r } \text { Dperating } \\ \text { Resources } \end{array} \\ \hline \text { Records } & 30 \% & 60 \% \\ \hline \text { Claims } & 50 & 20 \\ \hline \text { Finance } & 15 & 15 \\ \hline \text { Expansion } \\ \text { (outside use) } & 5 & 5 \\ \hline \text { Total } & 100 \% & 100 \% \\ \hline \end{array} IUI currently sells the equivalent of its expansion capacity to a few outside clients. When the system became operational, management decided to redistribute total expenses of the systems department to the user departments based upon actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows: \begin{array} { | l | r | r | } \hline \text { Department } & \begin{array} { r } \text { Percentage } \\ \text { Utilization } \end{array} & \text { Amount } \\ \hline \text { Records } & 60 \% & \$ 330,000 \\ \hline \text { Claims } & 20 & 110,000 \\ \hline \text { Finance } & 15 & 82,500 \\ \hline \text { Outside } & 5 & 27,500 \\ \hline \text { Total } & 100 \% & \$ 550,000 \\ \hline \end{array} The three user departments have complained about the cost distribution since the systems department was established. The records department's monthly costs have been as much as three times the costs experienced with the service bureau. The finance department is concerned about the costs distributed to the outside user category, because these allocated costs form the basis for the fees billed to outside clients. James Dale, IUI's controller, decided to review the distribution method by which the systems department's costs have been allocated for the past two years. The additional information he gathered for his review is reported in Tables 1, 2, and 3. Dale has concluded that the method of cost distribution should be changed to reflect more directly the actual benefits received by the departments. He believes that hardware and capacity-related costs should be allocated to the user departments in proportion to their planned, long-term needs. Any difference between actual and budgeted hardware costs should remain with the systems department. The remaining costs for software development and operations would be charged to the user departments based upon actual hours used. A predetermined hourly rate based upon the annual budget data would be used. The hourly rates proposed for the current fiscal year are as follows: \begin{array} { | l | r | } \hline \text { Function } & \text { Hourly Rate } \\ \hline \text { Software development } & \$ 30 \\ \hline \text { Operations } & \\ \hline \text { Computer related } & \$ 200 \\ \hline \text { Input/output related } & \$ 10 \\ \hline \end{array} Dale plans to use first-quarter activity and cost data to illustrate his recommendations. The recommendations will be presented to the systems department and the user departments for their comments and reactions. He then expects to present his recommendations to management for approval. Required: a. Prepare a schedule to show how the actual first-quarter costs of the systems department will be charged to the users if James Dale's recommended method is adopted. b. Explain whether James Dale's recommended system for charging costs to the user departments will (i) Improve cost control in the systems department. (ii) Improve planning and cost control in the user departments. (iii) Be a more equitable basis for charging costs to user departments. Table1 SystemsDepartmentCostsandActivityLevels Table2 HistoricalUtilizationbyUsers Table3 UtilizationofSystemsDepartment'sServicesforFirstQuarter (in Hours) \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \text { Operations } \begin{array} { | l | r | r | r | } \hline & \text { Software } &\text { Computer } & \text { Input/Output } \\ &\text { Development } &\text { Related }\\ \hline \text { Records } & 425 & 552 & 1,580 \\ \hline \text { Claims } & 1.700 & 184 & 5,530 \\ \hline \text { Finance } & 1.700 & 138 & 395 \\ \hline \text { Outside } & 425 & 46 & 395 \\ \hline \text { Total } & 4,250 & 920 & 7,900 \\ \hline \end{array} This problem, while couched as a cost allocation issue, is in effect a transfer pricing problem.$ Table2 HistoricalUtilizationbyUsers $The Independent Underwriters Insurance Co. (IUI) established a systems department two years ago to implement and operate its information technology system. IUI believed that its own system would be more cost-effective than the service bureau it had been using. IUI's three departments - claims, records, and finance - have different requirements with respect to hardware and other capacity-related resources and operating resources. The system was designed to recognize these differing demands. It was also designed to meet IUI's long-term capacity. The excess capacity designed into the system is being sold to outside users until IUI needs it. The estimated resource requirements used to design and implement the system are shown in the following schedule. \begin{array} { | l | r | r | } \hline & \begin{array} { r } \text { Hardware and } \\ \text { Other Capacity- } \\ \text { Related Resources } \end{array} & \begin{array} { r } \text { Dperating } \\ \text { Resources } \end{array} \\ \hline \text { Records } & 30 \% & 60 \% \\ \hline \text { Claims } & 50 & 20 \\ \hline \text { Finance } & 15 & 15 \\ \hline \text { Expansion } \\ \text { (outside use) } & 5 & 5 \\ \hline \text { Total } & 100 \% & 100 \% \\ \hline \end{array} IUI currently sells the equivalent of its expansion capacity to a few outside clients. When the system became operational, management decided to redistribute total expenses of the systems department to the user departments based upon actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows: \begin{array} { | l | r | r | } \hline \text { Department } & \begin{array} { r } \text { Percentage } \\ \text { Utilization } \end{array} & \text { Amount } \\ \hline \text { Records } & 60 \% & \$ 330,000 \\ \hline \text { Claims } & 20 & 110,000 \\ \hline \text { Finance } & 15 & 82,500 \\ \hline \text { Outside } & 5 & 27,500 \\ \hline \text { Total } & 100 \% & \$ 550,000 \\ \hline \end{array} The three user departments have complained about the cost distribution since the systems department was established. The records department's monthly costs have been as much as three times the costs experienced with the service bureau. The finance department is concerned about the costs distributed to the outside user category, because these allocated costs form the basis for the fees billed to outside clients. James Dale, IUI's controller, decided to review the distribution method by which the systems department's costs have been allocated for the past two years. The additional information he gathered for his review is reported in Tables 1, 2, and 3. Dale has concluded that the method of cost distribution should be changed to reflect more directly the actual benefits received by the departments. He believes that hardware and capacity-related costs should be allocated to the user departments in proportion to their planned, long-term needs. Any difference between actual and budgeted hardware costs should remain with the systems department. The remaining costs for software development and operations would be charged to the user departments based upon actual hours used. A predetermined hourly rate based upon the annual budget data would be used. The hourly rates proposed for the current fiscal year are as follows: \begin{array} { | l | r | } \hline \text { Function } & \text { Hourly Rate } \\ \hline \text { Software development } & \$ 30 \\ \hline \text { Operations } & \\ \hline \text { Computer related } & \$ 200 \\ \hline \text { Input/output related } & \$ 10 \\ \hline \end{array} Dale plans to use first-quarter activity and cost data to illustrate his recommendations. The recommendations will be presented to the systems department and the user departments for their comments and reactions. He then expects to present his recommendations to management for approval. Required: a. Prepare a schedule to show how the actual first-quarter costs of the systems department will be charged to the users if James Dale's recommended method is adopted. b. Explain whether James Dale's recommended system for charging costs to the user departments will (i) Improve cost control in the systems department. (ii) Improve planning and cost control in the user departments. (iii) Be a more equitable basis for charging costs to user departments. Table1 SystemsDepartmentCostsandActivityLevels Table2 HistoricalUtilizationbyUsers Table3 UtilizationofSystemsDepartment'sServicesforFirstQuarter (in Hours) \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \quad \text { Operations } \begin{array} { | l | r | r | r | } \hline & \text { Software } &\text { Computer } & \text { Input/Output } \\ &\text { Development } &\text { Related }\\ \hline \text { Records } & 425 & 552 & 1,580 \\ \hline \text { Claims } & 1.700 & 184 & 5,530 \\ \hline \text { Finance } & 1.700 & 138 & 395 \\ \hline \text { Outside } & 425 & 46 & 395 \\ \hline \text { Total } & 4,250 & 920 & 7,900 \\ \hline \end{array} This problem, while couched as a cost allocation issue, is in effect a transfer pricing problem.$ Table3 UtilizationofSystemsDepartment'sServicesforFirstQuarter (in Hours) $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\text { Operations }$ Software Computer Input/Output Development Related Records 425 552 1,580 Claims 1.700 184 5,530 Finance 1.700 138 395 Outside 425 46 395 Total 4,250 920 7,900 This problem, while couched as a cost allocation issue, is in effect a transfer pricing problem.

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a. $\begin{array}{|l|r|r|r|r|r|r|r|} \hline & \text { Records } & \text { Claims } & \text { Finance } & \text { Outside } & \begin{array}{r}\text { Total } \\\text { Charges }\end{array} & \begin{array}{r}\text { Net } \\\text { Allocated }\end{array} & \begin{array}{r}\text { Total } \\\text { Costs }\end{array} \\\hline \text { Hardware and } & & & & & & \\\text { other } & \$ 45,000 & \$ 75,000 & \$ 22,500 & \$ 7,500 & & \\\text { capacity } & (1) & (5) & (9) & (13) & \$ 150,000 & \$ 5,000 & \$ 155,000 \\\text { related costs } & & & & & &\\ \begin{array}{l}\hline\text { Software } \\\text { development }\end{array} & \begin{array}{r}12,750 \\(2)\end{array} & \begin{array}{r}51,000 \\(6)\end{array} & \begin{array}{r}51,000 \\(10)\end{array} & \begin{array}{r}12,750 \\(14)\end{array} & 127.500 & 2,500 & 130,000 \\\hline \begin{array}{l}\text { Computer } \\\text { related } \\\text { operations }\end{array} & \begin{array}{r}110.400 \\(3)\end{array} & \begin{array}{r}36,800 \\(7)\end{array} & \begin{array}{r}27.600 \\(11)\end{array} & \begin{array}{r}9.200 \\(15)\end{array} & 184,000 & 3,000 & 87,000 \\\hline \begin{array}{l}\text { Input/output } \\\text { related } \\\text { operations }\end{array} & \begin{array}{r}15.800 \\(4)\end{array} & \begin{array}{r}55,300 \\(8)\end{array} & \begin{array}{r}3,950 \\(12)\end{array} & \begin{array}{r}3.950 \\(16)\end{array} & 79,000 & (1,000) & 78,000 \\\hline & \$ 183.950 & \$ 218,100 & \$ 105,050 & \$ 33.400 & \$ 540,500 & \$ 9,500 & \$ 550,000 \\\hline\end{array}$
$\begin{array}{|c|c|c|c|c|c|c|c|c|c|c|c|c|c|c|}\hline \text { (1) }& \$ 150,000 & \times & .30 & \text { (5) } & \$ 150,000 & \times & .50 & \text { (9) } & \$ 150,000 & \times& .15 & \text { (13) } & \$ 150,000 & \times & .05 \\\hline\text { (2) }& \$ 30 & \times & 425 & \text { (6) } & \$ 30 & \times & 1.700 & \text { (10) } & \$ 30 & \times& 1.700 & \text { (14) } & \$ 30 & \times & 425 \\\hline\text { (3) }& \$ 200 & \times& 552 & (7) & \$ 200 & \times& 184 & \text { (11) } & \$ 200 & \times& 138 & \text { (15) } & \$ 200 & \times & 46 \\\hline \text { (4) }&\$ 10 & \times& 1.580 & \text { (8) } & \$ 10 & \times& 5.530 & \text { (12) } & \$ 10 & x & 395 & (16) & \$ 10 & \times & 395 \\\hline\end{array}$
b. (i) The new charging system is a form of transfer pricing and should improve cost control in the Systems Department (if the rates are valid) because inefficiencies can no longer be passed on to the user departments. Thus, the Systems Department would be forced to watch its costs more closely.
(ii) The recommended system for charging costs to user departments should improve planning and cost control in the user departments. The users will request service only if its benefits exceed its cost because the user charge is dependent upon services received and not Service Department costs.
(iii) The recommended system for charging costs to user departments appears more equitable than the present system because it is an insulating allocation scheme. No longer will the cost of serving one user affect the charge to other users. However, this reduces the incentives for the users to cooperate.
The old aggregate allocation basis used a single allocation base (computer time) to allocate the costs. In a multi-operational department such as the Systems Department, the use of pre-determined rates for different services (software, input/output, etc.) each requiring different skill levels can be more reasonable in some circumstances (see Chapter 11).

Encryption, Inc. (EI), sells and maintains fax encryption hardware and software. EI hardware and software are attached to both sending and receiving fax machines that encode/decode data, preventing anyone from wiretapping the phone line to receive a copy of the fax. Two EI product groups (Federal Systems and International) manufacture and sell the hardware and software in different markets. Both are profit centers. Federal Systems contracts with federal government agencies to manufacture, install, and service EI products. Existing contracts call for revenues of $1 million per quarter for the next eight quarters. International is currently seeking foreign buyers. Expected quarterly revenues will be $1 million, but with equal likelihood revenues can be $1.5 or $0.5 million in any given quarter. Federal Systems and International each have their own products that differ in some ways but share a common underlying technology. Fax encryption is a new technology and offers new markets. Transferring manufacturing and marketing ideas across products and customers provides important synergies. The variable cost of Federal Systems and International is 50 percent of revenues. The only fixed cost in EI is its Engineering Design group. Engineering Design is EI's R…D group. It designs new hardware and software that Federal Systems and International sell. Quarterly expenses for Engineering Design will be $0.60 million for the next two years. These expenses do not vary with revenues or production costs. Engineering Design costs are to be included in calculating profits for the Federal Systems and International groups. Two ways of assigning the Engineering Design costs to Federal Systems and International are (1) group revenues, and (2) an even 50-50 split. Required: a. Prepare financial statements for Federal Systems and International illustrating the effects of the alternative ways of handling Engineering Design costs. b. Which method of assigning Engineering Design costs do you favor? Why?

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a. The following financial statement calculates the profits of the two divisions using the two alternative cost allocations schemes: $a. The following financial statement calculates the profits of the two divisions using the two alternative cost allocations schemes: b. I prefer to allocate Engineer Design costs based on sales (Panel A). First, it is a non-insulating allocation scheme, meaning that each divisions' profits vary inversely with the other's profits. For example, Federal System's profits will either be $260 or $100, even though their sales and costs remain constant over time. With an even split (Panel B), Federal System's profits do not vary, they remain at $200. Non-insulating schemes encourage cooperation among divisions by giving each division an incentive to improve other divisions' sales and thereby their own profits. Second, the non-insulating scheme reduces the risk International bears and is likely to result in more efficient risk sharing. For example, consider the range of profits each division faces under the two schemes: \begin{array}{|l|c|c|} \hline & \text { Federal Int } & \text { Total } \\ \hline \text { Panel A (non-insulating): Range } & \$ 160\quad \$ 340 & \$ 500 \\ \hline \text { Panel B (insulating): Range } & 0 \quad \$ 500 & \$ 500 \\ \hline \end{array} In panel A, Federal System's net income is either $260 or $100, a range of $160. Whereas in Panel B, Federal System's net income is always $200, a range of zero. The insulating method (panel B) imposes all the risk on International. The non-insulating method spreads some of the risk to Federal Systems. Some may argue that it is not fair to Federal to bear some of International's risk. Certainly, Federal will have to be paid to bear this risk via a risk premium. However, by imposing this risk on Federal it creates incentives for Federal to cooperate with International by sharing production, marketing, and selling ideas.$ $a. The following financial statement calculates the profits of the two divisions using the two alternative cost allocations schemes: b. I prefer to allocate Engineer Design costs based on sales (Panel A). First, it is a non-insulating allocation scheme, meaning that each divisions' profits vary inversely with the other's profits. For example, Federal System's profits will either be $260 or $100, even though their sales and costs remain constant over time. With an even split (Panel B), Federal System's profits do not vary, they remain at $200. Non-insulating schemes encourage cooperation among divisions by giving each division an incentive to improve other divisions' sales and thereby their own profits. Second, the non-insulating scheme reduces the risk International bears and is likely to result in more efficient risk sharing. For example, consider the range of profits each division faces under the two schemes: \begin{array}{|l|c|c|} \hline & \text { Federal Int } & \text { Total } \\ \hline \text { Panel A (non-insulating): Range } & \$ 160\quad \$ 340 & \$ 500 \\ \hline \text { Panel B (insulating): Range } & 0 \quad \$ 500 & \$ 500 \\ \hline \end{array} In panel A, Federal System's net income is either $260 or $100, a range of $160. Whereas in Panel B, Federal System's net income is always $200, a range of zero. The insulating method (panel B) imposes all the risk on International. The non-insulating method spreads some of the risk to Federal Systems. Some may argue that it is not fair to Federal to bear some of International's risk. Certainly, Federal will have to be paid to bear this risk via a risk premium. However, by imposing this risk on Federal it creates incentives for Federal to cooperate with International by sharing production, marketing, and selling ideas.$ b. I prefer to allocate Engineer Design costs based on sales (Panel A). First, it is a non-insulating allocation scheme, meaning that each divisions' profits vary inversely with the other's profits. For example, Federal System's profits will either be $260 or $100, even though their sales and costs remain constant over time. With an even split (Panel B), Federal System's profits do not vary, they remain at $200. Non-insulating schemes encourage cooperation among divisions by giving each division an incentive to improve other divisions' sales and thereby their own profits. Second, the non-insulating scheme reduces the risk International bears and is likely to result in more efficient risk sharing. For example, consider the range of profits each division faces under the two schemes: $\begin{array}{|l|c|c|}\hline & \text { Federal Int } & \text { Total } \\\hline \text { Panel A (non-insulating): Range } & \$ 160\quad \$ 340 & \$ 500 \\\hline \text { Panel B (insulating): Range } & 0 \quad \$ 500 & \$ 500 \\\hline\end{array}$
In panel A, Federal System's net income is either $260 or $100, a range of $160. Whereas in Panel B, Federal System's net income is always $200, a range of zero. The insulating method (panel B) imposes all the risk on International. The non-insulating method spreads some of the risk to Federal Systems. Some may argue that it is not "fair" to Federal to bear some of International's risk. Certainly, Federal will have to be paid to bear this risk via a risk premium. However, by imposing this risk on Federal it creates incentives for Federal to cooperate with International by sharing production, marketing, and selling ideas.