CHAPTER RESPONSIBILITY ACCOUNTING 9-1 Responsibility Versus Control The manager of the meat department might have responsibility for such things as determining normal stock levels for various types of meat, ordering to maintain those levels, selecting new employees, supervising the work of employees, and monitoring the adequacy and accuracy of weighing equipment, the pricing of packaged items, and the adequacy and state of repair of storage equipment Three factors suggest that such a department could, at best, operate successfully as a cost center in a responsibility accounting system: (1) severe limits on the types of costs actually controllable by the manager; (2) the manager's inability to control prices; and (3) the extent to which decisions and actions of other managers at that store affect the sales volume in the meat department The meat manager might determine the quantity of meat of each kind required to meet the special demands of customers in the area; but the cost is determined by some higher-level manager who is responsible for a central purchasing function to serve all stores in the area The manager might determine how many employees of each type are needed and when each should work; but wage rates for each class of employees are probably established at a higher level Even the total number of hours worked in the department might depend on a higher-level decision about the hours during which the entire store will be open (A local manager may be able to decide that personal service will not be available in the meat department at all times, as is the case in some supermarkets that remain open for 24 hours but provide personal service in some departments for only some of those hours.) Many costs "related" to the meat department are joint costs (e.g., heat, light, power, depreciation on store equipment, wages of check-out clerks, rent, janitorial service) that should not be in a report that might be used to evaluate the manager's performance Thus, if the meat department is designated a responsibility center, a limited number of costs are likely to be fully controllable at the manager's level and hence properly includible in a report intended to reflect the results of decisions by that department's manager Although managers in individual stores might have authority to establish prices for specific types and cuts of meat, some central unit within the chain will mandate many prices because such are quoted in area-wide advertisements for the chain This factor speaks directly against designating the department as a profit center A similar conclusion flows from the fact that the sales volume in the department, no matter how good the manager's plans and supervision of his own area, can be greatly influenced by the abilities of managers of other departments and of the entire store (How good must the quality of service and product be in the meat department in a particular store in a chain in order to offset the loss of customers because repeated stockouts occur due to poor forecasts by the produce and general 9-1 grocery managers? Except in the case of advertised specials, to what extent today's shoppers patronize stores in different locations for different items on a normal shopping list?) In summary, while it might be possible to institute some type of responsibility accounting in the setting of an individual store of a chain of supermarkets, such a move requires considerable analysis to determine the items controllable by an individual manager, and this preliminary analysis suggests that cost centers, not profit centers, would be the most appropriate Note to the Instructor: The purpose of this question is as much to set the student thinking about the implications of a familiar situation as it is to test the student's grasp of the basic concepts introduced in the chapter We have found the question useful in getting the student to recognize (1) the magnitude of common costs in a seemingly uncomplicated situation, and (2) the need for in-depth study of a specific situation before embarking on some seemingly simple plan for implementing the basic concepts presented in the text We've also used some aspects of this question to anticipate the quantity/price distinction raised in connection with standard costs (Chapter 12) and to emphasize the relationships between responsibility accounting and previously discussed matters such as budgeting and decision making 9-2 First Union’s Allocations "Interrelationships of these business segments" presumably means that First Union provides similar products and services in four different business segments: Consumer Bank, Capital Management, Commercial Bank, and Capital Markets Allocations of costs to product lines are therefore inexact because much of the cost is common to several product lines Having centralized service and staff functions (probably bookkeeping, administration, legal, and the like) presents the same problem because such costs are largely common to both segments and geographical areas 9-3 Responsibility Centers Universities (a) Within universities it might be possible to identify several responsibility centers: individual colleges, the bookstore, the housing office (and possibly individual housing units), the medical center, the food service, the library, and the computer center In any one of such centers, however, there will be many costs not controllable by the individual responsible for the center, and many cases of only semicontrollability For example, the volume of business done in the bookstore is primarily a function of enrollment and textbooks chosen by faculty members, neither of which is under the control of the bookstore's manager Similarly, the occupancy rate of housing units is primarily a function of enrollment, which is not controllable by the housing manager Similar situations exist for the food service, the medical center, and the computer center Nevertheless, some costs are controllable by the manager of each of the segments mentioned, and such costs could be used for performance reporting (b) It might be possible to establish responsibility centers within the various colleges, perhaps along departmental lines In addition, there may be certain service units within the college (e.g., a Bureau of Business Research, a computer center, a library, a central secretarial and clerical service) that could be responsibility units For individual responsibility centers within a college, still fewer costs will be controllable by those 9-2 units, and many more costs will be joint (c) The likelihood of establishing responsibility centers within individual departments of a college is very low Some few costs might be partially controllable at the department levels (e.g., student and faculty salaries, travel, supplies) but at no lower level For example, few, if any, costs are likely to be controllable at the level of a single course offered The major cost for a given course would probably be the salary of the professor, and that cost would be not only an allocation of the professor's total salary, but also not under the control of the person responsible for the course (the professor) Note to the Instructor: You may want to go into more detail on the types of costs incurred in a typical university situation and the normal university budgeting procedures 9-4 Responsibility Reporting If each product line has a manager and individual salespeople are assigned to specific product lines, sales salaries need not be an allocated cost in responsibility reports by product line Without such specialization, the cost of salespeople would appear to be controllable by (and hence assigned to the responsibility report of) a high-level sales executive Whether or not the suggested change in reporting should occur depends on whether the individual responsible for each product line or cost-category was given control of the employment and supervision of the salespeople 9-5 Archer Daniels Midland Operations ADM probably had many profit/investment centers under its former mode of operation It probably has many fewer now It might well have revenue centers (as suggested by the statement about "one sales organization") and it almost certainly has more cost centers However, whether ADM is more or less centralized now is an open question Managers might still have a great deal of responsibility and freedom to make decisions But fewer managers will have profit/ROI responsibility under the new operating conditions 9-6 Evaluating a Performance Measure (a) In most cases, factors beyond the professor's control significantly affect enrollments in a particular class For example, the university, college, or department might have stated objectives for minimum/maximum enrollments for all (or some specific) courses Too, enrollment levels are influenced by whether a course is required or elective and, with respect to the latter, by what alternatives are available As a general rule, an individual professor is likely to exercise control of the number of enrollers only in elective courses, and then only with respect to the maximum enrollment But enrollments in elective courses are also influenced by the number of electives available and the extent of student interest in specific electives without regard to who is teaching the course (b) In those instances where a professor's actions/performance could influence enrollments, use of the suggested performance measure could motivate a professor to give higher grades than warranted, go slower than is reasonable, or take other actions that would reduce the educational value of his/her course (Those same behaviors might well occur when the results of 9-3 student evaluations are known to be a major factor in evaluating a professor's performance.) Note to the Instructor: This question prompts student interest because it is relevant to their experience Hence, you might wish to stimulate class discussion by asking about alternative performance measures Some alternatives that have been suggested include student performance on common examinations (in multiple-section courses), which ignores the potential differences in student ability from class to class; evaluations based on observation by a chair or head; and students' subsequent performance on professional examinations (CPA, CMA) It is important that the discussion, at some point, raise the issue of innate differences among students in a particular section, taking a particular subject, or enrolled at a particular institution 9-7 Pricing, Timing, Allocations, and Public Relations The concepts of capacity and common costs are relevant here In effect, the commentator is asserting that the company must provide capacity (operators on duty) in order to its job Providing capacity has a cost that is common to all services performed using the capacity, and common costs must be paid for by someone Some minimum level of capacity is needed to handle emergency calls, requests for services, and so on Other calls requiring operator assistance (directory assistance, person-to-person, and other special types of calls) can be handled with some expansion of that basic level of capacity, but the costs of capacity expansion remain common to all operator-assisted services How capacity costs will be recovered does not change the fact of their commonness The commentator focuses on a charge after three free calls for directory assistance One could just as easily argue that all such calls should be charged (The timing of the institution of the charge could be a factor in the commentator's position, because such calls were all free for many years.) Essentially, the commentator is arguing that the common cost of all directory-assistance calls should be recovered from (allocated to) other users of operator-assisted services Note to the Instructor: You might wish to draw an analogy to the capacity costs of a multiple-product manufacturer and the associated allocation and pricing problems The analogy is not perfect because the manufacturer operates in a more competitive environment, but the problem is present for most companies You might also wish to bring up the issue of regulation, and the statement that "Ma Bell" is reaping the benefit of the charge is worth some discussion Someone must pay the common costs, and it's likely that customers will pay in one way or another Implicit in the comments is the belief that stockholders should pay the cost through lower returns For a regulated company, lower returns to stockholders will usually generate rate increases or reductions in service For regulated or unregulated companies, lower returns will discourage investment and result in higher prices or reduced services Hence, in a regulated industry, customers will pay the cost in one way or another The only question is whether the customers will pay through a use-charge or in higher basic-service rates 9-8 Balanced Scorecard In a Not-for-Profit Organization 9-4 The balanced scorecard’s emphasis on non-financial dimensions of performance are quite applicable to not-for-profit organizations Even though the organization is "not-for-profit," there must be some measure of financial success for survival For UWSENE, the financial objectives stressed the costeffective generation of funds while learning and growth objectives emphasized employee development and alignment with organizational goals The customer perspective focused on the definition of the customer: the donor, the agency receiving the support, or the community UWSENE chose to use the donor as the customer and focused on recognition and ease of giving The internal business process objectives focused on how to deliver the financial and customer objectives The actual measures chosen by UWSENE can be found in Harvard Business School case 197-036 "United Way of Southeastern New England (UWSENE)." 9-9 Alternative Allocation Bases (a) Revenues, 20%, 45%, 35% $250,000 (b) Square feet, 20%, 30%, 50% $250,000 (5 minutes) Market Survey Promotion Brand Development $50,000 $112,500 $ 87,500 $50,000 $ 75,000 $125,000 Total This basic exercise shows that different allocation bases give different allocations Department A received the same allocations because its share of each base was the same The others differed because their shares differed 9-10 Basic Allocation Methods (10-15 minutes) Actual cost allocations: Cost to be allocated = $610,000 (fixed costs of $390,000 + variable costs of $220,000) Percentage of actual use x $610,000 = allocations Groceries 40% $244,000 Meat 25% $152,500 Dairy 35% $213,500 Dual allocations: Cost to be allocated equals the budgeted fixed cost + total invoices × budgeted variable rate ($400,000 + 10,500 × $20) = $610,000 Budgeted variable rate = $200,000 / (4,000 + 2,500 + 3,500) = $20 per invoice 9-5 Groceries Budgeted variable costs, $20 x actual invoices Budgeted fixed costs $400,000 x percentages of expected long-term use Total allocations Meat Dairy $ 84,000 $ 52,500 $ 73,500 120,000 $204,000 120,000 $172,500 160,000 $233,500 The dual-rate method, combined with allocating only budgeted costs, rather than actual costs, is better Allocating actual costs imposes the burden of service center inefficiencies on the profit centers Allocating all costs based on actual use also results in a center's allocation depending on the use that other centers make of the service Allocating fixed costs based on expected long-term use makes better sense because the company acquired the central capacity based on expected long-term use 9-11 Performance Report (15-20 minutes) The report should look about as follows Budget $32,900 34,200 15,250 5,600 4,200 5,700 $97,850 Materials Direct labor Indirect labor Supplies Small tools Maintenance equipment Totals 9-12 Actual $33,800 34,500 14,220 5,450 4,340 4,950 $97,260 Step-down Allocation Method (Related to Appendix) Direct costs Personnel Administration* Totals Personnel $400,000 (400,000) Administration $600,000 240,000 (840,000) Variance Over (Under) $ 900 300 (1,030) (150) 140 (750) $ (590) (15-20 minutes) ARCH HD $ 40,000 600,000 $640,000 $120,000 240,000 $360,000 * 50/.70 x $840,000, 20/.70 x $840,000 The total allocated to the two operating departments equals the total cost to be allocated ($640,000 + $360,000 = $1,000,000) The difference in the results of applying the different allocation methods stems from the high percentage of service that Personnel gives to Administration This is not considered in the direct method, but it is in the step-down method The controller decided to allocate the costs of the Personnel Department first because the largest percentage of its services is performed for the other service department (Administration) Administration uses 60% of Personnel services, while Personnel uses only 30% of the services performed by Administration 9-13 Reciprocal Allocation (Extension of 9-12) (15-20 minutes) Let P = Personnel adjusted costs and A = Administration adjusted costs P = $400,000 + 0.30A A = $600,000 + 0.60P 9-6 P P 0.82P P A = = = = = $400,000 + 0.30 x ($600,000 + 0.60P) $580,000 + 0.18P $640,000 $707,317 $1,024,390 [$600,000 + (0.60 x $707,317)] ARCH Personnel costs $707,317 x 10 $707,317 x 30 Administration costs $1,024,390 x 50 $1,024,390 x 20 Total allocations $1,000,000 HD Total $ 70,732 $212,195 512,195 $582,927 204,878 $417,073 The difference between these allocations and the step-down is nearly $58,000 (ARCH lower and HD higher than in step-down) The $111,400 ($640,000 - $528,600) difference between the step-down and direct methods is also striking Both the step-down and reciprocal methods increase the allocation to the Architectural Department because they indirectly allocate more Personnel cost to Architectural, through the intermediate allocation to Administration The Architectural Department is the heavier user of Administration, but under the direct method does not receive an allocation that reflects the total cost of Administration because it does not include the cost that Personnel incurs for the benefit of Administration 9-14 Allocations-Actual Versus Budgeted Costs (5-10 minutes) The title of the assignment suggests the alternative of using budgeted costs instead of actual costs Moreover, it would be a good idea to make the allocations based on expected long-term use of the Research Department's capacity instead of on actual use If upper-level managers understand that the fixed, indirect (to the operating departments) nature of research costs makes their allocation arbitrary, they will probably not penalize or reward the managers of segments unfairly However, the segment managers might not see it that way and might lose some motivation Under the present allocation scheme, the Fertilizer manager's allocation was increased by two factors that he cannot control: higher-than-budgeted costs of research and a cancelled project for the Seed Department This is not a good situation 9-15 Assignment of Responsibility (5-10 minutes) If the production manager can decide how and when to comply with rush-order requests from the sales manager, probably nothing is wrong except that the production manager doesn't understand the implications of his or her decisions If the production manager is required to meet the rush-order requests, as might be inferred from the statement that the sales manager "ordered" schedule changes, what's wrong is that the reporting system incorrectly reports production costs as controllable by the production manager (That is, actions of the sales manager affect to some extent the total production costs incurred.) When compliance with rush-order requests is required, the report to the sales manager should include costs identifiable as resulting from such compliance (the idle time of direct 9-7 laborers and costs of setup changes) The extent to which overtime premium should be assigned to the sales manager depends on how much flexibility the production manager has in meeting previously scheduled production needs 9-16 Transfer Prices and Goal Congruence (5-10 minutes) It is in the best interest of the operating manager to go outside; she pays a lower price and her performance looks better (and is better) The manager of the stenographic pool, a cost center, does not really care whether the operating manager stays inside or not; the pool manager's performance will be unaffected if performance is evaluated by reference to budgeted costs Unless the stenographic pool is working at full capacity, the transfer price should be lowered to make it profitable for the operating manager to keep her business inside If the pool is at full capacity, in the short run operating managers can be encouraged to seek the lowest cost However, once the stenographic pool is operating below capacity, the transfer price should again be set at or below the outside market Note to the Instructor: This exercise provides a straightforward situation in which a transfer price works against the best interest of the firm Students should recognize, from what they learned in Chapter 5, that it is in the company's best interest that the stenographic services be "bought" inside Pointing this out gives an opportunity to comment on the basic similarities of the approach taken in Chapters and 9, that the use of allocations is unwise in managerial accounting, both for decision making and performance evaluation 9-17 Basic Variance Analysis (10-15 minutes) and Budgeted contribution margin was $16 ($30 - $14), actual contribution margin was $17 ($31 - $14) Actual Results 38,000 x $17 $646,000 Actual Volume at Planned Price 38,000 x $16 $608,000 $38,000 favorable price variance Planned Results 40,000 x $16 $640,000 $32,000 unfavorable volume variance $6,000 favorable total variance Alternatively, Sales volume variance = $16 x (38,000 - 40,000) = $32,000 unfavorable Sales price variance = 38,000 x ($31 - $30) = $38,000 favorable 9-18 Relationships (5-10 minutes) 12,000 Actual unit sales Sales volume variance divided by budgeted CM, $18 - $15 Number of units under budget 9-8 11,000 $3,000U $3 1,000 Budgeted unit sales 12,000 $18.30 Budgeted price Sales price variance divide by units actually sold Price variance per unit (favorable) Actual price per unit $18.00 $ 3,300F 11,000 0.30 $ 18.30 Budget $36,000, 12,000 x ($18 - $15), Actual $36,300, 11,000 x ($18.30 - $15) or $36,000 budgeted plus $3,300 favorable price variance minus $3,000 unfavorable volume variance Note to the Instructor: This exercise tests the student's understanding of the relationships among budgeted results, actual results, and variances Requirements and rely on the formulas, Sales volume variance = budgeted margin x difference between budgeted and actual sales Sales price variance = actual volume x difference between budgeted and actual margin 9-19 Price and Volume Variances (15 minutes) Before beginning, we need two calculations The budgeted selling price was $14 ($210,000/15,000) and budgeted and actual variable cost was $10 ($150,000/15,000) 15,500 cans Actual variable costs Divided by variable cost per unit Actual unit volume $155,000 $10 15,500 $13.70 Actual sales in dollars Divided by sales in units, from requirement Equals selling price per unit $212,350 15,500 $13.70 9-9 Contribution Margin at Actual Volume and Planned Planned Unit Margin Results 15,500 x ($14 - $10) $57,350 $62,000 $60,000 $4,650 $2,000 price variance volume variance unfavorable favorable $2,650 total variance unfavorable Alternatively, Actual Results sales volume variance = (15,500 - 15,000) x $4 = $2,000 favorable sales price variance = ($13.70 - $14.00) x 15,500 = $4,650 unfavorable 9-20 Development of Performance Report (20 minutes) Performance Report J Harrison (a) (b) (c) (d) Sales Cost of goods sold Gross profit Operating costs, direct: Advertising Travel Depreciation Office expenses Product profit $487,000 262,000 225,000 $26,000 17,000 1,000 21,500 65,500 (e) $159,500 (a) The excess cost of goods sold resulted from production problems and are not the responsibility of the sales manager (b) The allocated advertising expenses are not controllable by the sales manager (c) Depreciation on furniture and fixtures in the sales manager's office is his responsibility, but not the depreciation on the building (d) The office expenses reported to the sales manager should not include the allocated costs of the office of the sales vice president (e) No administrative costs should be reported to the sales manager because those costs are allocated and are presumably not under his control 9-21 Cost Allocation (45 minutes) Direct Method Purchasing (60%/80%; 20%/80%) Administration (20%/70%; 50%/70%) Totals Trimming $225,000 142,857 $367,857 Cutting $ 75,000 357,143 $432,143 Total $300,000 500,000 $800,000 Step-down Method Administration 9-10 Purchasing Trimming Actual Results Actual Volume at Planned Price $44.0 x (66%/60%) $48.4 $45.6 Planned Results $44.0 $4.4 favorable volume variance $2.8 unfavorable price variance $1.6 favorable total variance Note to the Instructor: This assignment requires that students understand that the load factor can serve as a measure of unit volume It is also worth mentioning that because variable costs per passenger are relatively low for an airline, analyzing revenue instead of contribution margin is sensible (Most of the variable costs for an airline vary with the number of flights.) 9-39 Performance Reporting Alternative Organizational Structure minutes) Income Statement for March 20X2, by Markets Total Domestic Sales $1,300,000 $1,000,000 Less variable costs: Cost of sales (schedule A) 820,000 630,000 Selling costs (schedule B) 31,000 24,000 Total variable costs $ 851,000 $ 654,000 Contribution margin $ 449,000 $ 346,000 Direct fixed costs: Selling $ 74,000* $ 36,000 Administrative 60,000 25,000 Total direct fixed costs $ 134,000 $ 61,000 Margin earned by market $ 315,000 $ 285,000 Common (indirect) costs: Fixed manufacturing costs $ 190,000 Fixed administrative costs 12,000** Total common costs $ 202,000 Income $ 113,000 (40 Foreign $300,000 190,000 7,000 $197,000 $103,000 $ 38,000 35,000 $ 73,000 $ 30,000 * $105,000 - $31,000 **$72,000 - $60,000 Income Statement for March 20X2, by Product Total Sales Less variable costs: Cost of sales Selling Total variable costs Contribution margin Direct fixed costs—production Product profit Common (indirect) costs: Selling Administrative Production A B $1,300,000 $500,000 $400,000 $400,000 $ $300,000 15,000 $315,000 $185,000 48,000 $137,000 $280,000 8,000 $288,000 $112,000 $240,000 8,000 $248,000 $152,000 $112,000 $152,000 $ $ $ $ 820,000 31,000 851,000 449,000 48,000 401,000 74,000 72,000 142,000* 9-22 C Total common costs Income $ $ 288,000 113,000 * $190,000 - $48,000 Schedule A Variable Manufacturing Costs (1) (2) (3) (4) (5) (6) Variable Variable Variable Cost Domestic Cost Foreign Cost Product Ratio Sales (2) x (3) Sales (2) x (5) Total (4) + (6) A B C Totals $300,000 280,000 240,000 $820,000 60% 70% 60% $400,000 300,000 300,000 $240,000 210,000 180,000 $630,000 $100,000 100,000 100,000 $ 60,000 70,000 60,000 $190,000 (7) Schedule B Variable Selling Expenses (2) (3) (4) (5) (6) Variable Variable Variable Cost Domestic Cost Foreign Cost Product Ratio Sales (2) x (3) Sales (2) x (5) Total (4) + (6) A B C Totals $ 15,000 8,000 8,000 $ 31,000 (1) 9-40 3% 2% 2% $400,000 300,000 300,000 $ 12,000 6,000 6,000 $ 24,000 $100,000 100,000 100,000 $ $ Cost Allocations, Transfer Prices, and Behavior 3,000 2,000 2,000 7,000 (7) (25 minutes) Note to the Instructor: This problem provides ample opportunity to discuss (1) ways of encouraging or discouraging the use of resources, and (2) the need to fit the transfer pricing methods to the company's objectives (a) Computer costs could be allocated (or priced) in several ways that encourage use The following possibilities are listed in the general order in which they would probably encourage more use: no charge at all; no charge for use, but allocation of fixed cost; charge for use at budgeted variable cost, with or without allocation of fixed costs * Allocating the fixed cost and charging little or nothing for use might encourage more use than would no charge at all Managers might be more inclined to take advantage of a service if they felt that they were "paying for it anyway." If there's a charge for time used, the allocated fixed cost should not be affected by use * Charging nothing for use, or charging at budgeted variable cost (which would be very low) would make the service cheap, but perhaps too cheap This might be true with or without the allocation of the fixed component * If the company now has excess capacity in computer time, charging something more than the very low budgeted variable cost could encourage lower-level employees to use the service, though use should be monitored for overuse * Because increased use could exceed existing capacity and acquiring a second (or larger) computer would produce a large increase in cost, executives should arrange for monitoring of use so that the transfer price can be reconsidered at regular intervals 9-23 (b) Maintenance costs are being allocated in the worst possible way—namely, based on actual costs and proportion of actual current use As the chapter suggests, managers may have realized that increased use affects their costs severely if other managers refrain from using the service And the allocation is apparently high enough to motivate production managers to wait for maintenance until machinery breaks down The $10 budgeted variable cost per hour could be used to charge for hours worked, and the $200,000 fixed cost could be ignored or allocated based on some idea of long-run use of maintenance services If a $10 per hour charge produces a demand for service that puts a strain on the maintenance department, the price could be adjusted upward One recommendation is to study the relationships between the amount of maintenance work done, the frequency of breakdowns, and the lives of the machinery The cost of materials and supplies used by the maintenance department is not mentioned These could be charged to the other departments at cost, with hours worked being used to price labor and some variable overhead The resulting variable cost per hour would be somewhat less than $10 if the cost of materials is included in the $10 per hour (c) Consulting costs are apparently allocated in a manner that is producing too much use of the service Either the allocation is too small or there is no allocation at all A free (or very inexpensive) service might have been a good idea several years ago, but it is apparently not such a good idea now The time may have come to begin pricing these services so as to discourage frivolous use, if that is indeed the case This situation illustrates the need to reconsider transfer pricing methods when circumstances, including objectives, change One approach is to ask members of the consulting staff how much of their work they identify as important and how much is a result of managers' not wanting to things themselves that they well could (For example, one motive for a manager seeking the approval of the consulting staff is to avoid, or at least spread, the blame if something goes wrong.) Objective answers to such a question are hard to get, if only because the consulting staff has its own objectives, one of which could be the accumulation of power with growth in size In any case, the goal of any change in policy is to charge an amount sufficient to discourage excessive use 9-41 Allocations and Behavior (15-20 minutes) Note to the Instructor: This assignment probes some of the difficulties in achieving goal congruence and most students will be able to come up with reasonable answers to requirements and Fewer will see that the one possible solution is probably to use a variation of the dual-rate method, even though there is no issue of expected long-term use One might say that a month is long-term in this situation, because the traffic manager is essentially acquiring additional capacity each month The managers of the distribution centers would have little or no incentive to make good estimates Their costs are unaffected by how inaccurate their estimates are It is hard to tell whether they would tend to overestimate or underestimate their needs Allocations based on actual mileage also provide little or no incentive to estimate accurately Nor is there any basis for suggesting whether there 9-24 would be a tendency to overestimate or to underestimate One reasonable solution is to use a three-part charge, as follows: * Allocate total expected fixed costs, including the outside truckers' guarantee, based on the amounts estimated by each manager This part of the charge would discourage overestimation * Charge the average variable cost (fleet and outside) based on actual use * Charge a relatively high amount for actual miles in excess of the estimate as an incentive to avoid underestimation Determining the amount to charge could be difficult, but it should be high enough to discourage underestimation The situation could also be handled with multiple transfer prices, with different prices for estimated use and for use in excess of the estimated amount 9-42 Allocations and Managers' Bonuses (20 minutes) Allocate as shown below Dry Goods Bonuses ($60,000/$75,000) x $7,500 ($15,000/$75,000) x $7,500 $ Housewares 6,000 $ 9-25 1,500 Allocate as the manager of Housewares suggests Sales Total direct costs Controllable profit Indirect costs: Sales salaries* Other Total indirect costs Profit Bonuses ($40,000/$75,000) x $7,500 ($35,000/$75,000) x $7,500 Dry Goods $250,000 166,000 84,000 Housewares $500,000 437,000 63,000 Total $750,000 603,000 147,000 36,000 8,000 44,000 $ 40,000 12,000 16,000 28,000 $ 35,000 48,000 24,000 72,000 $ 75,000 $ 4,000 $ 3,500 * [$60,000/($60,000 + $20,000)] x $48,000 = $36,000; ($20,000/$80,000) x $48,000 = $12,000 The Dry Goods manager will say that Grove's Housewares manager will say that indirect sales related to direct sales salaries than to sales, proposal is probably the more reasonable of the method is better; the salaries seem more closely so the Housewares manager's two Grove could allocate the bonuses based on the relative controllable profits of the departments The results are Dry Goods $4,286 [($84,000/$147,000) x $7,500], and Housewares $3,214 [($63,000/$147,000) x $7,500] The advantage of this method is that it avoids the allocation problem, but one or another manager could still argue that his/her segment required less service This would lead to the demand that allocations should be made to "properly reflect" costs-which we know to be impossible to 9-43 Performance Report (35-40 minutes) The report that follows is in thousands of dollars Housewares $900 500 $400 Sales Cost of goods sold Gross profit Other expenses: Salaries (1) $ 33 Advertising (2) 27 Rent (3) 42 Depreciation 20 General and administrative Miscellaneous (4) 32 Total expenses $154 Departmental profits $246 Profit for store Clothing $1,200 680 $ 520 $ $ $ Sporting Not Goods Allocated $400 180 $220 54 36 42 16 $ 28 12 16 12 49 197 323 16 $ 84 $136 $ 75 50 250 80 $455 Total $2,500 1,360 $1,140 $ $ 190 125 100 48 250 177 890 $ 250 (1) Original amounts reduced by $0.03 per sales dollar ($75,000/$2,500,000) Housewares: $60,000 - ($900,000 x $0.03) Clothing: $90,000 - ($1,200,000 x $0.03) Sporting Goods: $40,000 - ($400,000 x $0.03) (2) Original amounts reduced by $0.02 per sales dollar ($50,000/$2,500,000) 9-26 (3) $1.05 per square foot for housewares and clothing, $0.80 per square foot for sporting goods The original rents were all $1.00 per square foot ($100,000/100,000) (4) Original amounts reduced by the dollar amounts given in item (g) Note to the Instructor: Allocating rent based on relative values of the space might not occur to students It is also worth pointing out that the cost allocations for rent also equal the current market rents (an unlikely occurrence) You might wish to discuss the possibility of charging the departments with the fair market value of the space they occupy, as an alternative to allocating the costs 9-44 Transfer Prices and Behavior (35 minutes) Increase of $1,000 per month Reduced maintenance costs (500 hours at $10) Increased variable costs (4,000 x $1) Increase in monthly profit of Department A Decrease of $3,000 per month Lost revenue (500 hours at $10) Reduced variable costs (500 hours at $4) Decrease in monthly profit of maintenance department $5,000 2,000 $3,000 Decrease of $2,000 per month, the sum of the changes to the individual departments Increase in variable production costs (requirement 1) Decrease in variable maintenance costs (requirement 2) Decrease in total monthly profit $5,000 4,000 $1,000 $4,000 2,000 $2,000 (a) 8,000 hours The current transfer price of $10 per hour yields an $8,000 profit after variable costs of $4 per hour and fixed costs of $40,000 The current level of activity can be calculated as follows, assuming X to be the level of activity $10X - $4X - $40,000 = $8,000 $6X = $48,000 X = 8,000 We can also determine the 8,000 hours by using the revised price and costs because the revised prices were designed to maintain the current level of profit $12X - $5X - $48,000 = $8,000 $7X = $56,000 X = 8,000 (b) $4,500 volumes and costs One approach is to calculate the profit using the new 9-27 Billed services [(8,000 hours - 500 hours) x $12] Variable costs (7,500 x $5) Contribution margin Fixed costs Profit $90,000 37,500 52,500 48,000 $ 4,500 An equally valid but more complex approach is to deal only with changes Gains: Additional revenue from services (7,500 hours x $2) $15,000 Cost (at previous cost level) saved on services no longer performed for Department A (500 x $4) 2,000 $17,000 Losses: Revenues from servicing Department A, at old prices 500 x $10 5,000 Additional variable costs at new level (7,500 x $1) 7,500 Additional fixed costs 8,000 20,500 Decrease in profit $ ( 3,500) Note to the Instructor: This problem illustrates one difficulty in using profit centers even when no outside service is contemplated The charge by the maintenance department is high enough to encourage the manager of Department A to reduce his use of the service at the expense of increasing his variable production costs (It is in his best interest to so.) The manager of the maintenance department would probably not want to reduce the price to this manager, lest he or she be forced to give the same reduction to all other departments One solution would be for a higher-level manager to order the manager of Department A to retain the current process; but such an action, if taken very often, would certainly reduce if not eliminate the value of the profit center concept as a motivating device 9-45 Cost Allocation $238,750 to cleaners and $1,671,250 to the others Cleaners All others Totals (25-30 minutes) Direct Labor Hours 50,000 350,000 400,000 Percentage of Total 12.5 87.5 100.0 x $1,910,000 = Allocation $ 238,750 1,671,250 $1,910,000 $208,450 to cleaners and $1,701,550 to the others Cleaners All others Totals Direct Labor Hours 50,000 350,000 400,000 Percentage of Total 12.5 87.5 100.0 9-28 x $1,580,000 = Allocation $ 197,500 1,382,500 $1,580,000 Cleaners All others Totals Record keeping 6,000 144,000 150,000 Percentage of Total 4.0 96.0 100.0 Cleaners All others Totals Number of Parts 100 3,900 4,000 Percentage of Total 2.5 97.5 100.0 Labor-based Record keeping Parts Totals Cleaners $197,500 7,200 3,750 $208,450 x $180,000 = Allocation $ 7,200 172,800 $ 180,000 x $150,000 = Allocation $ 3,750 146,250 $ 150,000 All Others $1,382,500 172,800 146,250 $1,701,550 Totals $1,580,000 180,000 150,000 $1,910,000 Labor-Based $16.50 7.96 $24.46 Direct costs Indirect costs* Total case cost Multiple Bases $16.50 6.95 $23.45 * $238,750/30,000 = $7.96 (rounded) from previous assignment; $208,450/30,000 = $6.95 (rounded) The cost of cleaners is lower under the multiple allocation because cleaners are relatively heavier in labor hours than in the other activities Note to the Instructor: You might wish to reinforce the point that all costs will still be allocated somewhere, so that the lower calculated cost of cleaners will be offset by higher costs for other products Whether the $1.01 difference is material here depends on the decision or analysis at hand The principal point is that the way in which allocations are made influences the reported cost, which could, in turn, influence decisions 9-46 Cost Allocations in a University (15-20 minutes) The current system is about as bad as possible Allocating actual costs over periods as short as a month makes per-unit and monthly charges fluctuate, not only with the use a given school or department makes of the service, but also with the use that other units of the university make in that month The problem could have been avoided had the dean (1) known in advance how the charges were computed, and (2) persuaded faculty members to copying in months of peak use Of course, if other deans acted the same way, the machines would probably run only a few months of the year One of the following transfer-pricing schemes is preferable Charge only for the cost of paper (variable cost), at $.02 ($700/35,000) Charge at $.057 per copy, the average cost during a normal month ($8,600/ 150,000) Charge only for paper for individual copies and charge the schools or departments with fixed costs on some other basis, for example, in proportion to the relative use of the service 9-29 Set a price somewhat above variable cost, perhaps even above average total cost per unit (e.g., $.07 or $.08 per copy) This charge should discourage overuse better than the others mentioned Overuse might lead to increased fixed costs for additional machines and salaries Note to the Instructor: This problem offers a particularly good basis for discussion of the relationship between cost allocations and transfer prices, and the extent to which alternative transfer-pricing schemes can be interpreted to transform cost centers into artificial profit centers One of the common allocation schemes involves allocating costs on the basis of the volume of services used by the cost-receiving departments, as is the case with the printing/duplicating department in the problem We have suggested some refinements of the allocation scheme, but none of the alternatives take on the character of a transfer price so as to turn the servicing department into an artificial profit center 9-47 Allocation of Costs Distribution Channels (30-35 minutes) The allocations for advertising, selling expenses, and general expenses are open to question It's possible that some expenses could be identified with one or the other group of customers For example, advertising in trade publications read only by wholesalers or only by retailers, if such publications exist, could be assigned, rather than allocated It's possible that some persons engaged in the activities described under "selling expenses" could devote full time to one or the other group of customers The bases actually being used may or may not be reasonable; physical volume of sales does not bear the same ratio of wholesale to retail as does sales in dollars (Prices to wholesalers are 20% less than those to retailers.) This fact casts doubt on the propriety of using sales dollars to allocate advertising and general expenses It would be arbitrary to allocate such costs based on unit volume, and the difference in prices makes it even more arbitrary to use sales dollars The ratio of cost of sales for each group to total cost of sales (44.4% for wholesale business, 55.6% for retail) is a reliable indicator of the volume of business that is accounted for by each group Since the same products are sold to both groups, it may be more legitimate to use these ratios than the sales ratios of 40% and 60% Allocating selling expenses other than advertising is questionable The costs of delivery may reasonably be allocated by number of deliveries, but whether each individual order is delivered separately is not known The cost of checking credit would seem to be related more to the number of customers in each group than to the number of orders Presumably, a customer's credit is not checked at the time of each order, especially a long-time customer for whom collection experience was good Some order-processing costs are associated with the number of orders, but there are likely to be fixed elements that cannot be allocated except arbitrarily Moreover, the complexity of an order would probably have some influence on the time required to process it, and it's possible that the orders from one group of customers are more difficult to process than those from the other (Retailers might order fewer items on more orders, a possibility supported by the fact that retailers have twice as many orders as wholesalers, since they have two-thirds of the selling expenses allocated to their business.) 9-30 Salespeople's expenses associated with travel, visiting customers, and securing orders would seem to have little relationship to the number of orders received It's possible that a visit generally results in an order, but it would be relatively easy to determine the number of visits to the two groups Even using the number of visits as an allocation device would be arbitrary because the expenses associated with salespeople's activities can be expected to be joint with respect to customers unless each salesperson covers only one group If each salesperson does cover only one group, the expenses are assignable and should be identified with the appropriate group Based on the information available, none of the advertising, selling, and general expenses have been allocated on the statement below Sales Cost of sales Sales commissions Managers' salaries Total assignable costs Contribution to unallocated costs Unallocated costs Income Wholesalers $2,000,000 $1,600,000 60,000 18,000 $1,678,000 $ 322,000 Retailers $3,000,000 $2,000,000 90,000 18,000 $2,108,000 $ 892,000 Total $5,000,000 $3,600,000 150,000 36,000 $3,786,000 $1,214,000 370,000 $ 844,000 Some of the other information that would be helpful has been referred to in requirement Analyses of various costs might turn up amounts that can be directly assigned to one of the groups Advertising in publications that reach only one group is one example Salespeople who call only on one kind of customer is another The cost of running credit checks could be better related to the numbers of customers in the groups if they are on the average of equal credit standing Analyses could be made of certain kinds of activities to try to establish fixed and variable components of the cost The cost of paper and supplies used in processing orders is probably directly assignable, but it might not be worthwhile to go to such lengths if the amounts of assignable cost discovered are small Nor would extensive volume-cost studies be wise if the variable components of the costs being studied are insignificant 9-48 Allocations and Behavior (15-20 minutes) $3.0 million before and $2.925 million after, a difference of only $75,000 Indirect cost per unit Times 25,000 units equals total indirect cost 9-31 Before $120 $3,000,000 After $117 $2,925,000 Preliminary calculations Increase in material costs [($85 - $80)/$80] 6.3% Decrease in departmental labor costs [($24 - $18)/$24] 25.0% Approximate total new labor cost ($2,000,000 x 90%) $1,800,000 Total indirect cost, approximations: Original ($2,000,000 x 500%) $10,000,000 New ($1,800,000 x 650%) $11,700,000 Increase ($1,700,000/$10,000,000) 17.0% Decrease in unit cost of product [($224 - $220)/$224] 1.8% Decrease in indirect cost allocated to product ($120 - $117)/$120, or ($3,000,000 - $2,925,000)/$3,000,000 2.5% The results are disappointing because a 25% decrease in labor time and cost yielded only a 1.8% decrease in total unit cost of the example product Several factors interacted to offset the labor savings The most obvious interaction, suggested in the problem, is the increase in material cost (6.3%) that accompanied the savings in labor Less obvious, because allocated indirect costs did decline, is a 17% increase in total indirect costs A less-than-proportionate decline in total and allocated overhead is to be expected because some indirect costs are fixed The increase in total indirect costs suggests that some indirect costs are related to activities other than labor For example, the use of new, more expensive materials and parts could bring increases in costs of purchasing, inspecting, safeguarding, and other material-related activities The results of the labor-reduction efforts suggest that the company might benefit from a thorough study that identifies its cost drivers 9-49 Activity-based Allocations and Behavior (Extension of 10 -48) minutes) Rate calculations Activity Labor Record keeping Materials Engineering Related Indirect Costs / Amount of Activity $ 4,940,000 $ 1,740,000 $ 420,000 1,200,000 $ 5,650,000 $24,000,000 $ 370,000 2,000 = Rate $ 2.8391 $ 0.3500 $ 0.2354 $185.0000 Allocation to Department Z and product line Activity Labor Record keeping Materials Engineering Total Department Z Activity $ 450,000 200,000 $2,125,000 150 Rate $ 2.8391 0.3500 0.2354 185.0000 Materials and components Direct labor at $12 Indirect ($1,875,570/25,000) Total cost (15-20 Allocation $1,277,595 70,000 500,225 27,750 $1,875,570 $ 85 18 75 $178 The value of the new allocation scheme is not that it gives a lower cost 9-32 per unit for Z's product ($178 as opposed to $220), but that it charges the department with indirect costs in proportion to its use of specific services The text notes that allocation schemes can encourage (or discourage) specific types of behavior For the company to benefit from the new allocation scheme, however, both operating managers and design engineers must understand what activities drive indirect costs Only with such understanding is it possible to recognize what trade-offs between labor and material cost are likely to benefit the company The Tektronix example in the text discussed motivating design engineers to reduce the number of parts and, in so doing, reduce materials-related indirect costs If operating managers understand the relationships among labor, materials, and indirect costs, they will be better able to analyze changes proposed by design engineers 9-50 Performance Measurement in an Automobile Dealership (25-30 minutes) The scheme is disadvantageous for the new-car manager because his performance is directly affected by something not under his control The used-car manager might set the offering prices so low that it becomes difficult to sell new cars (The offering prices could be low because, as indicated in the case, used-car sales may be slow and the lot full.) There is a disadvantage for the used-car manager if the transfer price is the trade-in allowance given by the new-car salesman If the trade-in allowance is charged to the used-car manager, the profits on used-car sales will be affected by the sales transactions effected by the new-car manager Although the new-car manager is free to go elsewhere to obtain a price he considers reasonable for a specific trade-in, it seems quite possible that this opportunity will be used as a bargaining point by the new-car manager to prompt an equal offer internally The two managers could spend so much time bickering that they neglect other, more profitable work Even if the new-car manager decides to take the traded-in car to an outside buyer, he will be taking time away from his primary task of selling new cars; he is, in effect, going into the used-car business Nevertheless, the opportunity to deal with an outside buyer does tend to eliminate the influence of the used-car manager on the new-car manager's performance measure The new procedure does not really encourage the used-car manager to quote prices other than would have been quoted under the old procedure except in one instance A used-car manager in need of cars is encouraged to quote a price that is in excess of the most likely price available outside the firm If the sales prices on used cars are set by competitive pressures, the end result for the total company is a smaller inflow of resources Generally, the procedures described in the case not really encourage the two managers to work together for the benefit of the total firm Note to the Instructor: The business manager of a large automobile dealership related to the authors the method used to compensate that company's new- and used-car managers The company evaluates the two managers together rather than separately, because it had had a great deal of trouble using the kind of system described in requirement of the case The owner of the agency finally decided that the profit center concept was simply not workable 9-51 Home Office Allocations and Decisions (35 minutes) The manager of the Miami office is best off with a 5% reduction 9-33 Selling Price Decrease 5% 10% Sales* $2,400,000 x 95% x 120% $2,400,000 x 90% x 135% Cost of sales $1,200,000 x 120% $1,200,000 x 135% Gross margin Other costs: Salaries and commissions: Fixed** Variable Rent, utilities, insurance Home-office charge, at 8% of revenue Total operating costs Profit $2,736,000 $2,916,000 1,440,000 $1,296,000 1,620,000 $1,296,000 $ $ $ $ 130,000 410,400 86,000 218,880 845,280 450,720 $ $ 130,000 437,400 86,000 233,280 886,680 409,320 * The first adjustment is the reduction in selling price; the second is for the expected increase in volume The unit price charged by the home office stays the same, so cost of sales increases by the percentage increase in volume ** Total salaries and commissions in current budget $490,000 Less variable portion ($2,400,000 x 15%) 360,000 Fixed portion of salaries and commissions $130,000 Note to the Instructor: A glance at the equal gross margins under the two plans should cause the student to reject the 10% decrease because the higher sales dollars are known to produce higher commissions and home office charges Most students will not recognize this point and will complete the income statement as indicated above The company is best off with a 10% reduction The allocated costs, including those in the transfer price for goods, cause the differing results between requirements and Selling Price Decrease 0% 5% 10% Sales Variable cost of sales* $960,000 x 120% $960,000 x 135% Commissions, 15% Total variable costs Contribution margin Direct fixed costs: Salaries as computed in part Rent, etc Total direct fixed costs Contribution to company $2,400,000 960,000 $2,736,000 $2,916,000 1,152,000 410,400 1,562,400 1,173,600 1,296,000 437,400 1,733,400 1,182,600 130,000 86,000 216,000 864,000 130,000 86,000 216,000 957,600 130,000 86,000 216,000 966,600 $ 360,000 1,320,000 1,080,000 $ $ * $2,400,000 x 40% = $960,000 The fixed costs included in the transfer price are not relevant to the analysis The $960,000 variable costs at the budgeted volume are multiplied by the ratios of the expected volume to the budgeted volume to determine the variable costs The direct fixed costs are not needed here, and the analysis could stop with contribution margin The difference in incomes between the 5% and 10% reductions is not large, so a 5% reduction could be a good idea Moreover, there would 9-34 probably be some increases in costs not considered here if Miami volume were to increase by 20% or 35% The 5% reduction does show a large increase in contribution, so that some reduction almost certainly makes sense Note to the Instructor: The point of the case is obvious: allocated costs can get in the way of making good decisions because the "paying" manager sees them, quite correctly from his or her point of view, as incremental Yet such costs are not incremental to the firm In this case, variable costs appear to Holden to be 73% of sales (50% for cost of sales + 15% commissions + 8% for home office charges) From the company's point of view, variable costs are only 55% of sales (40% for production costs and 15% for commissions) Hence, any decision involving holding prices constant such as the decision to increase advertising to spur unit volume might be made incorrectly For example, if dollar volume could be raised by $500,000 while holding prices constant, Holden would probably be willing to spend up to $135,000 to so, because that amount equals the present contribution margin on sales [$500,000 x (100% - 73% variable cost)] From the company's viewpoint, the opportunity to increase sales by $500,000 without changing prices warrants an expenditure of up to $225,000 [$500,000 x (100% - 55% variable cost to the firm)] 9-52 Incurred Costs and Performance (15-20 minutes) The resolution of the problem proposed in the memos may vary somewhat, but each memo should cover the substance of the following items The refinery manager has no control over the $3 difference; he can get the help he needs at $7 per hour and should not be charged at $10 per hour He should be charged the $7 per hour because he does need the help (for which he knows he would have to pay $7) and is not just taking on excess workers The reason for the company's policy of employing the drivers year-round at their winter rates is important in developing a reasonable way to assign the costs associated with that policy Either (1) top managers consider the arrangement to be economically sound, or (2) the managers perceive an obligation to the driver even though year-round employment at the higher rate is not economically sound Suppose the manager of the fuel-oil distribution department, and his superiors, believe that it is better to keep the drivers on all year because not doing so would result in the loss of qualified workers, extensive hiring and training costs, and higher operating costs It could be argued that the manager of the fuel-oil distribution department is receiving a large benefit from the refinery manager who is providing the summer employment Under these circumstances, it would seem reasonable to charge the fuel-oil distribution manager with the $3 per hour difference between the wages paid and the wages at which the refinery manager could obtain qualified help Suppose, on the other hand, that the company's top managers know it is economically unsound to provide year-round employment at the usual pay but they believe the company has an obligation to so The manager of fuel-oil distribution has no control over the practice, is not directly responsible for the difference in wages, and should not be charged with the wage differential ($3) Managers at a much higher level have made the decision, and the refinery manager should not be held responsible for the $3 difference either One possibility under these conditions is to leave the $3 per hour difference unallocated Although many managers and accountants would object to that suggestion, adherence to the principle of controllability would 9-35 preclude charging the difference to either the refinery manager or the distribution manager The distribution manager might get some benefit from having the drivers employed year-round (because of reduced turnover, better morale, lower costs of hiring and training, etc.), but it is assumed that those benefits were not sufficient to justify the decision to provide year-round employment on solely economic grounds 9-36 ... March 20X2, by Product Total Sales Less variable costs: Cost of sales Selling Total variable costs Contribution margin Direct fixed costs—production Product profit Common (indirect) costs: Selling... March 20X2, by Markets Total Domestic Sales $1,300,000 $1,000,000 Less variable costs: Cost of sales (schedule A) 820,000 630,000 Selling costs (schedule B) 31,000 24,000 Total variable costs $ 851,000... variable cost was $10 ($150,000/15,000) 15,500 cans Actual variable costs Divided by variable cost per unit Actual unit volume $155,000 $10 15,500 $13.70 Actual sales in dollars Divided by sales