Deck 7: Cost Allocation: Theory

Question 1

Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below: Variable factory overheads are estimated to be $1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid $24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total $3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs. Assuming normal production levels, what is the direct materials and direct labor cost (i.e., the prime cost) per drum?

A)$1,433.33
B)$1,413.33
C)$1,313.33
D)$1,293.33
E)None of the above

Answer 1

B

Question 2

Which is not a reason for allocating internal costs to cost objects?

A)Managers should be charged for benefits received by departments (or products) under their control
B)US GAAP requires allocation of factory overheads
C)To determine the selling price of products
D)To determine the amount to be reimbursed under a cost-reimbursement contract
E)All of the above are reasons for allocating internal costs to cost objects

Answer 2

C

Question 3

Choosing Allocation Bases for Levying Taxes
The town of Seaside has decided to construct a new sea aquarium to attract tourists. 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

Possible methods of taxing include:
a. 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.
b. 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.
c. 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.
d. 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

King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to $4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh. In the following month, the power generation department costs amounted to $4.3 million for 51 million kwh. Kong Dept.'s usage was the same, but the Kang Dept. increased output to 4.1 million kangs, each using the standard power allowance. If KKC employs an insulating cost allocation mechanism, and fixed costs are shared equally, which is true?

A)Kang will be charged $1.93 million
B)Kong will be charged $1.79 million
C)Kong will be charged $2.07 million
D)Kang will be charged $2.29 million
E)None of the above

Question 5

A sound allocation system should:

A)be cheap and easy to administer
B)provide incentives for cost control
C)charge in proportion to amount used or benefit received
D)be perceived as equitable by those who are charged
E)be all of the above

Question 6

Jim Shoe, chief executive officer of Jolsen International, a multinational textile conglomerate, has recently been evaluating the profitability of one of the company's subsidiaries, Pride Fashions, Inc., located in Rochester, New York. The Rochester facility consists of a dress division and a casual wear division. Daneille's Dresses produces women's fine apparel, while the other division, Tesoro's Casuals, produces comfortable cotton casual clothing.
Jolsen's chief financial officer, Pete Moss, has recommended that the casual wear division be closed. The year-end financials Shoe just received show that Tesoro's Casuals has been operating at a loss for the past year, while Daneille's Dresses continues to show a respectable profit. Shoe is puzzled by this fact because he considers both managers to be very capable.
The Rochester site consists of a 140,000-square-foot building where Tesoro's Casuals and Daneille's Dresses utilize 70 percent and 30 percent of the floor space, respectively. Fixed overhead costs consist of the annual lease payment, fire insurance, security, and the common costs of the purchasing department's staff. Fixed overhead is allocated based on percentage of floor space. Housing both divisions in this facility seemed like an ideal situation to Shoe because both divisions purchase from many of the same suppliers and have the potential to combine materials ordering to take advantage of quality discounts. Furthermore, each division is serviced by the same maintenance department. However, the two managers have been plagued by an inability to cooperate due to disagreements over the selection of suppliers as well as the quantities to purchase from common suppliers. This is of serious concern to Shoe as he turns his attention to the report in front of him. $$\begin{array} { | l | r | r | } \hline & \begin{array} { r } \text { Tesoro's } \\\text { Casuals } \\( \$ 000 s )\end{array} & \begin{array} { r } \text { Daneille's } \\\text { Dresses } \langle \$ 000 s )\end{array} \\\hline \text { Sales revenue } & \$ 500 & \$ 1,000 \\\hline \text { Expenses: } & & \\\hline \text { Direct materials } & \langle \$ 200 ) & \langle \$ 465 ) \\\hline \text { Direct labor } & ( 70 ) & \langle 130 ) \\\hline \begin{array} { l } \text { Selling expenses } \\\text { (all variable) }\end{array} & ( 100 ) & \langle 200 ) \\\hline \begin{array} { l } \text { Overhead } \\\text { expenses: } \\\text { Fixed overhead }\end{array} & \langle 98 ) & \langle 42 )\\\hline \begin{array} { l } \text { Variable overhead }\end{array} & \langle 40 ) & \langle 45 ) \\\hline \begin{array} { l } \text { Net income before } \\\text { taxes }\end{array} & \$ ( 8 ) & \$ 118 \\\hline\end{array}$$ Required:
a. Evaluate Pete Moss's recommendation to close Tesoro's Casuals.
b. Should the overhead costs be allocated based on floor space or some other measure? Justify your answer.

Question 7

King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to $4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh. If KKC uses the simplest algorithm to allocate power costs, which is not true?

A)Kong will be charged $1.6 million
B)Kang will be charged $2.18 million
C)Kang's charge will depend on Kong's usage
D)Since the production departments consume the vast majority of the plant's power costs, it is not cost-efficient to allocate power costs to the service departments
E)All are true

Question 8

Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below: Variable factory overheads are estimated to be $1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid $24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total $3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs. A government agency wants to purchase 200 drums of Xentra at cost plus a flat fee. Which allocation method gives the profit-maximizing result?

A)The current method of determining cost
B)Allocating overheads per machine hour
C)Allocating overheads per direct labor hour
D)Allocating overheads per pound
E)None of the above

Question 9

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, she wants to pay herself $50 per hour for working with clients. In other words, the lawyer's billing rate is the sum of her hourly fee ($50) and a fee to recover the expected overhead spread over 2,000 hours. The lawyer, however, does not bill all of her clients based on covering overhead costs and her 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 her 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 she receives half. Actual overhead was $210,000.
Required:
What does the lawyer earn during the year after expenses?

Question 10

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?

Question 11

If Pluton selects the cost allocation method indicated by your answer to Q7-7, how much will profits increase on this order compared with the present system?

A)No change
B)Change by $31,666.67
C)Change by $17,571.43
D)Change by $6,380.95
E)None of the above

Question 12

You are going to dinner with three friends, one who likes steak, another wine, and the third is a vegetarian (which is assumed to be the least expensive). Which is true?

A)How the bill is shared has no effect on what and how much people choose to eat
B)Equal sharing of the bill ensures that people order a similar dollar amount of food
C)The wine-drinker will argue for equal shares, and will drink as fast (and/or as much) as possible
D)The vegetarian will be better off with equal shares
E)None of the above

Question 13

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)?

Question 14

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.

Question 15

Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below: Variable factory overheads are estimated to be $1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid $24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total $3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs. Assuming normal production levels, what is the full cost per drum?

A)$1,725.00
B)$1,700.73
C)$1,625.00
D)$1,609.00
E)None of the above

Question 16

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.
Required:
Evaluate the pros and cons of the present university accounting for tuition benefits. What changes would you recommend making?

Question 17

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.
Required:
If Peluso Co. manufactures the headlights, how much of a gain (loss) for each headlight will result?

Question 18

Which of the following are true about cost allocation?

A)Cost allocation is a form of transfer pricing for indirect costs
B)Cost allocation is an internal tax on services
C)Cost allocation distorts choices that managers would make otherwise
D)Cost allocation should be imposed when marginal cost exceeds average cost of an internal resource
E)All of the above

Question 19

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.

Question 20

Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below: Variable factory overheads are estimated to be $1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid $24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total $3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs. Assuming normal production levels, what is the conversion cost (direct labor and overhead) per drum?

A)$191.67
B)$287.40
C)$311.67
D)$315.67
E)None of the above

Question 21

Cost Allocations can Change the Relative Profitability of Products
Woodley Furniture is a small boutique manufacturer of high quality contemporary wood tables. They make two models: end tables and coffee tables in a variety of different woods and finishes. Current annual production of end tables is 8,000 units that sell for $250 and have variable cost of $120 each. Current annual production of coffee tables is 6,000 units that sell for $475 and have variable cost of $285 each. Woodley has fixed costs of $2.4 million. Woodley sells all the tables they produce each year.
Required:
a. Calculate total firm-wide profits and product-line profits for the end tables and coffee tables after allocating the fixed costs to the two product lines using sales revenues as the allocation base.
b. Which of the two products is the most profitable based on total profits (after allocating fixed costs)? Is Woodley making an adequate profit?
c. Woodley management decides to add a dining table to its product offerings. The plant currently has excess capacity, so no additional fixed costs are required to produce the dining tables. The new dining table will not affect the number of units sold or prices of the existing coffee and end tables. They expect to sell 4,000 dining tables at a price of $620 each, and variable cost per table is $500. Calculate total firm-wide profits and product-line profits for the end tables, coffee tables, and dining tables after allocating the fixed costs to the three product lines using sales revenues as the allocation base.
d. Analyze the profitability of the three products and firm-wide profits calculated in part (c) compared to the profitability of the two products alone and firm-wide profits in part (a).
e. Recalculate your answers to parts (a) and (c), but, instead of allocating the $2.4 million of fixed costs using sales revenues as in parts (a) and (c), allocate the $2.4 million of fixed costs using the total contribution margin of each product (total sales revenue less total variable cost).
f. Discuss the relative advantages and disadvantages of using total contribution margin to allocate the fixed costs in part (e) relative to using sales revenues to allocate the fixed costs, as in parts (a) and (c).

Question 22

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?

Question 23

Analyzing Alternative Allocation Schemes for Distribution Costs
Telstar Electronics manufactures and imports a wide variety of consumer and industrial electronics, including stereos, televisions, camcorders, telephones, and VCRs. Each line of business (LOB) handles a single product group (e.g., televisions) and is organized as a profit center. The delivery of the product to the wholesaler or retailer is handled by Telstar's distribution division, a cost center. Previously, Telstar was organized functionally, with manufacturing, marketing, and distribution as separate cost centers. Two years ago, it reorganized to the present arrangement.
Distribution assembles products from the various LOBs into larger shipments to the same geographic area to capture economies of scale. The division is also responsible for inbound shipments and storage of imported products. It has its own fleet of trucks, which handles about two-thirds of the shipments, and uses common carriers for the remainder. Currently, the costs of the distribution division are not allocated to the LOBs, but LOBs do pay the cost for any special rush shipment using an overnight or fast delivery service, such as Federal Express or UPS. For example, if a customer must have overnight delivery, the LOB ships directly without using Telstar's distribution center and the LOB is charged for the special delivery.
The corporate controller is mulling over the issue of allocating the costs of distribution. Several allocation schemes are possible:
1. Allocate all distribution division costs based on gross sales of the LOBs.
2. Allocate all distribution division costs based on LOB profits.
3. Allocate the direct costs of each shipment (driver, fuel, truck depreciation, tolls) using the gross weight of each LOB's product in the shipment. Then allocate the other costs of the distribution division (schedulers, management, telephones, etc.) using the total direct shipping costs assigned to each LOB.
One argument against allocating is that it will distort relative profitability. The controller says, "Because allocations are arbitrary, the resulting LOB profitabilities become arbitrary." Another argument is that it is not fair to charge managers for costs they cannot control. LOBs cannot control shipping costs. For example, there are savings when two small separate shipments are combined into a single large shipment. LOBs will tend to avoid opening up new sales territories when other Telstar products are not being shipped to that area.
Required:
Write a memo addressing the controller's concerns. Should Telstar begin allocating distribution costs to the LOBs? If so, which allocation scheme should it use?

Question 24

Bio Labs is a genetic engineering firm manufacturing a variety of gene-spliced, agricultural-based seed products. The firm has five separate laboratories producing different product lines. Each lab is treated as a profit center and all five labs are located in the same facility. The wheat seed lab and corn seed lab manufacture two of the five product lines. These two labs are located next to each other and are of roughly equal size in terms of sales. The two departments have close interaction, often sharing equipment and lab technicians. Both use very similar technology and science and usually attend the same scientific meetings.
Recent discoveries have shown how low-power lasers can be used to significantly improve product quality. The wheat seed and corn seed managers are proposing the creation of a laser testing department to employ this new technology. Leasing the equipment and hiring the personnel cost $350,000 per year. Supplies, power, and other variable costs are $25 per testing hour. The testing department is expected to provide 2,000 testing hours per year. The wheat seed manager expects to use 700 testing hours per year of the laser testing department and the corn seed manager expects to use 800 testing hours. The remaining 500 hours of testing capacity can be used by the other three labs if the technology applies or can be left idle for future expected growth of the two departments. Initially, only wheat and corn are expected to use laser testing.
The executive committee of Bio Labs has approved the proposal but is now grappling with how to treat the costs of the laser testing department. The committee wants to charge the costs to the wheat seed and corn seed labs but is unsure of how to proceed.
At the end of the first year of operating the laser, wheat seed used 650 testing hours, corn seed used 900 hours, and 450 hours were idle.
Required:
a. Design two alternative cost allocation systems.
b. Give numerical illustrations of the charges the corn and wheat seed labs will incur in the first year of operations under your two alternatives.
c. Discuss the advantages and disadvantages of each.

Question 25

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.