Solution manual cost accounting by LauderbachRESPONSIBILITY ACCOUNTING

CHAPTER 9
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
do 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 do 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)

1. 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

2. 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

3. 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)

1.
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.
2. 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 5 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)

1. and 2. 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
1.

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
2.

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

3.

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 1 and 2 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).
1.

2.

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 1
Equals selling price per unit

$212,350
15,500
$13.70

9-9


3.
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
1.

Cost Allocation

(45 minutes)

Direct Method
Purchasing (60%/80%; 20%/80%)
Administration (20%/70%; 50%/70%)
Totals

2.

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


Cutting
Direct cost
Administration (30%, 20%, 50%)
$250,000
Purchasing (60%/80%; 20%/80%)
112,500
Totals
$362,500

$500,000
(500,000)

$300,000
150,000

$100,000

(450,000)

337,500
$437,500

The total allocated is still $800,000 ($437,500 + $362,500), but there is
a difference of $69,643 in the amounts allocated to each operating department
using the step-down method as opposed to the direct method.
Note to the Instructor: To draw attention to the differences that can
result from the order in which the service department costs are allocated,
you might wish to show the results you would have obtained had you allocated
Purchasing costs first.
Purchasing
Cutting
Direct cost
$300,000
Purchasing (20%, 60%, 20%)
(300,000)
60,000
Administration (20%/70%; 50%/70%)
400,000

Totals
$460,000

Administration

Trimming

$500,000
60,000

$180,000

(560,000)

$

160,000
$340,000

The difference between the allocations to the operating departments using
the two step-down alternatives is $97,500.
3.

Reciprocal Method

Let P = adjusted costs for Purchasing and A = adjusted costs for
Administration.
P
A
P

P
0.94P
P
A

=
=
=
=
=
=
=

$300,000
$500,000
$300,000
$450,000
$450,000
$478,723
$595,745

+
+
+
+

0.30A
0.20P
0.30 x ($500,000 + 0.20P)
0.06P

[$500,000 + (0.20 x $478,723)]
Trimming

Purchasing costs
$478,723 x .60
$478,723 x .20
Administration costs
$595,745 x .20
$595,745 x .50
Total allocations

Cutting

Total

$287,234
$ 95,745
119,149
$406,383

297,872
$393,617

$800,000

The results here are closer to those under the direct method than to
those of the step-down method. The difference between these allocations and
the step-down is $1,117. The difference between the reciprocal and direct
methods is $38,526. The differences depend strictly on the numbers selected
and it is not possible to generalize about how close the reciprocal results

will be to the direct method results or results of the step-down method using
9-11


any sequence.
9-22
1.

Performance Reporting And Allocations

(15 minutes)

Income statement

Sales
Direct costs
Controllable profit
Indirect costs*
Income

Indoor
$800,000
240,000
560,000
320,000
$240,000

Outdoor
$700,000
240,000

460,000
280,000
$180,000

Total
$1,500,000
480,000
1,020,000
600,000
$240,000

* Allocations = ($800,000/$1,500,000) x $600,000 = $320,000 and
($700,000/$1,500,000) x $600,000 = $280,000. Or, the rate of indirect cost
per sales dollar is 40%, $600,000/$1,500,000, which multiplied by $800,000
and $700,000 gives the same allocations.
2. The manager of the outdoor department did nothing to boost the company's
income. The increase in outdoor's income came about only because the
increase in indoor sales caused it to absorb more indirect costs. The indoor
department increased its controllable profit by $100,000 ($560,000 $460,000), which accounts for the entire increase in income.
9-23

Responsibility for Rush Orders

(10-15 minutes)

Note to the Instructor: Students will describe the issues in various
ways. A more basic question is whether the company's objectives are being
served under one or another method of attempting to resolve the conflict.
The problem doesn't state who is held responsible for the increased costs
associated with rush orders. That the production manager is complaining

suggests that he is being held responsible, but he might be complaining just
because of the aggravation in meeting the sales manager's rush orders.
1.
The production manager should not be held responsible for excess costs
unless he is given a budget for them. It's not his fault that rush orders
occur. What needs to be decided is whether the rush orders are justified,
whether meeting such orders is as critical as the sales manager says it is.
(Competitors might not offer such service and customers might be taking
advantage of a good thing.)
If accepting rush orders is justified from the standpoint of the
objectives of the firm, which may include providing rapid service, then
neither manager can be charged with the excess costs except arbitrarily. The
sales manager would normally be held responsible for such costs; but if the
company's policy requires the rapid filling of rush orders, it would seem
unfair not to provide for such costs in his budget.
2. The memo should suggest that the first step in developing the best course
of action is to analyze the costs involved in (a) filling the orders rapidly,
(b) carrying more inventory, and (c) not filling orders so rapidly (the
possible lost sales and contribution margin). If this can be done with
acceptable accuracy, a policy could be established that would provide enough
flexibility to allow the sales manager to deal with some cases as
circumstances warranted. Thus, new customers might be given rush service,
with the understanding that such service would not continue, except in
unusual cases of need or at greater cost.

9-12


It is not the fault of the production manager that rush orders cost
more, unless he is not producing, at budgeted levels, the mix of products

that has been previously budgeted. If he is deviating from the production
budget, there is some legitimacy to charging him with excess costs if the
rush orders could have been filled from normal production according to the
budget.
9-24

Performance Measurement

(15-20 minutes)

1. While the sales manager exceeded the budget for total sales, contribution
margin would have been higher if the actual mix had been closer to that
planned. Actual results were:
Alpha
Beta
Gamma
Total
Sales
$500,000 $400,000 $200,000 $1,100,000
Variable costs (50%, 45%, 30%)
250,000
180,000
60,000
490,000
Contribution margin
$250,000 $220,000 $140,000 $ 610,000
Contribution margin was $15,000 less than planned because of the unfavorable
change in the sales mix, and the sales manager did not perform as well as
would have been expected given that he exceeded the sales budget. The
weighted average contribution margin based on budgeted sales is 62.5%. Had

the $1,000,000 of actual sales been in the normal mix, contribution margin
would have been $687,500.
2. The memo should note that the current performance measure does not
encourage goal congruence because it fails to consider the relative
profitabilities of different products. The sales manager could concentrate
on the more easily sold products, which might well be low-margin items. The
sales manager's performance should be judged by a measure of profitability
such as revenues minus budgeted variable costs of production and actual
selling costs. (Using actual production costs would pass on inefficiencies
of production. The sales manager should, however, be responsible for selling
costs.)
9-25

Behavioral Problem

(5-10 minutes)

Apparently, the lower charge-per-copy resulting from the lower variable
cost has stimulated use. We cannot be sure that there is unnecessary copying
being done, but we can surmise it given that volume was 8,000 copies per day
before the new copier was bought. If the manager in charge believes that
copying is excessive, he or she could simply raise the per-copy charge,
making it a transfer price. This could be accompanied by dropping the
allocation of the fixed costs. It might also be that the copying is
justified, so that it might be wise to acquire more capacity. Testing this
hypothesis requires charging more than variable cost per copy.
The problem here, as in so many cases, is the behavior of managers under
a particular system of responsibility accounting (and cost allocation). As
the chapter states, an important objective of charging users (through either
cost allocation or transfer prices) is encouraging desirable behavior. The

chapter also argues that dual rates (as used by Watson) are better than
single rates, but there can be undesirable consequences of using dual rates
when the variable component is extremely low.
9-26

Hospital Allocations and Decisions

9-13

(15-20 minutes)


1.

Current reimbursements
Medical
$126,000
48,000

Admissions, given
Records ($800,000 x .20 x .30)
($800,000 x .80 x .90)
Totals
2.

$174,000

Surgical
$162,000

Total
$288,000

576,000
$738,000

624,000
$912,000

New reimbursements
Medical
$123,480

Admissions ($588,000 x .70 x .30)
($588,000 x .30 x .90)
$282,240
Records ($820,000 x .20 x .30)
($820,000 x .80 x .90)
639,600
Totals
$921,840

Surgical

Total

$158,760
49,200
590,400
$172,680

$749,160

Reimbursements increase by $9,840 ($921,840 - $912,000), which exceeds the
$8,000 cost increase.
3. The hospital benefits from the change by increasing its reimbursement
from third parties for indirect costs. Patients of that hospital might also
benefit if the prices of services are reduced because of the higher
reimbursements. However, someone will have to bear the higher cost of
third-party reimbursements, whether the burden falls on taxpayers--for
services supported by government--or on participants in insurance plans.
Note to the Instructor: The distinctive feature of this problem is that
making the change is an economically sound decision for the hospital because
the hospital would increase its reimbursements by more than its costs would
increase. The problem demonstrates a number of points. First, it confirms
that allocations can influence behavior. Second, it confirms that, by virtue
of its effect on behavior, an allocation can have economic consequences.
Third, it draws attention to the potential effects of programs or contracts
that include reimbursing (sharing) indirect costs. Fourth, it presents the
opportunity to discuss the difference between the micro and macro effects of
a decision.
9-27

Allocations, Expense Reimbursement, and Ethics (10 minutes)

1. Probably $740, the actual cost, though the company would have paid $760
for the business trip alone, the round-trip fare to Los Angeles. A request
to be reimbursed for more than one has spent would certainly be rejected.
2. There are several possibilities, none of which could be called correct.
The harshest is to allow nothing on the grounds that you really took the trip

to play golf and the business portion was a ruse. (Scrooge himself would
have trouble with that.) A more reasonable approach is to allocate the total
cost based on the time spent (60% business, 40% pleasure), giving $444 ($740
x 60%) to be reimbursed. This approach allocates the special price reduction
(for staying over a weekend) between the business and personal portions of
the trip, though the reduction might not have occurred without the personal
side trip. It is also reasonable to argue for a reimbursement of $595. The
personal part of the trip would have cost $145, $105 (Los Angeles to San
Francisco) plus $40 ($420 San Francisco to Atlanta minus $380 Los Angeles to
Atlanta). The reimbursement would then be the $595 difference between the
$740 actual cost and the $145 personal cost.
9-14


Other reasonable approaches are to allow $530 (the $740 actual cost less
the $210 round-trip fare from Los Angeles to San Francisco) or even $550 (the
$760 round-trip fare less the $210).
Note to the Instructor: It should be interesting to see how students
answer the first question. While this problem demonstrates again the
allocation problem, it also offers exposure to a business decision that
students are likely to encounter. Those instructors interested in
considering ethical issues in class will want to explore the decisions facing
both the employee and the supervisor.
9-28

Step-Down Allocation (Related to Appendix)

(20-25 minutes)

General Administration Machining

Assembly
Total
DP transactions
30,000
40,000
10,000
100,000
Percent of total
30%
40%
10%
100%
No. of employees
100
300
600
1,000
Pct. of total
10%
30%
60%
100%
Direct costs before allocation
$1,000,000 $1,500,000 $2,500,000
Pct. of total
40%
60%
100%
Personnel
20,000

20%

Data
General AdProcessing Personnel ministration Machining
Direct costs
$150,000
$100,000
$200,000
$1,000,000
Data Processing
(150,000)
30,000
45,000
60,000
Personnel
(130,000)
13,000
39,000
General Administration
(258,000)
103,200
Totals
$1,202,200
9-29

Performance Report for a Cost Center

Assembly
$1,500,000
15,000

78,000
154,800
$1,747,800

(15-20 minutes)

Monthly Cost Report, Casting Department
July 20X1
Controllable costs:
Materials
$ 32,800
Direct labor
66,800
Indirect labor
2,380
Variable power (9,500 x $0.05)
475
Variable maintenance (800 x $0.80)
640
Other
9,350
Total controllable costs
$112,445
Noncontrollable costs:
Fixed power ($130,000 x .10)
$ 13,000
Fixed maintenance ($24,000 x .15)
3,600
Total noncontrollable costs
16,600

Total costs
$129,045
Note to the Instructor: The point in the revised performance report is
not that costs are lower than originally reported, but that they are more
reasonably reported. The revised report differentiates between the
controllable and noncontrollable costs. As the chapter suggests, because
they are aware of the noncontrollable costs, the departmental managers might
help to keep those costs lower than they might otherwise be.
9-30

Variances in a Service Business

(25 minutes)

9-15


Junior Staff
Actual
Results

Actual Hours at
Planned Rate
($40 x 26,000)
$1,040,000

$988,000
$52,000
rate variance
unfavorable

Planned
Results
$1,200,000

$160,000
volume variance
unfavorable
$212,000
total variance
unfavorable

Senior Staff
($80 x 15,000)
$1,200,000

$1,260,000
$60,000
price variance
favorable

$960,000

$240,000
volume variance
favorable
$300,000
total variance
favorable

In summary, junior staff worked less than planned and at lower rates,
showing unfavorable variances both for rate and volume. Senior staff worked
more than planned and at higher rates, showing a favorable overall variance.
In some situations, the rate and volume variances are probably related in the
sense that the rate change causes an opposite change in volume. That might
not be the case for a CPA firm. We can only speculate about the causes.
Perhaps the firm developed a great deal more work requiring higher level
people.
9-31

Performance Report in a Service Company

(15-20 minutes)

1.

Revised Performance Report for the Litigation Department
February
Revenues
$140,600
Less direct costs:
Staff salaries expense
76,800
Travel and supplies expense
7,800
Total direct costs
84,600
Controllable profit
56,000
Less allocated indirect costs:

Occupancy and utilities expense
9,800
General office expense
15,400
Total indirect costs
25,200
Income
$ 30,800

March
$148,400
77,400
8,100
85,500
62,900
10,900
21,800
32,700
$ 30,200

2. Controllable profit was higher in March than in February, indicating that
the Litigation Department actually did better in March. The increase in
allocated occupancy expense resulted from a decision made by the top managers
of the firm, not by Saunders. But at least all managers shared the increase
on a consistent basis not affected by their actions. The allocation of
general office expense is more troublesome for performance reporting. The
cost allocated to the Litigation Department increased not only because of the
Litigation Department's increased activity, but also because of decreased
activity in the other departments.
9-16

9-32
1.

Product-Line Income Statements

(35 minutes)

The first step is to find the number of each product sold.
Saws:
4,000 ($500,000 x 40%)/$50
Drills:
7,500 ($500,000 x 30%)/$20
Sanders:
3,750 ($500,000 x 30%)/$40

Mifflan Tool Company
Income Statement for January
Total
Saws
Sales
$500,000
$200,000
Cost of sales (1)
307,500
120,000
Gross profit
$192,500
$ 80,000

Shipping and delivery (2)
23,000
8,000
Contribution margin
$169,500
$ 72,000
Fixed costs (3)
140,000
Income before taxes
$ 29,500
(1)
(2)
(3)
2.

20X3
Drills
$150,000
112,500
$ 37,500
7,500
$ 30,000

Sanders
$150,000
75,000
$ 75,000
7,500
$ 67,500

Saws
= 4,000 x $30
Drills
= 7,500 x $15
Sanders
= 3,750 x $20
Saws
= 4,000 x $2
Drills
= 7,500 x $1
Sanders
= 3,750 x $2
Rent, salaries, and other expenses of $40,000, $70,000, and $30,000
At the expected mix the sales of each product would have been as follows:
Saws:
Drills:
Sanders:

3,000
5,000
6,250

($500,000 x 30%)/$50
($500,000 x 20%)/$20
($500,000 x 50%)/$40

Mifflan Tool Company
Expected Income Statement for January 20X3
Sales
Cost of sales

Gross profit
Shipping and delivery
Contribution margin
Fixed costs
Income before taxes

Total
$500,000
290,000
$210,000
23,500
$186,500
140,000
$ 46,500

Saws
$150,000
90,000
$ 60,000
6,000
$ 54,000

Drills
$100,000
75,000
$ 25,000
5,000
$ 20,000

Sanders

$250,000
125,000
$125,000
12,500
$112,500

3. Calculations of weighted-average contribution margin and gross profit
rates are as follows.
Expected Percentages:
Selling price
Cost of sales
Gross profit
Gross profit percentage
Mix percentage
Weighted average

Total

42%

Gross margin, above
9-17

Saws
$50.00
30.00
$20.00
40%
30%
12%

Drills
$20.00
15.00
$ 5.00
25%
20%
5%

Sanders
$40.00
20.00
$20.00
50%
50%
25%

$20.00

$ 5.00

$20.00


Less shipping and delivery
Contribution margin
Contribution margin percentage
Weighted average
Actual Percentages:
Gross profit percentage

Actual sales mix
Weighted average
Contribution margin percentage
Weighted average

37.3%

2.00
$18.00
36%
10.8%

Total
38.5%
33.9%

Saws
40%
40%
16%
36%
14.4%

1.00
$ 4.00
20%
4.0%
Drills
25%
30%

7.5%
20%
6.0%

2.00
$18.00
45%
22.5%
Sanders
50%
30%
15%
45%
13.5%

The effect of the change in mix was to reduce the gross margin percentage
to 38.5% from 42%, 3.5 percentage points. This resulted in a $17,500 drop in
gross margin ($500,000 x 3.5%). The percentage of shipping and delivery
expenses dropped from 4.7% ($23,500/$500,000) to 4.6% ($23,000/$500,000).
This 0.1% decrease gained an additional $500 of contribution margin and
profit.
Some students will deal only with the change in the WACM (37.3% expected
versus 33.9% actual), a drop of 3.4 percentage points, giving the $17,000
profit shortfall ($500,000 x 3.4%). Whether or not variable costs are
discussed individually, the president can be told that the shift in mix was
unfavorable because the lowest margin product, drills, increased its share
and the highest margin product, sanders, reduced its share.

9-33

Selecting an Allocation Base

(15 minutes)

1. $300,000
floor space)]

[$3,000,000 x (20,000/200,000, the sum of the first and second

2.

(7.5% x $3,000,000)

$225,000

Total rental value:
First floor (25 x 100,000)
Second floor ($15 x 100,000)
Total
Housewares' Department ($15 x 20,000)
Percentage ($300,000/$4,000,000)

$2,500,000
1,500,000
$4,000,000
$ 300,000
7.5%

3. Bisson's method makes more sense because it recognizes the value and,
indirectly, the cost of the space that her department occupies. Rental value

is therefore a better measure of benefits received than is floor space.
Note to the Instructor: Some students might ask why the company can
rent space worth $4,000,000 for $3,000,000. Several possibilities suggest
themselves. One is that the lease might be a few years old, reflecting lower
rental values. Another is that a basket purchase, such as renting an entire
building instead of some space on one floor or the other, often yields
savings.
9-34
1.

Allocations and Decisions

(10-15 minutes)

No, because profit would fall by $30,000.

Revenue (20,000 x $30)
Variable costs excluding corporate charge
9-18

$600,000


(20,000 x $27)
Corporate charge
Incremental loss
30,000)

$540,000
90,000

($600,000 x .15)

630,000
($

Alternatively, working with per-unit amounts, $30 - $27 - ($30 x .15) =
-$1.50
2. Yes, profit for the company as a whole would increase by $60,000
($600,000 - $540,000 incremental variable costs).
9-35

Performance Measures

(20-25 minutes)

Preliminary Note to the Instructor: This problem shows how important it
is for management to state its objectives clearly so that measures of
subsequent performance will motivate actions consistent with those
objectives. Throughout, this problem brings out the disadvantages of using a
single performance measure. One way to approach the problem is to consider
what "bad" actions a manager might take that would appear to be "good" based
on the criterion being used to measure performance.
(a) The measure might be effective if one could determine and implement an
adequate notion of what is meant by "no longer requiring treatment." If
discharge from a hospital is the statistic used to implement the notion, the
dangers are (1) premature discharge of patients and (2) concentration on
patients requiring little treatment. The measure is faulty without some
recognition that the "treatment" for each patient is not the same.
(b) The usefulness of this measure depends on the intended beneficiaries of

the program. The suggested measure could encourage concentration on the easy
cases, many of whom could probably find jobs on their own within a short
period of time. While such persons can use help, the need is likely to be
greater elsewhere--namely, with the chronically unemployed and underemployed.
As with the previous part, the measure fails to recognize that unemployed
persons are not all equally unemployable.
Another consideration is the type of job that will be found. It is not
a significant gain to place a person in a dead-end job that he or she could
probably have found anyway. Moreover, if that does come to pass, the
turnover rate will probably be high, which will make the director look even
better because of the increase in unemployment that will occur as persons go
through several poor jobs with periods of unemployment after each job.
Consequently, some consideration of the length of time persons remain on the
jobs found for them is needed to improve the measure.
(c) As with the previous question, the issue is defining the objectives to
be accomplished. If the objective is to eliminate as much substandard
housing as possible, the measure may be useful as long as adequate building
codes are established. While such a policy might be effective in terms of
numbers, however, it might not get at the more critical problems of bad
housing.
The performance measure is weak if the real target of the program is
elimination (or major rehabilitation) of major slum areas. The measure could
encourage concentration on easy rehabilitation projects, such as houses
having one or two easily corrected deficiencies such as missing glass or
screens, or a leaky roof. Because the measure fails to recognize the
relative difficulty of bringing individual houses up to standards, houses
with more difficult defects (perhaps structural problems) might be ignored.
9-19

(d) Hours of
or other cost
circumstances
turned on and
way, consider
responsible.

operation is an input measure, with no consideration of output
(like wasted materials). Except under the unlikely
that the machine produces at a steady rate whenever it is
an operator is present, the performance measure should, in some
both output and other costs for which the operator is

(e) A reasonable objective for a salesperson is to increase the average
order size while maintaining (or increasing) the number of customers served.
The measure is trying to get at two things at once, but the ratio form of the
measure could encourage salespeople to concentrate on the customers who are
likely to give large orders, perhaps ignoring those with smaller orders.
Classes that have been through Chapter 8 will be aware that maximizing a
ratio (IRR in that chapter) is generally inferior to maximizing a dollar
amount (NPV). Moreover, the suggested measure ignores the profitability of
the sales, so that salespeople might push the high-volume, low-margin
products at the expense of more profitable ones.
9-36

Evaluation of Compensation Plans

(20-25 minutes)

1. The morale and harmony problem may be caused at least partially by having

salespeople like McTavish making large commissions while taking actions not
in the company's interest. That fact could also explain the profitability
problems. The commissions are based solely on gross sales ($270,000 x 8% =
$21,600 commission for McTavish, and $200,000 x 8% = $16,000 for Christy).
But the return to the company from the efforts of the two salespeople is
quite different, as shown below.
Gross sales orders
Sales returns *
Net sales
Cost of goods sold
Gross margin
Commissions
Contribution margin
Discretionary expenses
Incremental profit

McTavish
$270,000
18,500
251,500
139,500
112,000
21,600
90,400
19,200
$ 71,200

Christy
$200,000
8,000

192,000
68,400
123,600
16,000
107,600
21,500
$ 86,100

* The company earns nothing and may even suffer a loss if the returned
goods must be resold at reduced prices)
McTavish is receiving larger commissions, but the return to the company
on his efforts is smaller than the return to the company on Christy's
efforts. The higher level of discretionary expenses incurred by Christy does
not outweigh the higher return produced on sales he made. Moreover,
McTavish's customers return merchandise at a greater rate than do Christy's
($8,000/$200,000 = 4% for Christy, versus $18,500/$270,000 = 6.9% for
McTavish).
Considering only the quantitative data in the above analysis, it appears
that Christy is underpaid relative to McTavish. If even a few of the above
facts (such as the variable cost of sales) are known to the sales force, it
is understandable that disharmony could exist among its members. The
performance measure used currently, dollars of gross sales, encourages a
salesperson to ignore all the other factors that affect the company's return
9-20


on those sales. (For example, perhaps McTavish is providing loose credit
terms, overselling, or using high-pressure tactics, all of which would prompt
the higher return rate. He also might be concentrating on easy-to-sell items
and/or easy-to-sell customers, or perhaps he is ignoring smaller customers.

Christy, on the other hand, might be doing more development work, calling on
companies that are not now customers in the hope of increased business in the
future.)
2. This problem is a good example of the use of a performance measurement
(and reward system) that concentrates on only one phase of responsibility.
The salespeople are being evaluated and rewarded in a way that fails to
reflect how their actions can influence profitability. One alternative would
be to base compensation on incremental profit, such as computed in
requirement 1. (Of course, the commission percentage would have to be
adjusted to achieve approximately the same total cost to the company.)
Another alternative is to pay a base salary plus bonuses for meeting specific
targets considered important to specific objectives of the company (e.g.,
number of new accounts obtained, percentages of repeat business held). At a
minimum, the plan should be revised to recognize merchandise returned by
customers.
9-37

Allocations and Ethics

1.
The direct costs of the mailing were the costs of (a) postage, (b)
stationery, (c) printing the cover letter and the material containing the
"five health tips," and perhaps (d) stuffing and addressing envelopes.
Mailing costs would probably also include obtaining a mailing list of
prospective donors and maintaining the mailing list of past donors. If
permanent employees regularly do the stuffing and mailing and maintain master
mailing lists, a total cost for the mailing would probably include an
allocation of the salaries of these employees. In addition, the charity is
likely to purchase mailing lists of prospective donors, and the total cost
for the mailing in question is likely to include an allocation of this

purchase cost.
The charity's four major cost categories are (a) research programs, (b)
public education programs associated with fund-raising appeals, (c) fundraising, and (d) administrative expenses. The total cost of the mailing, as
described above, is probably allocated between the second and third of those
cost categories, with the public-education category carrying most of the
cost. The mailing qualifies for that category because of the inclusion of the
"health tips."
2. The decision to support or not support this charity is a personal matter
that might or might not be influenced by the information provided in the
mailing. A charity that devotes only 21% of its funds specifically to the
charitable purpose for which it claims to exist is unlikely to garner support
from most people. However, an individual who is personally aware that most
of the charity's public education programs are major undertakings having only
a peripheral relationship to fund-raising might not react negatively to the
fund-raising connection in the category that uses 43% of the charity's funds.
Moreover, an individual having a personal interest in the charitable purposeperhaps because a member of the family had already benefited, or hoped to
benefit, from the charity's work-might disregard what others could conclude
were disproportionate expenditures on fund-raising and administration.
9-38

Revenue Variances for an Airline
9-21

(20 minutes)


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

1.

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
2.

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 do things themselves that they well could do. (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 1 and 2. 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.
1. 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.
2. 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.
3.

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
1.

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