Deck 7: Cost Allocation: Theory

Question 1

Cost Allocation and Contingency Fees
A lawyer allocates overhead costs based on his hours working with different clients.The lawyer expects to have $200,000 in overhead during the year and expects to work on clients' cases 2,000 hours during the year.In addition he wants to pay himself $50 per hour for working with clients.The lawyer,however,does not bill all of his clients based on covering overhead costs and his own salary.Some clients pay her on contingency fees.If the lawyer works with a client on a contingency fee basis,the lawyer receives half of any settlement for his client.During the year the lawyer works 1,200 hours that are billable to clients.The remaining hours are worked on a contingency basis.The lawyer wins $300,000 in settlements for his clients of which he receives half.Actual overhead was $210,000,
What does the lawyer earn during the year after expenses?

Answer 1

Solution to Cost Allocation and Contingency Fees (10 minutes)

Question 2

Incentive Effects of Cost Allocations
Eastern University prides itself on providing faculty and staff a competitive compensation package.One aspect of this package is a faculty and staff child tuition benefit of $4,000 per child per year for up to four years to offset the cost of a college education.The faculty or staff member's child can attend any college or university,including Eastern University,and receive the tuition benefit.If a staff member has three children in college one year,the staff member receives a $12,000 tuition benefit.This money is not taxed to the individual staff or faculty member.
Eastern University pays the benefit directly to the university where the staff/faculty member's child is enrolled or if the student is attending Eastern,it reduces the amount of tuition owed by the faculty/staff member.The university then charges this payment to a benefits account.This benefits account is then allocated back to the various colleges and departments based on total salaries in the college or department.
Evaluate the pros and cons of the present university accounting for tuition benefits.What changes would you recommend making?

Answer 2

Solution to Incentive Effects of Cost Allocations (20 minutes)
Pros: The major advantage of the tuition benefit is that it provides tax-free income to faculty and staff.This can reduce the total compensation cost to the University by the amount of the tax savings,or else the staff receives a windfall gain if their base pay is not adjusted to reflect this additional income.
The current accounting treatment via the benefits account is simple.College tuition benefits are not completely "free" to each college.When making hiring decisions,deans of the colleges will take into consideration the average cost of the tuition benefit.If a large number of faculty/staff in one college are drawing the benefit,their budget is not unduly burdened in this year.
Cons: The problem with the present scheme is that the individual colleges are not charged with the actual cost of the tuition benefits they generate.Deans have incentive to hire staff with college-bound children since they do not bear 100% of the cost.Salary administration is made more difficult.Since a particular dean does not pay the full cost of the tuition benefit of each individual faculty/staff in his or her college,the dean is not aware of the benefit the faculty/staff is drawing,and thus is less likely to adjust the base pay,making it more likely that the faculty/staff receives a windfall gain from the tuition benefit.The deans of each college do not take into account the full cost of hiring/retaining a staff/faculty member with several college-bound children.
Proposal: Each college should be charged for the actual tuition benefits paid for children of faculty/staff in its college.

Question 3

Choosing Allocation Bases For Levying Taxes
The town of Seaside has decided to construct a new sea aquarium to attract tourist.The cost of the measure is to be paid by a special tax.Although most of the townspeople believe the sea aquarium is a good idea,there is disagreement about how the tax should be levied.
Required:
Suggest three different methods of levying the tax and the advantages and disadvantages of each.

Answer 3

Solution to Choosing Allocation Bases for Levying Taxes (15 minutes)
Possible methods of taxing include:
1.Sales tax on hotel rooms and restaurants: This is the most common method of taxing for the construction of a tourist site because the hotels and restaurants benefit directly from tourism.This taxing method is the same as allocating all the costs to the primary customers of the aquarium.
2.Property tax on businesses: This method allocates most of the costs of the aquarium to the businesses with the most expensive property.These businesses are most likely to be able to afford the additional tax.Not all businesses,however,will benefit from the aquarium.
3.Income tax on individuals: Once again,this method allocates costs to the individuals who are most likely to be able to afford the additional tax.But not all of these individuals will benefit from the aquarium.
4.A non-tax method of covering the cost of the aquarium is to issue a bond to pay for the aquarium and then use proceeds from ticket sales to pay the principle and interest on the bond.

Question 4

Allocating Computer Costs
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.
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:
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: 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.
Table 1
Systems Department Costs and Activity Levels Table 2
Historical Utilization by Users
Table 3
Utilization of Systems Department's Services for First Quarter
(in Hours)

Question 5

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:
The overhead costs were as follows:
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:
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.

Question 6

Outsourcing and Overhead
Peluso Company,a manufacturer of snowmobiles,is operating at 70 percent of plant capacity.Peluso's plant manager is considering manufacturing headlights,which are now being purchased for $11 each (a price that is not expected to change in the near future).The Peluso plant has the equipment and labor force required to manufacture the headlights.The design engineer estimates that each headlight requires $4 of direct materials and $3 of direct labor.Peluso's plant overhead rate is 200 percent of direct labor dollars,and 40 percent of the overhead is fixed cost.If Peluso Co.manufactures the headlights,how much of a gain (loss)for each headlight will result?

Question 7

Fixed Costs and Allocated Costs
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?