CH-10 Managing and Allocating Support-Service Costs – Cost Management: Strategies for Business Decisions : Book Guide

Chapter 10 Managing and Allocating Support-Service Costs ANSWERS TO REVIEW QUESTIONS 10.1 The following factors should be considered when deciding whether to outsource a support service: • cost • quality, timeliness, and reliability • security of sensitive information • knowledge required 10.2 Some of the costs of cost allocation include: • additional bookkeeping; • additional management costs in selecting allocation methods and allocation bases; and • costs of making the wrong decision if the allocations provide misleading information. 10.3 Some of the benefits of cost allocation include: • instilling responsibility for all costs of the company in the division managers; • relating indirect costs to contracts, jobs and products; and • constructing performance measures (“net profit”) for a division that may be more meaningful to management than contribution margins. 10.4 Aside from regulatory requirements, costs are allocated if the benefits of cost allocation exceed the costs incurred to make the allocation. 10.5 Management often uses this type of information for performance evaluation and to assess long-run decisions. That is, in the long run, an activity (e.g., production) must recover all of its costs (both direct and indirect). 10.6 Some common cost categories and allocation bases are: Cost Category Allocation Bases Labor-related costs number of employees labor hours wages paid some other labor-related base Machine-related costs machine hours current value of machinery number of machines some other machine-related base Space-related costs area occupied volume occupied some other space-related base Service-related costs computer time service hours some other service-related base 10.7 The essential difference is the allocation of costs among service departments. The direct method makes no inter-service-department allocation, the step method makes a partial inter-service-department allocation, while the reciprocal method recognizes inter-service-department activities. 10.8 Allocations usually begin from the service department that has provided the greatest proportion of its services to other departments, or that services the greatest number of other service departments. This criterion is used to minimize the unrecognized portion of reciprocal service department costs. (Recall that the amount of service received by the first department to allocate in the step allocation sequence is ignored.) ANSWERS TO CRITICAL ANALYSIS 10.9 The answer probably depends on each party’s point of view. Sharing equally is simplest, but may not accurately reflect the use of housekeeping resources. Relative size of rooms, frequency of use, and relative neatness also could be used, but the latter two will be difficult to monitor. Using size of rooms also ignores use and cleaning of common areas. (In college, my roommates and I had several cleaning rules, which would have appalled my mother: wash dishes when there were no more to use, clean your own room whenever you felt like it, jointly clean common areas before special guests were due to arrive.) 10.10 Cost is one dimension of the outsourcing decision, and external providers may have a cost advantage in providing certain support services. Market forces work to keep the prices charged for outsourced services competitive, probably more efficiently than internal, budgetary controls. But direct cost of the service is not the only consideration, and there may be other costs of outsourcing a service. For example, many companies use internal audit departments for management training. Though they perhaps could get the internal audit service more cheaply by outsourcing, they would lose the benefits of simultaneous management training. 10.11 The allocation of Joe’s overhead costs to the counter space is, for the most part, “nutsy”. Joe faces a business decision, not an allocation problem. The key issues that Joe should consider are (1) the incremental costs and benefits of adding the peanuts and (2) the opportunity costs of the counter space. In addition to the costs of the nuts and the rack, Joe might incur a small cost for ordering peanuts, stocking the rack, recording the sales and keeping that part of the counter clean. But these costs are likely to be minimal. Joe should consider the impact of the sale of peanuts on other products. Does having the rack of peanuts mean that some customers will buy a bag of nuts instead of buying a dessert? Finally, Joe should consider the opportunity cost of the counter space. If the peanuts truly take up a dead spot, then the opportunity cost might be zero. However, presumably, Joe could put something else for sale, such as candy or newspapers, at the “dead spot”. 10.12 Cost allocations are arbitrary and potentially misleading; however, that does not mean that they are capricious or necessarily dangerous. Deciding which services to provide should depend on an analysis of the costs and benefits of those services. Users of the services may provide the best signals about which services they need by their demand for those services. If the services cost users nothing, they will overuse any beneficial service. If the services are overpriced, they will under-use services. If there are no market prices to use as guides, allocated costs of services may be a successful way for managers to gauge demand for internal services. 10.13 Allocating zero costs is another allocation method. It, too, is an arbitrary method. However, an advantage of not allocating costs is that the time saved reduces the expenses of cost allocation itself. A disadvantage is that common costs must be covered before the company as a whole earns a profit. Cost allocation may make managers more aware of common costs affecting long-run profitability. 10.14 If cost allocations affect the budgets or performance evaluations of service and user departments, you can be sure that both sides will scrutinize how the cost allocations are made. Even though there may be no question about the technical correctness of cost allocations, issues of fairness often are resolved politically. This may be especially important if methods of cost allocation change significantly, and unbalance the system of charges that everyone had gotten used to. 10.15 The reciprocal method takes into account all of the services rendered among the service departments. It is preferred (assuming cost-effectiveness) since it results in an allocation scheme that reflects the total cost of the use of each service. 10.16 If no service department performs services for any other service department (or if all service departments render services to producing departments in the same proportions) then the direct method will give the same answer as any other allocation method. 10.17 The addition of an employee in one department will increase the allocation base and, therefore, reduce the allocation to the department which does not add the employee. The manager of the department which does not add the employee benefits from the actions of the other department. An example may serve to highlight the point. If each producing department has one employee and service department costs total $12,000, then the allocation would be: To P1: 1 employee x ($12,000  2 employees) = $6,000. This would be the same as the allocation to P2. Now if P1 adds an employee, the allocation would be: P1 2 employees x ($12,000  3 employees) = $8,000 P2 1 employee x ($12,000  3 employees) = $4,000 The manager in P2 has a $2,000 cost reduction even though the manager of P2 took no action which would warrant such a reduction in costs. One of the problems that may give rise to this situation is that the costs allocated do not bear a relationship to the allocation base. Thus, if a number of employees were an appropriate allocation base, one would not expect the total cost to remain fixed when the number of employees increases. In practice, though, it may not be possible to obtain correlation between a cost and the allocation base. 10.18 The statement seems to imply that service cost spending is driven by unit-level demand for services. In most cases, however, the primary cost driver of a support service is the management decision to provide the capacity to deliver the service. If cost allocations are charges for services, then users will only demand services if they perceive benefits in excess of the costs of the service. Lack of demand for some services should be a signal to management that the organization has too much service capacity. This should lead to reductions of service costs. If, however, the cost allocations are unrelated to use of services, then cost allocations, as the statement points out, will do little to control service costs. 10.19 The service costs are being allocated on the basis of use when, in fact, some of the costs were incurred to provide capacity. When usage goes down, the cost per unit of use goes up. Capacity costs could be allocated on the basis of the capacity requested by each of the departments while the costs of use could be allocated on the current use. Or, the company could allocate using a standard cost per unit that does not change per unit as the total usage changes. SOLUTIONS TO EXERCISES 10.20 (20 min) Alternative allocation bases a. The Klingons would argue that since each party has one-half of the land, the proceeds should be split equally. They would hold that they must give up their use of the whole 4,000 acres to accommodate the intrusion of the oil developer. It doesn’t matter to the Klingons what the underground deposit looks like. What is important is the impact it will have on their enjoyment of the surface. b. The Romulans would prefer costs to be allocated based on the relative volume of the underground oil reservoir (i.e., the acre-feet). They would argue that since 3/4 of the oil-bearing rock is under their land, they are entitled to 3/4 of the purchase price. Surface areas are irrelevant because the asset being assigned is the right to the underground minerals, not the use of the surface. c. The agreed upon solution will vary, but will likely be some mix of the two options described in (a) and (b). 10.21 (15 min) Alternative service-cost allocation bases c. Allocation by wire service hours increases the allocation of costs to the TV station. Use of hours of news broadcast as a basis increases the allocation of costs to the radio station. The choice of allocation methods will impact the profitability of each station (TV and radio). If managers are paid a bonus based on profits of their respective stations, the choice of method will certainly affect these bonuses. 10.22 (20 min) Alternative allocation bases b. The front of the store may be more valuable space. If so, “Meat” should be allocated more per square foot than “Dry Goods.” There is little question that store areas with a greater customer traffic count are considered more valuable. An allocation scheme based on traffic count or profits before cost allocation might be considered more reasonable. 10.23 (25 min) Alternative service-cost allocation bases Amount to allocate $ 1,600,000 Allocation Base Amount Percentage Allocation Cost of Data Purchased Standard Report $20,000 40% $640,000 Executive Report 30,000 60% 960,000 Total $50,000 100% $1,600,000 Research hours Standard Report 12,000 40% $640,000 Executive Report 18,000 60% 960,000 Total 30,000 100% $1,600,000 Interview hours Standard Report 1,000 20% $ 320,000 Executive Report 4,000 80% 1,280,000 Total 5,000 100% $1,600,000 Number of reports Standard Report 8,000 80% $1,280,000 Executive Report 2,000 20% 320,000 Total 10,000 100% $1,600,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.24 (25 min) Alternative allocation bases a. Standard Executive Cost of data purchased ….… $20,000 $30,000 Cost of labor: Research hours……………… 12,000 18,000 Interview hours……………… 1,000 4,000 Total hours……………………. 13,000 22,000 Total cost at $40 per hour... $520,000 $880,000 Total cost of data and labor $540,000 $910,000 Number of reports 8,000 2,000 Data and labor cost per report…. $67.50 $455.00 Cost allocation: Using the data purchased allocation base $640,000 $960,000 Service cost per report……….. $ 80.00 $480.00 Data and labor cost per report. 67.50 455.00 Total cost per report…………… $147.50 $935.00 Cost allocation: Using the research hours allocation base $640,000 $960,000 Service cost per report $ 80.00 $480.00 Data and labor cost per report. 67.50 455.00 Total cost per report…………… $147.50 $935.00 Cost allocation: Using the interview hours allocation base $320,000 $1,280,000 Service cost per report……….. $40.00 $640.00 Data and labor cost per report. 67.50 455.00 Total cost per report…………… $107.50 $1,095.00 Cost Allocation: Number of reports $1,280,000 $320,000 Service cost per report……….. $160.00 $160.00 Data and labor cost per report. 67.50 455.00 Total cost per report…………… $227.50 $615.00 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. The different cost numbers in this report are a result of the four different allocation bases available. The allocation method chosen does not affect the company’s total service costs, only the costs assigned to each service. c. Answers will vary, but should address the fact that management must evaluate the cause and effect relationship comprising overhead costs to determine the most appropriate allocation base. 10.25 (20 min) Cost allocations; direct method a. S1 S2 P1 P2 Row total Proportion of S1 service used 0.20 0.20 Allocation of S1 to: $(80,000) $ 40,000 $ 40,000 $ 0 Proportion of S2 service used 0.50 0.30 Allocation of S2 to: $(100,000) $ 62,500 $ 37,500 $ 0 Total allocated service costs 102,500 77,500 $180,000 Direct departmental costs 160,000 140,000 300,000 Total departmental costs $262,500 $217,500 $480,000 b. Build your own spreadsheet EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.26 (30 min) Service department costs allocated first to production departments and then to jobs P1's service costs P2's service costs Job 10 Job 11 Row total Amount of P1 production used (labor hours) 80 10 90 Proportion of P1 production used (80/90, 10/90) 0.89 0.11 1.00 Allocation of P1's service cost $(102,500)* $91,225 $11,275 $ 0 Amount of P2 production used (Machine hours) 20 90 110 Proportion of P2 production used (20/110, 90/110) 0.18 0.82 1.00 Allocation of P2 service cost $(77,500)* 13,950 63,550 $ 0 Total allocated service costs to jobs $105,175 $74,825 $180,000 * Calculated in Exercise 10.25 10.27 (25 min) Cost allocation; direct method Gen'l factory admin (GFA) Maintenance Cutting Assembly Row Total Amount of area occupied (sq ft) 1,000 1,000 3,000 4,000* Proportion of area occupied 0.25 0.75 1.00 Allocation of maintenance cost $ (48,000) $12,000 $36,000 $ - Amount of labor hours 100 100 400 500** Proportion of labor hours 0.20 0.80 1.00 Allocation of GFA cost $(20,000) 4,000 16,000 $ - Total allocated service costs to jobs $16,000 $ 52,000 $68,000 * Excludes area occupied by GFA ** Excludes labor hours for Maintenance EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.28 (30 min) Cost allocation; step method a. Starting with S1 S1 S2 P1 P2 Row total Proportion of S1 service used 0.60 0.20 0.20 Allocation of S1 to: $(80,000) $48,000 $ 16,000 $ 16,000 $ 0 Proportion of S2 service used (0.5/0.8, 0.3/0.8) 0.625 0.375 S2 direct cost 100,000 Allocation of adjusted S2 to: (0.625x148,000, 0.375x148,000) $(148,000) $ 92,500 $ 55,500 $ 0 Total allocated service costs $108,500 $ 71,500 $180,000 Direct departmental costs 160,000 140,000 300,000 Total departmental costs $268,500 $211,500 $480,000 b. Starting with S2 S1 S2 P1 P2 Row total Proportion of S2 service used 0.2 0.50 0.30 Allocation of S2 cost $ 20,000 $(100,000) $ 50,000 $30,000 $ 0 Proportion of S1 service used (0.2/0.4, 0.2/0.4) 0.50 0.50 S1 direct cost $ 80,000 Allocation of adjusted S1 cost $(100,000) $ 50,000 $50,000 $ 0 Total allocated service costs $100,000 $80,000 $180,000 Direct departmental costs 160,000 140,000 300,000 Total departmental costs $260,000 $220,000 $ 480,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.29 (30 min) Cost allocation; step method Gen'l factory admin (GFA) Maintenance Cutting Assembly Row total Amount of area occupied (sq ft) 1,000 1,000 3,000 5,000 Proportion of area occupied 0.2 0.20 0.60 1.00 Allocation of maintenance cost $ 9,600 $ (48,000) $ 9,600 $ 28,800 $ 0 Amount of labor hours 100 400 500 Proportion of labor hours 0.20 0.80 1.00 Direct GFA cost 20,000 Allocation of adjusted GFA cost $(29,600) 5,920 23,680 $ 0 Total allocated service costs to jobs $ 15,520 $ 52,480 $ 68,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE The direct method of allocation versus the step method yields these different total service costs for the departments. Cutting Assembly Direct Method $ 16,000 $ 52,000 Step Method $ 15,520 $ 52,480 Difference $ 480 $ (480) In this example the differences are minor; however, the differences can be quite significant in other cases. 10.30 (20 min) Cost allocation comparisons The direct method of allocation versus the step method yields these different total service costs for the departments. P1 P2 Direct Method $ 102,500 $ 77,500 Step Method $ 108,500 $ 71,500 Difference $ (6,000) $ 6,000 The difference between the two methods is $6,000, a relatively significant amount. Although the direct method is simpler, the step method is more accurate because it reflects the use of support-service resources by other support service departments. 10.31 (30 min) Cost allocation; reciprocal method Note: Answers might differ because of rounding. FROM: S1 S2 P1 P2 P3 Total Coefficients and Spending Relative use coefficients TO: S1 -1.00 0.10 0.00 0.00 0.00 S2 0.40 -1.00 0.00 0.00 0.00 P1 0.30 0.20 1.00 0.00 0.00 P2 0.20 0.15 0.00 1.00 0.00 P3 0.10 0.55 0.00 0.00 1.00 Spending for support services $67,000 $59,500 $ - $ - $ - $126,500 Inverse coefficient matrix TO: S1 -1.042 -0.104 0 0 0 S2 -0.417 -1.042 0 0 0 P1 0.396 0.240 1 0 0 P2 0.271 0.177 0 1 0 P3 0.333 0.583 0 0 1 Support-service cost allocations TO: S1 $(69,792) $ (6,198) $ - $ - $ - S2 (27,917) (61,979) - - - P1 26,521 14,255 - - - 40,776 P2 18,146 10,536 - - - 28,682 P3 22,333 34,708 - - - 57,042 $126,500 Total Costs P1 P2 P3 Total Costs allocated from service departments $ 40,776 $ 28,682 $ 57,042 $126,500 Departmental costs 120,000 312,500 390,000 822,500 Totals $160,776 $341,182 $447,042 $949,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.32 (30 min) Cost allocation; reciprocal method Note: Answers might differ because of rounding. FROM: Admin Maintenance Cutting Assembly Total Coefficients and Spending Relative use coefficients TO: Admin -1.00 0.20 0.00 0.00 Maintenance 0.17 -1.00 0.00 0.00 Cutting 0.17 0.20 1.00 0.00 Assembly 0.67 0.60 0.00 1.00 Spending for support services $ 20,000 $ 48,000 $ - $ - $ 68,000 Inverse coefficient matrix TO: Admin -1.034 -0.207 0 0 Maintenance -0.172 -1.034 0 0 Cutting 0.207 0.241 1 0 Assembly 0.793 0.759 0 1 Support-service cost allocations TO: Admin $ (20,690) $ (9,931) $ - $ - Maintenance (3,448) (49,655) - - Cutting 4,138 11,586 - - $ 15,724 Assembly 15,862 36,414 - - 52,276 $ 68,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.33 (20 min) Evaluation of cost-allocation methods a. & b. The answer to these questions depends on the cost and benefits of each method. The reciprocal method takes into account the fact that each service department uses the services of the other. Although the difference in costs is small (see below), there is a gain of increasing cross-department cost monitoring. The value of any particular method depends on how the numbers will be used. If the allocations are used only to compute inventory values and cost of goods sold in external financial statements, then it usually makes sense to use the easiest method. If the numbers are to be used for managerial decision making, then the increased precision of the more complex methods may justify the additional cost. Comparison of three costing methods Costs allocated Cutting Assembly Total Direct Method $ 16,000 $ 52,000 $ 68,000 Step Method $ 15,520 $ 52,480 $ 68,000 Reciprocal Method $ 15,724 $ 52,276 $ 68,000 10.34 (40 min) Explain differences in cost-allocation methods Responses will vary, but presentations should focus on tradeoffs between perceived costs and benefits of using different allocation bases. Traditional allocation bases usually are readily available, whereas ABC cost-driver bases must be investigated. Thus, an ABC approach will be more costly to install and maintain. On the other hand, ABC allocations will more closely represent use of support service resources, leading to better decision making about service capacity and use. SOLUTIONS TO PROBLEMS 10.35 (25 min) Service cost allocation; direct method Assume the following bases: Computing services Computer time Human resources Payroll Custodial service Area occupied * Sum of computing cost, HR cost and custodial cost. b. Build your own spreadsheet EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.36 (30 min) Cost allocation: Direct method Note that rounding affects some of the answers. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.37 (40 min) Cost allocation; step method Cost allocation bases in other service departments Building occupancy Human resources Designs & patterns Total base % of base in other service departments Building occupancy - 8,100 3,900 81,000 14.8% Human resources 3 - 6 60 15.0% Design & patterns - - - 60 0.0% By a very small margin, Human Resources is the more general service department and Building Occupancy is second. Allocation of service costs Building occupancy S1 Human Resources S2 Design & patterns S3 Shirt-making P1 Printing P2 Sales P3 Total Amount of HR base 3 - 6 30 15 6 60 Proportion of HR base 0.05 0.10 0.50 0.25 0.10 1.00 Allocation of HR cost $ 1,000 $(20,000) $ 2,000 $10,000 $ 5,000 $ 2,000 $ - Amount of Building occupancy base 0 0 3,900 27,000 36,000 6000 72,900 Proportion of Building occupancy base - - 0.0535 0.3704 0.4938 0.0823 1.00 Building occupancy direct cost $ 45,000 Allocation of adjusted Building occupancy cost $ (46,000) $ 2,461 $17,037 $ 22,716 $ 3,786 $ - Amount of Design & patterns base - - - 15 40 5 60 Proportion of Designs & patterns base - - - 0.25 0.6667 0.0833 1.00 Design & patterns direct cost $10,000 Allocation of adjusted Designs & patterns - $ (14,461) $ 3,615 $ 9,641 $ 1,205 $ - Total allocated service costs to jobs $30,652 $ 37,357 $ 6,991 $75,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.38 (40 min) Effects of alternative cost-allocation methods. Note: Answers might differ because of rounding. a. Direct Method: All service department costs are allocated based on the number of employees, so only one cost pool is necessary. Call it “service costs.” Allocation of service costs Service Assembly Bolting Total Receiving cost $ 25,000 Repair 35,000 Tool 10,000 Total service costs $ 70,000 Number of employees 25 12 37 Proportion of employees 0.6757 0.3243 1.00 Allocation of service cost $ 47,299 $ 22,701 $70,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. Step method c. The total amounts allocated to the production departments will be almost the same for the step method as for the direct method. In this particular case, the production departments will not be too concerned about which method is used. However, the step method allocates costs to support service departments (prior to being allocated to the production departments), so support departments will care. 10.39 (45 min) Choice of appropriate allocation bases a. There are several possibilities regarding the allocation of costs to the two products. The first approach allocates conversion and materials costs based on annual costs divided by annual output (called “normal” costing). This analysis is shown below. The second approach allocates conversion costs based on the annual costs divided by 365 to get a cost per day, which is then allocated to production depending on the units of chips produced each day. Actual daily materials costs are tied directly to each chip (treated as a direct cost). This approach is shown below. * Materials cost per chip equals cost of materials used divided by the number of units produced (for example, for the RAM-A chips $0.1250 = $25,000 / 200,000 units EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.39 (continued) The third approach allocates conversion costs based on annual costs divided by 365 to get a cost per day, which is then allocated to production each day depending on the unit-level cost of materials used. Actual daily materials costs are tied directly to each chip (treated as a direct cost). This approach is shown below. RAM-A RAM-B Total Conversion cost per day ($3,025,000/365) $ 8,288 Unit-level materials, $ 25,000 1,896 26,896 Allocations based on materials, $ 7,703 584 8,288 Conversion per chip $ 0.0385 $ 0.3651 Materials per chip* 0.1250 1.1850 Total cost per chip $ 0.1635 $ 1.5501 * Materials cost per chip equals cost of materials used divided by the number of units produced (for example, for the RAM-A chips $0.1250 = $25,000 / 200,000 units The fourth approach allocates conversion costs based on annual costs divided by 365 to get a cost per day, which is then allocated to production each day depending on the cost of labor used. Actual daily materials costs are tied directly to each chip (treated as a direct cost). This approach is shown below. RAM-A RAM-B Total Conversion cost per day ($3,025,000/365) $ 8,288 Labor used, $ 2,000 1,200 3,200 Allocations based on labor, $ 5,180 3,108 8,288 Conversion per chip $ 0.0259 $ 1.9425 Materials per chip* 0.1250 1.1850 Total cost per chip $ 0.1509 $ 3.1275 * Materials cost per chip equals cost of materials used divided by the number of units produced (for example, for the RAM-A chips $0.1250 = $25,000 / 200,000 units Answers will vary regarding the recommendation of a cost-allocation approach. However, for a process that is highly automated (such as this one), it is likely that the cost of labor does not drive the costs being allocated and should not be used. If the cost of materials used drives conversion costs, then this might be an appropriate choice. b. Answers will vary. Whichever cost-allocation method is selected, the total manufacturing cost per chip is shown in the four charts above. 10.39 (continued) c. Here is a graph presentation (not required). Several cost differences are driven by changes in the costs of material inputs. For example, the current cost of materials for the RAM-A chip is half the normal cost. Current material costs for the RAM-B chips are slightly higher. Note that a FIFO method of accounting for these costs would show the differences dramatically in costs of goods completed compared to average costs if prior costs were close to normal costs. The largest differences in costs per unit occur when comparing other costs to the daily cost using direct labor as the allocation base for conversion costs. The large allocation of conversion cost using labor as the base demonstrates that use of labor is largely a batch activity, unrelated to the number of chips produced. A small batch of RAM-B chips requires nearly the same amount of setup labor as a much larger batch of RAM-A chips. 10.40 (45 min) Step method with three service departments a. Allocation of costs using the step method EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.40 (continued) b. Calculation of service costs per unit Department Allocated service costs Units produced Unit cost Mechanical Repair $ 665,703 1,000 $ 666 Body Work $ 458,297 1,000 $ 458 The company met management’s standards of keeping service department costs below $500 per unit in Body Work but not in Mechanical Repair. 10.41 (30 min) Cost allocation; direct method Since the direct method is used, there are no allocations between service departments. Here’s an algebraic solution: Using information about use of S2 by producing departments only [0.3/(0.5 + 0.3)] x S2 = $22,500; S2 = $60,000 Since $22,500 is allocated to P2, the allocation of S2 to P1 is $60,000 - $22,500 = $37,500. Also, [0.5/(0.5 + 0.3)] x $60,000 = $37,500 Since S1 + S2 = $100,000, S1 = $100,000 - $60,000 = $40,000 Since the allocation of S1 to P1 = $40,000, the allocation of S1 to P2 is $40,000 - $40,000 = 0 or 0% to P2 and 100% to P1 a. Total service costs allocated to P2 = $22,500 + 0 = $22,500 b. Completing the 2 x 2 chart: Costs allocated to P1 Costs allocated to P2 $40,000 from S1 $0 from S1 $37,500 from S2 $22,500 from S2 c. 100% of S1 is allocated to P1, 0% to P2 10.42 (60 min) Cost allocation; step method with analysis and decision making EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.42 (continued) Comparison of internal electricity cost with outsourced cost (Assuming that electricity generation causes the costs allocated to it.) The company should not outsource unless there are considerations not reflected in this analysis. b. Revised comparison of cost of internal electricity with outsourced cost (Again assuming that the costs allocated to Electricity generation would be saved if electricity generation is outsourced.) Opportunity cost of natural gas $ 58,000 (alternatively, could net this against the cost of external electricity Adjusted electricity generation cost 138,000 total cost of internal generation 196,000 Outsourced cost $ 160,000 Cost difference $ 36,000 Perhaps the company should outsource unless there are other considerations. 10.43 (45 min) Cost allocation; reciprocal method a. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. The total cost of Electricity Generation (S2) using the reciprocal approach, is the sum of the costs allocated to S2 from all service departments = $30,059 + $118,089 + $9,791 = $157,939. The sum of all reciprocal costs of the service departments, $322,593, is greater than the spending for these departments, $228,000, because these service costs are reallocated among the service departments. If a department is eliminated and the direct costs of that department are saved, the total savings to the company might be the reciprocal costs (e.g, $157,939) because of the savings to other departments. (The step method does not reallocate costs among the service departments. Instead, once a cost is allocated out of a service department to other departments, that service department is no longer considered in the allocation process.) 10.44 (30 min) Cost allocation and decision making It is important to distinguish between costs that are traced or assigned directly to the department and those that are arbitrarily allocated for full costing purposes. If the promotion department is outsourced, only those costs caused by the activities of that department could be saved. Other, facility-level costs may continue and be re-allocated to other departments. From the problem description, we can make the following assumptions about possible cost savings from outsourcing the promotion department: Department costs $128,750 Would be saved if equipment and facilities are sold and personnel are let go. Otherwise, no costs would be saved. If these direct costs are saved, other termination costs may be incurred (severance, training, etc.) Charges from other departments $ 33,460 Would be saved if service departments would reduce their spending (e.g., reduce capacity and terminate personnel). Otherwise, no costs would be saved. General administrative overhead 22,125 Would be saved only if central administration reduced spending as well. Otherwise no costs would be saved. Overall, it is almost impossible to estimate the cost savings from closing the Promotion Department. 10.45 (30 min) Service department cost allocation; direct and step methods a. Factory maintenance is allocated based on square footage occupied. The direct method is used. The amount allocated to the fabrication department is [88,000 / (88,000 + 72,000)] x $203,200 = $111,760 b. General factory administration is allocated based on direct labor hours. The direct method is used. The amount allocated to the assembly department is [437,500 / (562,500 + 437,500)] x $160,000 = $70,000 c. Factory cafeteria costs are allocated based on number of employees. Using the step method, the amount allocated to the factory maintenance department is [8 / (8 + 12 + 280 + 200)] x $240,000 = $3,840 d. In the step method, there is no allocation of costs back to the department after costs have been allocated from it. Factory cafeteria costs have already been allocated from it to other departments. 10.46 (40 min) Cost allocations; comparison of single and multiple cost pools Division Time Usage % time use Storage Capacity % storage Total Reservations 2,500 16.1290% 1,500 60.0% Scheduling 1,700 10.9677% 600 24.0% Maintenance 6,300 40.6452% 210 8.4% Accounting 5,000 32.2581% 190 7.6% Totals 15,500 100.0000% 2,500 100.0% Service cost $ 7,050,000 $ 5,000,000 $ 12,050,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE a. Allocate computer service costs based on: (1) single cost pool based on time usage Reservations Scheduling Maintenance Accounting Total Allocations based on time usage % $ 1,943,545 $ 1,321,608 $ 4,897,747 $ 3,887,100 $ 12,050,000 (2) two cost pools based on time usage and capacity used Reservations Scheduling Maintenance Accounting Total Allocations based on time usage % $ 1,137,095 $ 773,223 $ 2,865,487 $ 2,274,195 $ 7,050,000 Allocations based on storage % 3,000,000 1,200,000 420,000 380,000 5,000,000 Totals $ 4,137,095 $ 1,973,223 $ 3,285,487 $ 2,654,195 $ 12,050,000 b. Differences between one cost pool and two Answers to this will vary. The table below shows the difference between the two approaches used in requirement (a). A discussion of the results follows the table. Reservations Scheduling Maintenance Accounting Total One cost pool costs $ 1,943,545 $ 1,321,608 $ 4,897,747 $ 3,887,100 $ 12,050,000 Two cost pool costs 4,137,095 1,973,223 3,285,487 2,654,195 12,050,000 Difference $(2,193,550) $(651,615) $1,612,260 $1,232,905 $ - % difference 113% 49% -33% -32% (10.46 cont.) These are dramatic swings in cost allocations. If the two-cost pool method is judged to reflect use of resources more accurately than the single-cost pool method, management should think about switching. Considerations are cost of the more complex system, changes in use of computing systems that may result, effects on the other departments’ budgets, evaluations, and decision-making. 10.47 (20 min) Cost allocation for travel reimbursement a. (1) Since the round-trip cost of the Salt Lake City portion (2 x $1,400 = $2,800) is greater than the cost of the ticket obtained, the employee would request the full $2,640. (2) The minimum cost to the company would be $1,400. b. Answers will vary, but should address the maximum and minimum reimbursements calculated in part (a). SOLUTIONS to CASES 10.48 (40 min.) Cost allocation for rate-making purposes a. Consumer Group Presentation: Premium revenue $ 300 Operating costs: Claims $ 205 Administrative, total = $ 55 38.5 70% of total Sales commissions, total = $40 32 80% of total Total operating cost $ 275.5 Insurance profit $ 24.5 Percent on premiums 8.17% $24.5/$300 Target return at 5% $ 15 0.05 x $300 Rebate to policy holders $ 9.5 $24.5 - $15 Investment income $ 35 Administrative costs $ 16.5 30% of total Sales commissions $ 8 20% of total Total operating cost $ 24.5 Investment profit $10.5 b. The argument usually given is that the administrative and sales costs are incurred to operate the insurance activities. These costs would not change regardless of investment activity. The investment income is separate and incidental to the primary underwriting business. The problem indicates this may not be so. c. This requirement is done in class. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.49 (45 min) University instructional cost study a. There are a number of problems associated with using these broad, average allocations for decision-making purposes, which have to do with unrecognized diversity in mission and activities performed. For example, allocations of departmental salary and administrative costs appear to ignore the three types of services—teaching, service and research—because all of these costs are allocated only to instruction of FYE. This effectively gives no value of resource use to either research or service. This practice assumes that other sources of funding support these activities, which probably is not the case. Thus, costs of instruction are overstated in colleges that do not have significant external sources of research funds, for example. The allocations also do not distinguish among levels of teaching, which may place different demands on instructional resources. Typically, graduate teaching requires more highly qualified (and costly) instructors, smaller class sizes, and more instructional support (laboratories, libraries, etc.). Thus, colleges with relatively more graduate instruction will appear to be more costly. b. These statements may reflect higher efficiency at the Duluth campus, which the Twin Cities campus should emulate. Note that the comment conveniently ignores the much higher average cost of medical instruction in Duluth. However, the comments also may reflect lack of understanding about different missions and activities at the two campuses. The Twin Cities campus may engage in more graduate education and may have faculty who are more engaged in research activities than those at Duluth. Even if the campuses are similar, however, simply transferring students or programs may not result in cost savings because many of the costs are incurred for facility- or program-level resources that will not change unless entire facilities and programs are relocated. Perhaps that is what the critic has in mind, but the argument should not be based on unit-level costs. c. These average costs per FYE probably are not comparable across campuses because of the differences in missions and activities. They may be useful as internal benchmarks over time or compared to costs per FYE at comparable institutions. Even then they should be used with caution because they reflect only public sources of funds and do not reflect external research grants, gifts, or endowment income, all of which may be significantly different across institutions. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.50 (90 min) Federal highway cost allocation study Vehicles VMT Total (millions) Percent VMT Number of Vehicles Percent Vehicles PCE PCE -weighted VMT Percent weighted VMT Autos 1,818,461 67.50% 167,697,897 69.98% 1 1,818,461 43% Pickups/Vans 669,198 24.84% 63,259,330 26.40% 1 669,198 16% Buses 7,397 0.27% 754,509 0.31% 4 29,588 1% Single unit trucks 83,100 3.08% 5,970,431 2.49% 5.4 448,740 11% Combination Trucks 115,689 4.29% 1,971,435 0.82% 10.6 1,226,303 29% Total 2,693,845 239,653,602 4,192,290 a. Allocations on vehicles vs. VMT Highway costs $27,102 million Vehicles (2) Allocations on VMT (1) Allocations on vehicles Percent difference Autos $18,295 $18,965 -4% Pickups/Vans $6,733 $7,154 -6% Buses $74 $85 -15% Single unit trucks $836 $675 19% Combination Trucks $1,164 $223 81% Total $27,102 $27,102 Since highway repair costs are likely driven by two key factors, vehicle miles traveled and size of vehicles used, the best allocation base of the two used above would be vehicle miles traveled. However, some consideration should be given to the fact that bus and truck miles are tougher on highways than autos, pickups, and vans. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 10.50 (continued) b. Multiple cost pools without mass transit Highway costs w/o mass transit ($billions) Base New construction $ 19.161 wtd VMT Bridge construction $ 3.757 VMT Highway enhancement $ 4.184 wtd VMT Mass transit * $ - VMT Total $ 27.102 * change this to 5.787 to have new allocations reflect mass transit spending Allocations based on separate cost pools Vehicles New construction Bridge construction Highway enhancement Mass transit Total Difference from single pool % Diff Autos $8,311 $2,536 $1,815 - $12,662 ($5,633) -31% Pickups/Vans 3,059 933 668 - 4,660 ($2,073) -31% Buses 135 10 30 - 175 $101 135% Single unit trucks 2,051 116 448 - 2,615 $1,779 213% Combination Trucks 5,605 161 1,224 - 6,990 $5,826 501% Total $19,161 $ 3,756 $ 4,185 - $27,102 $0 This allocation system will shift costs from passenger vehicles to commercial trucks in a significant way. 10.50 (continued) Allocations based on separate cost pools with mass transit Highway costs incl mass transit ($billions) Base New construction $ 19.161 wtd VMT Bridge construction $ 3.757 VMT Highway enhance $ 4.184 wtd VMT Mass transit* $ 5.787 VMT Total $ 32.889 * change this to "0" to put new allocations on same basis as old allocations Vehicles New construction Bridge construction Highway enhancement Mass transit Total Difference from single pool % Diff Autos $ 8,311 $2,536 $1,815 $ 3,906 $16,568 ($1,726) 9% Pickups/Vans 3,059 933 668 1,438 6,098 ($635) 9% Buses 135 10 30 16 191 $117 -157% Single unit trucks 2,051 116 448 179 2,794 $1,957 -234% Combination Trucks 5,605 161 1,224 249 7,239 $6,075 -522% Total $19,161 $ 3,756 $ 4,185 $ 5,788 $ 32,890 $5,787 This new set of allocations (including mass transit spending) shows that single and combination trucks can expect a large increase in fees. Passenger vehicles, however, will pay for most of the increased spending on mass transit, which may be a desirable policy outcome. 10.51 (60 min) WeCare Hospital: Cost-allocation, step method Step method solution: Order of allocation: 1 Buildings depreciation and maintenance 4 Maintenance of personnel 2 Employee health & welfare 5 Central supply 3 Laundry & linen Since the services of Buildings Depreciation and Maintenance, Employee Health & Welfare, and Maintenance of Personnel are not used by departments ahead of these departments in the allocation order, the proportion allocated to each department equals the proportional usage of the total service allocation base. Additional computations: a .85 = sum of proportions allocated to departments after laundry & linen in the allocation order = .30 + .10 + .05 + .40. The sum of the allocation percentages (i.e., .353 + .118 + .059 + .470) equals 1.000. (The last term was rounded down so the four would sum to one.) b .82 = sum of the proportions allocated to departments after central supply in the allocation order = .09 + .04 + .03 + .66. (The third term was rounded down so the four would sum to one.) 10.51 (continued) a $83,000 = .10 x $830,000; $41,500 = .05 x $830,000; $16,600 = .02 x $830,000; $589,300 = .71 x $830,000 b These allocations are computed by multiplying the proportions on the previous page times the amount to be allocated. Solution Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533