Question Detail:
Carolina College
The computer-service center of Carolina College serves two major users, the Department of Engineering and the Department of Humanities and Sciences (H&S). When the computer equipment was initiallyinstalled, the procedure for cost allocation was straightforward: The actual monthly costs were compiled and divided between the two departments on the basis of the computer time used by each. For example, in March 2012, the first full month of operation, the costs were $100,000, composed of $80,000 fixed costs plus $100 variable cost per hour of time used by each department. Since each department used 100 hours in March, one-half of the
$100,000, or $50,000, was allocated to each department.
1. Assume that in April 2012 costs were $115,000 because of inefficiencies in the operation of the computer center. How much cost would be allocated to each department? Does such an allocation seemjustified? Explain.
2. Assume that in May 2012 the cost behavior pattern of the computer service center was identical to that in March. However, H&S used only 50 hours while Engineering used
100 hours. How much cost would be allocated to each department? Do the May allocations seem justified? Explain.
3. As the computer-service center developed, a committee with representatives from H&S and Engineering determined the size and composition of the center’s equipment. The committee based its planning on an expected long-run average utilization of 180 monthly hours for H&S and 120 monthly hours for Engineering. Assume the $80,000 fixed costs are allocated through a budgeted monthly lump sum based on long-run average utilization, and variable costs are allocated through a budgeted unit rate of $100 per hour. How much cost would be allocated to each department assuming the usage of computer services as in May, i.e., 50 hours for H&S and 100 hours for Engineering? What are the advantages of this dual-rate allocation method over the prior single-rate method?
4. What are the likely behavioral effects of lump-sum allocations of fixed costs? For example, consider the representative of H&S on the planning committee: What will his or her bias be in predicting long-run usage?
Scott Manufacturing
Scott Manufacturing produces lawn mowers, snowblowers, and garden tillers. The company has six divisions, organized as investment centers. Divisional managers are evaluated and rewarded on the basis of Return On Investment (ROI). Company policy dictates that internal transfers must take place whenever possible and that the transfer price will be full cost plus 10 percent. Bart Booth, vice-president of operations, is reevaluating the internal transfer pricing policy after receiving the following memo from Dana Lemmons, manager of the Parts Division.
MEMORANDUM To: Bart Booth, VP-Operations
From: Dana Lemmons, Manager, Parts Division
Subject: Transfer Pricing Policy
Bart, I must register a serious concern about our transfer pricing policy of full cost plus 10 percent. First, I believe this policy creates a significant understatement of my division's ROI. Second, it creates a disincentive for my division to decrease our manufacturing costs.
For example, consider our production of small carburetors. Currently, we are producing 300,000 of these each year, of which 200,000 are transferred to the Small Motor Division at a price of
$16.50 each and 100,000 are sold to external customers at $20 each. I know we can sell every carburetor we make to external customers. By being forced to transfer internally, we are losing income and showing a smaller ROI than we could otherwise.
But the problem is even greater. My engineers have created a new design that will allow us to decrease our variable manufacturing costs for carburetors by $5 per unit. However, if we implement this design our transfer price will drop to $11, and the revenues we receive from internal sales will drop significantly. All the savings and more would be captured by the Small Motor Division.
In my opinion, these problems can be resolved by simply allowing each divisional manager to set transfer prices and allowing each of us to buy or sell our products as we see fit.
END OF MEMORANDUM
After reading Dana’s memo, Bart gathered some production information:
Manufacturing cost of carburetor:
Direct materials
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$ 6.00
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Direct labor
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1.25
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Variable overhead
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1.50
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Fixed overhead
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6.25
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Total cost
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$15.00
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Manufacturing cost of small motor:
Carburetor
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$16.50
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Direct materials
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23.50
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Direct labor
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8.75
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Variable overhead
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3.25
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Fixed overhead
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8.40
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Total cost
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$60.40
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Production and sales of small motor:
Production
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200,000
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Sales
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200,000
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Unit price
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$75
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1. Assume the Parts Division implements the new design. Assume also the internal demand for carburetors remains constant. Determine the change in profit for the firm as a whole. Also determine the change in profits for the Parts Division and the Small Motor Division. Was Dana's concern valid? Are all the benefits of the improved design captured by the Small Motor Division?
2. Now assume the reduced cost of the carburetor increases the internal demand from
200,000 to 300,000 units, and that the Small Motor Division can sell an additional
100,000 motors. Evaluate the impact on firmwide profit and on each division's profits. (Assume the unit price of the small motor remains at $75.) If Dana anticipated the effect of the change in divisional profits, do you think she would implement the cost-reducing design? Explain.
3. Bart wants to know the effect of allowing each divisional manager to set transfer prices and to buy/sell their products as they see fit. Assuming the Small Motor Division can buy carburetors of equal quality for $20 from outside suppliers, provide an assessment of the effect. In your assessment, include the change in firmwide and divisional profits. Also, comment on the incentive that Dana would now have for implementing the cost- reducing design.
Circle Enterprises
Circle Enterprises is a distributor of two types of products: A and B. Units of Product A arrive at Circle in cases and are shipped to customers in these same cases. In contrast, Circle receives units of Product B in bulk shipments. Circle must unpack these products and then repack them into cases to meet smaller order quantities.
Circle has two types of customers: Type I Customers order small volumes, mostly consisting of
Product A. Type II Customers order large volumes of both Product A and Product B.
Circle currently uses a simple costing system to determine both product profitability and customer profitability. The only direct costs are the purchase costs of Products A and B. All other costs are treated as indirect and are allocated to the two products using a single indirect cost pool with “pounds of product” as the cost-allocation base. Cost and operating data for the most recent year are shown below.
Product Data
Product A
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Product B
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Annual demand in cases
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2,800
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2,000
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Average purchase cost per case
Average weight per case
Average sales price per case
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$70
20 pounds
$460
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$120
35 pounds
$790
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Customer Data
Type I Type II
Product A demand in cases
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1,200
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1,600
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Product B demand in cases
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400
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1,600
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Total annual demand in cases
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1,600
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3,200
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Orders
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160
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70
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Other Data
The single cost pool consists of resources needed to perform seven types of activities: receiving, storing, picking, packing, shipping, order processing, and customer service activities. The annual cost of these resources is $1,134,000.
Questions 1 and 2 assume the simple costing system described above is used.
1. Determine the gross margin of each customer type (“customer gross margin”) for the most recent year.
2. Based on your answer to (1), recommend a strategy to improve customer profitability.
A study of Circle’s operations suggested that “number of orders” is a better cost-allocation base than “pounds of product” for two of the seven activities: order processing and customer service activities.The cost of resources used by these two activities is $453,600 out of the total indirect cost pool of $1,134,000. Circle decides to refine its costing system by allocating costs related to order processing and customer service activities directly to customers rather than to products.
Questions 3 and 4 assume the refined costing system has been implemented.
3. Determine the customer gross margin, the customer cost-to-serve, and the customer profit margin of each customer type for the most recent year.
4. Compare customer profitability results determined by the refined costing system to the results determined by the simple costing system. Explain the differences. Based on your results, recommend a strategy to improve customer profitability.
Wang Company
Wang Company operates three independent divisions in Asia. The company’s founder and principal shareholder, Mr. G. Wang, strongly supports a decentralized management philosophy. He has asked you to respond to certain questions that have arisen in the three divisions. You should assume the issues in each division are
independentof those in the other divisions.
1. Division A produces small volumes of a specialized product. During June 2,000 units were produced. During July 2,200 units were produced. The division has seven different types of manufacturing costs, noted below as A-G. Information for June and July
follows:
June July Volume 2,000 2,200
Cost Type:
A $414,000 $455,400
B 164,000 176,400
C 268,000 286,000
D 310,000 341,000
E 340,000 364,000
F 900,000 900,000
G 415,000 415,000
Total costs $2,811,000 $2,937,800
Which of these costs exhibit a “mixed” cost behavior pattern, i.e., they have both fixed and variable components? Explain.
2. Division B produces five products. It uses a traditional cost system that assigns overhead to these products based solely on direct labor cost. Suppose an activity based cost (ABC) system replaces the traditional cost system. The ABC system has seven overhead cost pools. The products differ substantially in their use of the resources represented by these pools, depending on the complexity involved in their manufacture.
The typical monthly volume of each product, its relative complexity, and its unit cost as reported by the current traditional cost system are provided below.
Monthly Relative Cost Reported by
Product Volume Complexity Current System
A 10,000 Medium $60
B 13,000 Low $110
C 5,000 Medium $180
D 4,000 High $118
E 4,000 Medium $130
Which of the following best describes the most likely impact on reported product costs of changing to the ABC system? (Choose only one answer.) Explain.
- Lower cost for B and higher cost for E
- Lower cost for D and higher cost for B
- Higher cost for A and lower cost for C
- Higher cost for D and lower cost for B
- Lower cost for A and higher cost for E
3. Division C manufactures and sells four products. The division recently implemented a program aimed at reducing its receivables and inventory. Selected information for the current year follows:
Receivables
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$800,000
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Inventory
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$1,700,000
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Other current assets
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$900,000
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Fixed assets
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$7,600,000
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Current liabilities (non-interest-bearing)
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$1,000,000
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Long-term liabilities (interest bearing @ 10%)
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$8,500,000
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Shareholders equity
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$1,500,000
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Net income
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$450,000
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Weighted-average cost of capital (WACC)
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8%
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This division uses EVA as its principal performance measure and makes no adjustments to GAAP financial statement amounts. Assume that in the coming year the division’s level of production and sales, as well as its sales prices and the costs of inputs, are identical to those of the current year; all other aspects of its operations are identical as well, with the exception that both receivables and inventory are reduced by 45%.
a. Will the coming year’s EVA be greater than, less than, or equal to the current year’s EVA? If greater or less, by what amount? Explain.
b. The division currently uses a traditional, labor-based cost system to determine product costs. Suppose the division changes from this traditional system to an activity based cost (ABC) system. As a result, the reported costs of three of its four products decrease, while the reported cost of the other product increases. All else equal, is the most likely effect of changing to the ABC system an increase in EVA, a decrease in EVA, or neither? Why?
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