CHAPTER 8

COST ALLOCATION: PRACTICES

P 8-1: Solution to Step-Down (15 minutes)

[Step down vs. direct allocations]

This statement is not correct for a number of reasons:

1. One allocation method can only be assessed as “better” than another one after
specifying how the resulting accounting numbers are being used (taxes, decision
making, control, etc). Since the quote does not specify how the cost allocations
are being used, there is no logical way to assess which method is better.

2. Presumably, one criteria implied by the quote is in terms of accuracy. That is,
does the step-down method more accurately reflect the opportunity costs of
resources consumed by the service department? Under this criterion, it is still not
obvious that the step-down allocation method is more accurate than the direct
allocation method. Both allocation methods are approximations and each
contains errors.
Look at the formula for the overhead rate in the step down method:

Service department’s allocation rate = (own cost + allocated costs

from higher service departments) / (quantity of services provided to
users below the service department)

The numerator becomes more accurate in terms of resources used by the service
department the further down in the sequence of service departments. But the
denominator becomes less accurate because fewer actual users are included in the
denominator. Look at the first department in the sequence. Its numerator
includes no service department costs allocated to it, and hence understates the
resources consumed by the first department in the sequence. But its denominator
includes all of the users of its services.
The direct allocation method also contains errors. The numerator excludes
costs of resources consumed from other service departments and the denominator
excludes other service department users.

3. Both methods include fixed service department costs, and hence the allocated
costs per unit of service provided do not reflect marginal (variable) costs of the
service provided.

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Instructor’s Manual, Accounting for Decision Making and Control 8-1
P 8-2: Solution to Outback Opals (20 minutes)
[Joint cost allocations and NRV does not necessarily minimize taxes]

a. Allocated joint cost per stone using the number of stones:

Grade I Grade II Grade III Total

Number of stones per batch 70 105 175 350
Percent of stones 20.00% 30.00% 50.00% 100.00%
Allocated cost to each grade A$7,000 A$10,500 A$17,500 A$35,000
Allocated joint cost per stone A$100 A$100 A$100

Alternatively, A$35,000 / 350 stones = A$100.00 per stone.

b. Allocated joint cost per stone (before taxes) using net realizable value:

Grade I Grade II Grade III Total

Selling price per stone A$800 A$300 A$110
Additional cost to package and
sell each stone (250) (120) (5)
Net realizable value per stone A$550 A$180 A$105
X Number of stones per batch 70 105 175
Net realizable value per batch A$38,500 A$18,900 A$18,375 A$75,775
Percent of net realizable value per batch 50.81% 24.94% 24.25% 100%
Allocated cost to each grade A$17,784 A$8,729 A$8,488 A$35,000
Allocated joint cost per stone A$254.05 A$83.13 A$48.50

c. Which of the two methods to choose depends on how the numbers will ultimately
be used. If they are used for decision making, one might be tempted to argue that
NRV is better because it does not distort the relative profitability of the joint
products. However, this answer is short sighted because it does not consider the
possible tax affects of the alternative joint cost allocations. Presumably,
whichever method Outback uses for internal purposes is likely to be seen by the
tax authorities if Outback’s tax returns are audited. That is, although Outback can
use different joint cost allocation methods for taxes and internal purposes,
separate systems undermine Outback’s tax case if they are ever audited. The
following tables calculate the income tax liability arising from each method.

Income taxes based on number of stones: Grade I Grade II Grade III Total
Revenue A$56,000 A$31,500 A$19,250 A$106,750
Allocated joint cost (based on number of stones) (7,000) (10,500) (17,500) (35,000)
Additional packaging and selling cost (17,500) (12,600) (875) (30,975)
Net income before taxes 31,500 8,400 875 40,775
Income taxes A$ 9,450 A$ 1,260 A$394 A$ 11,104

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8-2 Instructor’s Manual, Accounting for Decision Making and Control
 Income taxes based on NRV:
Revenue A$56,000 A$31,500 A$19,250 A$106,750
Allocated joint cost (based on nrv) (17,784) (8,729) (8,488) (35,000)
Additional packaging and selling cost (17,500) (12,600) (875) (30,975)
Net income before taxes 20,717 10,171 9,888 40,775
Income taxes A$ 6,215 A$ 1,526 A$ 4,449 A$ 12,190

Notice, that the pre-tax cash flows are identical under the two joint cost allocation
methods. Net income before taxes (and cash flows) is A$40,775. How the joint
costs are allocated affects the amount of profit and hence taxes paid in each of the
three countries, because the three tax jurisdictions have very different tax rates.
The NRV method actually results in higher taxes than using the number of stones.
Therefore, to minimize taxes, the number of stones should be used, assuming that
it is an allowed method by all three tax jurisdictions.

P 8-3: Solution to Rose Hospital (25 minutes)

[Step-down allocations]

a. & b. The first of the following two tables computes the allocation rates, and the second
table applies these rates to allocate the service department costs.

ALLOCATION RATES

Building Food Intensive General

Services Service Care Surgery Medicine Total
Direct Allocations:
Building 10,000 20,000 40,000 70,000
Services 14% 29% 57% 100%

Food 3,000 4,000 98,000 105,000

Service 3% 4% 93% 100%
Step-down — Building Services First:
Building 15,500 10,000 20,000 40,000 85,500
Services 18% 12% 23% 47% 100%

Food 3,000 4,000 98,000 105,000

Service 3% 4% 93% 100%

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Instructor’s Manual, Accounting for Decision Making and Control 8-3
Step-down — Food Service First:
Building 10,000 20,000 40,000 70,000
Services 14% 29% 57% 100%

Food 12,000 3,000 4,000 98,000 117,000

Service 10% 3% 3% 84% 100%

ALLOCATED COSTS

Building Food Intensive General

Services Service Care Surgery Medicine Total
Direct Allocations:
Building 14% 29% 57%
Services $.84 $1.74 $3.42 $6.00

Food 3% 4% 93%
Service $0.09 $0.12 $2.79 $3.00
$0.93 $1.86 $6.21 $9.00
Step-down — Building Services First:
Building 18% 12% 23% 47%
Services $1.08 $0.72 $1.38 $2.82 $6.00

Food 3% 4% 93%
Service $0.12 $0.16 $3.79 $4.08
$0.84 $1.54 $6.61 $10.08*
Step-down — Food Service First:
Food 10% 3% 3% 84%
Service $0.30 $0.09 $0.09 $2.25 $3.00

Building 14% 29% 57%

Services $0.88 $1.83 $3.59 $6.30
$0.97 $1.92 $6.11 $9.30*
* Note: The totals allocated ($10.08 and $9.30) contain amounts allocated first to the service departments
and then re-allocated to the end users. The total allocated costs to the end users in all cases sum to
$9.0 million.

c. The step-down method with Food Service first allocates about $0.50 million less
to General Medicine and about $0.4 million more to Surgery than using Building
Services first. These differences are caused by General Medicine’s almost entire
consumption of meals (ranging between 84 percent to 93 percent). By starting
with Building Services, another $1.08 million of building costs are assigned to
Food Service, most of which are passed through to General Medicine. Starting

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8-4 Instructor’s Manual, Accounting for Decision Making and Control
 with Food Service reduces the total amount of Food Service costs allocated, thus
lowering General Medicine’s total bill.

P 8-4: Solution to Mystic Herbals (30 minutes)

[Joint cost allocations are not useful for decision making]

a. Allocated joint cost is $60 per ounce ($30,000 ÷ 500 ounces):

QV3 VX7 HM4 LZ9 Total

% of batch by ounce 20% 16% 25% 39% 100%
Allocated joint cost $6,000 $4,800 $7,500 $11,700 $30,000

b. Decisions to process further:

QV3 VX7 HM4 LZ9

Incremental revenue per ounce from $23 $8 $25 $14
further processing
Number of ounces per batch 100 80 125 195
Incremental revenue from further $2,300 $640 $3,125 $2,730
processing
Cost of further processing $2,400 $400 $2,500 $2,800
Decision to process further NO YES YES NO

c. Batches of Xubonic root should be produced because each batch yields profits of
$3,200.

QV3 VX7 HM4 LZ9 Total

Revenue from further
processing or
immediate sale $6,200 $4,560 $15,875 $9,165
Cost of further processing 0 400 $2,500 0
Net realizable value $6,200 $4,160 $13,375 $9,165 $32,900
Joint cost of processing a
batch $30,000
Profit per batch $ 2,900

d. Profit after allocating joint cost using net realizable value:

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Instructor’s Manual, Accounting for Decision Making and Control 8-5
 QV3 VX7 HM4 LZ9 Total
NRV $6,200 $4,160 $13,375 $9,165 $32,900
% of NRV 18.84% 12.64% 40.65% 27.86% 100%
Allocated joint cost $5,653 $3,793 $12,196 $8,357 $30,000
Net income per batch $547 $367 $1,179 $808 $2,900

e. Joint cost allocations do not enhance the decision to further process joint
products. Net realizable value does not harm the decision process, but it does not
add anything. The decisions in part (b) to process each joint product further or
sell after the split off point were made without any joint cost allocations.

P 8–5: Solution to Fidelity Bank (30 minutes)

[Step-down allocations]

a. The first step is to allocate Telecom’s costs to Information Management (IM):

Telecom direct operating expenses $ 3,500,000

IM’s share of Telecom’s services 0.15
Costs allocated to IM $ 525,000
IM’s Direct operating expenses 9,800,000
Total IM costs to be allocated $10,325,000

Next, calculate Credit Card’s share of IM services, ignoring Telecom’s use of IM

(20 percent). Telecom’s utilization must be ignored in order that all the service
department’s costs can be stepped down.

Credit Card’s share of IM: 15% ÷ (100% - 20%) = 18.75%

IM cost allocated to credit cards: $10,325,000 × 18.75% = $1,935,938

b. The calculated cost per gigabyte increases if IM is moved to the end of the
sequence for two reasons. First, IM receives allocated costs from all four of the
other service departments rather than just Telecom. Thus, the numerator in the
overhead rate formula is higher. Second, the denominator is smaller because the
only users of IM services are now the three lines of business.

c. Using the direct allocation method, IM is not allocated any other service
department costs and does not allocate any of its costs to the other service
departments. Thus, all of its $9.8 million are allocated directly to the three lines
of business. Using only the lines of business utilization rates, the percentage of
Credit Card division’s use of IM is 0.15 ÷ (0.20 + 0.20 + 0.15) = 27.27%. This
leads to an allocated IM cost to Credit Cards of $2,672,460 (27.27% × $9.8
million).

Chapter 8 © The McGraw-Hill Companies, Inc., 2011

8-6 Instructor’s Manual, Accounting for Decision Making and Control
P 8–6: Solution to Joint Products, Inc. (30 minutes)
[Joint cost allocation and further processing]

Use net realizable value to allocate joint costs. While all allocation methods are
arbitrary, NRV does not distort the relative product profitabilities.

a. Inventory values calculated using net realizable value:

Products_______
X V Total

Sales value per batch $ 8,000 $ 4,000 $12,000

less: Additional processing costs 1,800 3,400 5,200
Net realizable value $ 6,200 $ 600 $ 6,800

% of net realizable value 91.2% 8.8% 100%

Allocated joint cost $ 7,296 $ 704 $ 8,000
Processing + allocated joint cost $ 9,096 $ 4,104
Number of pounds/batch 200 400
Cost per pound $45.48 $ 10.26
Units in ending inventory 2,000 1,000
Ending Inventory value $90,960 $10,260 $101,220

These ending inventory valuations are above market value, indicating that the
overall operation is unprofitable. Because of the financial accounting rule that
says that inventory must be valued at the lower of cost or market, the inventory
values are $40 and $10 respectively, and the ending inventory values are:

Ending Inventory $80,000 $10,000 $90,000

Inventory values calculated using pounds:

Products_______
X V Total

Pounds per batch 200 400 600

% of batch 33.33% 66.66% 100%
Allocated joint cost $ 2,667 $ 5,333 $8,000
Processing cost 1,800 3,400
Total cost $ 4,467 $ 8,733
Number of pounds/batch 200 400
Cost per pound $ 22.33 $ 21.83
Units in ending inventory 2,000 1,000
Ending Inventory value $44,670 $21,830 $66,500

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Instructor’s Manual, Accounting for Decision Making and Control 8-7
b. Currently, the firm is losing money processing the joint products. Each batch has
joint costs of $8,000 plus additional processing costs of $5,200 or total costs of
$13,200. Each batch generates revenues of $12,000, thus producing a loss of
$1,200.
The table below indicates X should be sold before additional processing
whereas V should be processed further.

Products
Further Processing X V
Revenues $8,000 $4,000
Additional costs 1,800 3,400
Net realizable value $6,200 $ 600
Sale of intermediate product $7,000 $ 400
Optimal decision Sell Process Further

If X is sold and V is processed, the net receipts are $7,000(X) + $600(V) –

$8,000 = $-400. The best the firm can do is lose $400 on each batch processed.
The question is whether the firm can make money by purchasing the
intermediate products, X and V, in the market and processing them further.

Net realizable value from additional X V

processing/lb. $31 $1.50
Price of intermediate products $35 $1.00

If these prices are expected to persist, the firm should stop buying the
common input and separating it into X and V. Rather, it should buy the
intermediate product V for $1 and process it into a final product. V can be
purchased for $1, processed into a final product for $8.50, and sold for a $.50
profit. If they decide to continue to process the joint products, then to minimize
their losses, X should be sold at $35 without further processing, but V should be
processed further.

P 8–7: Solution to Talor Chemical Company (CMA adapted) (30 minutes)

[Evaluating an analysis involving joint costs]

a. The net relative sales value method does not provide the correct analysis for the
marketing decision. Joint cost allocation is necessarily arbitrary and, although
useful for financial accounting purposes, is not relevant to the decision to market
DMZ-3 and Pestrol. The joint or common costs are irrelevant to this decision
because they are incurred in both cases, i.e., the method of cost allocation has no
impact on the differential profit. Talor Company should calculate the incremental

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8-8 Instructor’s Manual, Accounting for Decision Making and Control
 profit of its alternate choices by comparing the incremental revenues and
incremental costs.

b. Talor Company's analysis is incorrect because it incorporates allocated portions of

the common costs of VDB. The weekly cost of VDB ($246,000) will be incurred
whether or not RNA-2 is converted through further processing. Thus, any
allocation of the common cost of VDB is strictly arbitrary and not relevant to the
decision to market DMZ-3 and Pestrol.
Talor Company's decision not to process RNA-2 further is incorrect. The
decision resulted in a loss of $20,000 in gross profit per week as indicated by the
following analysis.

Revenue from further processing of RNA-2:

DMZ-3 (400,000 × $57.50/100) $230,000
Pestrol (400,000 × $57.50/100) 230,000
Total revenue from further processing $460,000
Less revenue from sale of RNA-2 (400,000 × $80/100) 320,000
Incremental revenue $140,000
Less incremental cost* 120,000
Incremental profit $ 20,000

* The cost of VDB is not relevant and, thus, is omitted from the solution.

P 8–8: Solution to Donovan Steel (30 minutes)

[Step-down allocations]

a. Using the step-down allocation method starting with the Water service department
results in a cost per kilowatt hour of $0.019, calculated as follows:

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Instructor’s Manual, Accounting for Decision Making and Control 8-9
 Service Departments Profit Centers

Service Electricity Water Ingots Stainless Total

Departments Steel
Water 1,000 gal --- 1,000 gal 2,000 gal 4,000 gal
consumed
% of cost 25% --- 25% 50% 100%
Allocated cost
of Water $15 million --- $15 million $30 million $60 million
Department
Electricity
operating cost $80 million --- --- --- ---
Total cost to $95 million --- --- --- $95 million
be allocated
Electricity
consumed --- --- 3,000 kwh 2,000 kwh 5,000 kwh
(millions)
Cost per kwh --- --- --- --- $.019/kwh
Electricity
costs allocated
--- --- $57 million $38 million $95 million
to profit
centers
Electricity +
Water costs
--- --- $72 million $68 million $140 million
allocated to
profit centers

b. There are several problems with using the step-down method:

(i) Arbitrariness. If, instead of starting with the Water department, Electricity
was the first department allocated, the cost per kilowatt is lower for two
reasons. First, no water costs are included in the electricity charge and
second, more kilowatt hours are used in the allocation base because
Water's use of kilowatts is included. Specifically, the cost per kilowatt
hour is roughly half of that when Electricity includes Water charges
($.0107 versus $.019) and is computed as:

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8-10 Instructor’s Manual, Accounting for Decision Making and Control
 Service Departments Profit Centers
Service Electricity Water Ingots Stainless Total
Departments Steel
Electricity
consumed --- 2,500 kwh 3,000 kwh 2,000 kwh 7,500 kwh
(millions)
% of cost --- 33% 40.0% 27% 100%
Electricity $80 million --- --- --- $80 million
operating cost
Cost per kwh --- --- --- --- $.0107/kwh
Allocated cost
of Electricity --- $26.4 million $32.0 million $21.6 million $80 million
Department
Water --- $60 million --- --- $60 million
operating cost
Total cost to be --- $86.66 --- --- ---
allocated million
Water --- --- 1,000 gal 2,000 gal 3,000 gal
consumed
% of cost --- --- 33% 67% 100%
Water costs
allocated to --- --- $28.5 million $57.9 million $86.4
profit centers million

Electricity +
Water costs --- --- $60.5 million $79.5 million $140
allocated to million
profit centers

Notice that under both cases, the entire $140 million of service department
costs are allocated to the two profit centers. Because the cost per kilowatt
hour varies so much depending on which method is used, it leads to the
belief that the accounting system is arbitrary.

(ii) Conflicts of interest. Starting with the Water department's costs, Ingots
receives $72 million of cost. Starting with the Electricity department's
costs, Ingots can lower their allocation to $60.5 million of service costs.
Thus, Ingots has the incentive to argue for starting with Water costs and
Stainless Steel has the incentive to argue for starting with Electricity costs.
This creates a conflict between the two profit centers that will only be
resolved by (costly) senior management intervention.

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Instructor’s Manual, Accounting for Decision Making and Control 8-11
 (iii) Incentive effects. Clearly, the managers' consumption of electricity will
differ if the transfer price is $.019 per kwh versus $.0107 per kwh. If the
opportunity cost to the firm of supplying another kwh differs from the
allocated cost, then the managers of the profit centers will use either too
much or too little electricity. Neither of these cost allocations is a market-
based transfer price. If the market price is below these cost-based transfer
prices, the profit center managers have incentives to go outside the firm to
purchase electricity. Likewise, if the market price is above the cost-based
transfer price, the profit center managers have incentive to stay with the
inside Electricity department when outside purchase is warranted.

P 8-9: Solution to Murray Hill’s Untimely Demise (30 minutes)

[Step-down allocations]

(a) The first step is to recompute the allocation percentages for the remaining service
and operating departments. For example, when allocating B’s costs to C, D1, D2,
and D3, you can not use the percentage of A’s use of B (8 percent) because this
would allocate 8 percent of B back to A and then not all of B’s costs are allocated
DOWN to the remaining departments. So C’s use of B is 15 percent/92 percent,
or about 16.30 percent. Panel B recomputes the revised utilizations and Panel C
completes poor Murray’s spreadsheet using these recomputed utilization
percentages.

Panel A: Utilization Data

Service Service Departments Operating Departments
Dept. Cost A B C D1 D2 D3 Total
$600,000 A 5% 10% 20% 30% 15% 20% 100%
300,000 B 8% 0% 15% 22% 20% 35% 100%
200,000 C 15% 5% 7% 20% 30% 23% 100%
1,100,000

Panel B: Revised Utilizations

A 0 0.105263 0.210526 0.315789 0.157895 0.210526 1.0000
B 0 0 0.163043 0.23913 0.217391 0.380435 1.0000
C 0 0 0 0.273973 0.410959 0.315068 1.0000

Panel C: Completed Step-Down Allocations

$600,000 A $0 $63,158 $126,316 $189,474 $94,737 $126,316 $600,001
$363,158 B $0 $0 $59,211 $86,842 $78,947 $138,158 $363,158
$385,527 C $0 $0 $0 $105,624 $158,436 $121,467 $385,527
$381,940 $332,120 $385,941 $1,100,001

b. The following table lists the dollar utilization of each service department
(percentage utilized times the department costs)

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8-12 Instructor’s Manual, Accounting for Decision Making and Control
 Service
Service Departments
Dept. Cost A B C
600000 A $30,000 $60,000 $120,000
300000 B $24,000 $0 $45,000
200000 C $30,000 $10,000 $14,000

Here we see that the three largest dollar utilizations are $120,000, $60,000, and
$45,000. So the preferred step-down order should capture these large dollar
flows. A should be allocated first in order that the $60,000 of B’s use of A and
C’s $120,000 use of A are captured. B should be second in order to allocate the
$45,000 of C’s use of B. Finally, C is allocated last. Thus, the preferred step-
down order that captures the largest dollar utilizations is A, then B, and finally C.

P 8–10: Solution to Enzymes (30 minutes)

[Pricing joint products and allocating joint costs]

a. The analysis of the pricing decisions is completely wrong because it takes the
joint cost of the batch (which is a fixed cost), allocates it to the products, and then
treats it as though the allocated costs are marginal costs.
There are separate demand curves for the final, fully processed enzymes:

PQ = 1,300 – 2Q

PY = 950 – 4Y

The $200,000 joint cost is a fixed cost of each batch. The marginal cost of Q =
$100, and the marginal cost of Y = $150. These should be the only costs that
enter the pricing decision.

In the problem, it appears as if Q is generating profits of $80,000 and Y is

generating profits of $10,000, or in total $90,000. But this $90,000 profit ignores
the fixed costs that are included in the 250 ounces that are not sold. Only half the
output is sold. The other 250 ounces have been allocated $100,000 of joint costs
(250 ounces × [$200,000 ÷ 500]) that have been incurred, but not included in the
profits of $90,000. So, in reality, the firm is losing $10,000 ($90,000 - $100,000)
per batch. Another way to see this is: each ounce of Q has a contribution margin
of $800, and each ounce of Y has a contribution margin of $600. Selling 200
ounces of Q and 50 ounces of Y yields total contribution margin of $190,000
($800 × 200 + $600 × 50). Deducting the $200,000 of joint costs again yields a
loss of $10,000 per batch.

b. The joint cost of producing a batch is a fixed cost, once a batch is produced. As
long as the maximum profits from the optimum pricing decisions for Q and Y
exceed the joint cost of $225,000, they should continue to produce batches. The

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Instructor’s Manual, Accounting for Decision Making and Control 8-13
 table below shows that the maximum profit is $220,000. When the cost per batch
was $200,000, maximum profit after batch costs was $20,000. However, once
batch costs rise to $225,000, the firm should stop producing.

Incremental Incremental
Price of Price of Revenue of cost of Total profit Revenue of cost of Total profit
QTY Q Y Q Q of Q Y Y of Y
50 $1200 $750 $60000 $5000 $55000 $37500 $7500 $30000
100 1100 550 110000 10000 100000 55000 15000 40000
150 1000 350 150000 15000 135000 52500 22500 30000
200 900 150 180000 20000 160000 30000 30000 0
250 800 na 200000 25000 175000
300 700 na 210000 30000 180000

P 8–11: Solution to Sunder Toys (30 minutes)

[Ignoring fixed costs when excess capacity exists leads to overinvestment]

a. The following table shows that Sunder should produce 1,000 chewies daily:

Variable Contribution Contribution Lease

Price Quantity Cost/unit Margin/unit Margin Cost Profit
$16.11 900 $3 $13.11 $11,800 $10,000 $1,800
15.00 1,000 3 12.00 12,000 10,000 2,000
14.18 1,100 3 11.18 12,300 10,800 1,500
12.83 1,200 3 9.83 11,800 10,800 1,000
12.23 1,300 3 9.23 12,000 11,200 800
11.50 1,400 3 8.50 11,900 11,200 700

b. The table below shows that with private information the manager produces 1,100
chewies daily and will buy a machine with 1,200 units of capacity so as not to be
charged any fixed cost. There is no reason to lease the machine with 1,400 units
of capacity since the 1,200 unit machine gives excess capacity (and hence no
fixed costs are charged). In fact, leasing the 1,400 unit machine may cause senior
managers to review this lease if they begin to see 300 units of unused capacity,
whereas they are more likely to ignore 100 units of excess capacity on the 1,200
unit machine.

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8-14 Instructor’s Manual, Accounting for Decision Making and Control
 Leased Variable Contribution
Price Capacity Quantity Cost/unit Margin Profit
16.11 1,000 900 3 13.11 11,799
15.00 1,200 1,000 3 12.00 12,000
14.18 1,200 1,100 3 11.18 12,298
12.83 1,400 1,200 3 9.83 11,796
12.23 1,400 1,300 3 9.23 11,999
11.50 1,400 1,400 3 8.50 700

c. The policy of not charging managers fixed cost when excess capacity exists
causes the firm to overinvest in capacity.

P 8-12: Solution to WWWeb Marketing (35 minutes)

[Tradeoff between over investment and underutilization]

a. WWWeb Marketing’s current policy of not charging the profit centers the IT
costs as long as IT has excess capacity creates the incentive for the three divisions
to always lobby for more capacity to ensure that the divisions are not charged IT
costs. This leads to an over investment problem in IT capacity. This over
investment in IT capacity is contributing to WWWeb’s current low profitability.
The advantage of the current policy is that it causes the divisions to efficiently
utilize the existing excess capacity – WWWeb is avoiding the under utilization
problem. That is, whenever IT has unused capacity (and the opportunity cost of
this capacity is zero because the users are not interfering with each other), by
charging the divisions zero for their use of this excess capacity encourages the
divisions to more fully utilize these resources. However, since the divisions view
IT resources as free, they are probably not considering IT costs when pricing the
services the divisions charge WWWeb clients. Each division is maximizing their
division profits, which excludes IT costs.
By not charging IT costs to the three profit centers, the profit center
managers have no incentive to monitor IT’s spending. That is, there is no mutual
monitoring of IT by the profit centers.
With respect to the decision as to whether WWWeb should double its IT
capacity at an additional cost of 20 percent, this decision should be deferred until
after they evaluate the current treatment of IT charges to the divisions.

b. To reduce WWWeb’s over investment problem, the divisions should be charged

for IT services. The cost recovery system or cost allocation should be based on
the long-run cost IT incurs for hardware, software, and access line fees. For
example, if the IT system tracks megabytes uploaded or downloaded, then IT can
develop a cost per megabyte transferred by dividing the budgeted cost of the IT
department ($548,000) by the budgeted number of megabytes transferred. In this
way, each division is charged the average cost of the IT resources consumed by
the division. Such a non-insulating allocation or recharge system encourages
cooperation among the profit centers. If one expands, the overhead rate falls and
the other divisions’ IT costs call.
Chapter 8 © The McGraw-Hill Companies, Inc., 2011
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 After they implement this cost allocation scheme, WWWeb can then
determine whether to double its existing capacity. The “cost” of this change in
the policy of charging the divisions for IT resources consumed is that there will be
a tendency for the divisions to under utilize any excess capacity of the IT group.

P 8–13: Solution to ITI Technology (35 minutes)

[Joint costs of computer chips]

a. The major problem with ITI's accounting method is that they are allocating both
joint and separable costs based on the number of chips manufactured and not
using net realizable value (NRV). This leads to erroneous conclusions about the
relative profitability of the two products.
HD and LD chips, up until they are tested and sorted, are joint products.
The joint costs are $8,000 and the costs beyond the split-off point are $21,100.
The profitability of LD and HD chips are being overstated by the treatment of the
scrap costs. By separating scrap costs out as a separate “product,” the costs of the
HD and LD costs are lowered.
By allocating the joint costs using NRV, product profitability is not
distorted. The following table illustrates the calculation:

ITI Technology
Relative Profitability of HD and LD Chips
(Net Realizable Value Method)

Total HD Chips LD Chips

Revenue $36,400 $30,000 $6,400
Cost beyond split-off $21,100 $14,500 $6,600
NRV $15,300 $15,500 ($200)

Percent NRV 100% 101.31% -1.31%

Joint Cost Allocation $8,000 $8,105 ($105)

Profit per batch $7,300 $7,395 ($95)

Revenues from the LD chips are not covering the costs incurred beyond the split-
off point to produce the chips.

b. LD chips are not profitable beyond the split-off point and further processing
should be discontinued unless the final selling price can be increased or the costs
of processing and marketing beyond split-off can be decreased.

However, there might be demand-side interdependencies that might prevent ITI

from discontinuing LD chips. Suppose that customers of HD chips also want to

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 buy LD chips, presumably from the same supplier of HD chips so they only have
to deal with one vendor. If this is the case, then ceasing to produce LD chips
adversely affects the demand for HD chips.

P 8–14: Solution to Metro Blood Bank (35 minutes)

[Advantages and disadvantages of net realizable value]

a. i Profits after allocation by pints:

Joint cost to be allocated $300

÷ Number of pints of plasma and platelets 3
Cost of whole blood per pint $100

Profits Per Pint

Platelets Plasma
Selling Price $165 $115
Cost of whole blood (100) (100)
Variable cost of additional processing (15) (45)
Profit (loss) $ 50 ($30)

a. ii Profits after allocating the cost of whole blood by Net Realizable Value:

2 Pints of 1 Pint of
Platelets Plasma Total
Selling Price $330 $115 $445
Further Processing Costs (30) (45) (75)
Net realizable value $300 $70 $370
% of Total 81.08% 18.92% 100%
Allocated cost of whole blood $243 $57 $300
Allocated cost per pint $122 $57

Profits Per Pint

Platelets Plasma
Selling price $165 $115
Cost of whole blood (122) (57)
Variable cost of processing (15) (45)
Profits $ 28 $ 13

b. Advantages of NRV (disadvantages of allocating by pints):

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Instructor’s Manual, Accounting for Decision Making and Control 8-17
 • Product line profits are not distorted. Both products are yielding positive
contribution margins.
• The contribution to overall profits of each product is more clearly delineated.
There are fewer tendencies to shut down either product line because it appears
to be losing money.

Advantages of allocating by pints (disadvantages of NRV):

• It is simple. You do not have to collect data on the selling prices (or
revenues) of the products, nor further processing costs.
• Allocating by pints is an insulating allocation scheme. The profit of each
product line does not vary with the selling prices or further processing costs in
the other product line.1
• Performance evaluation of each product manager is not distorted by the
performance of the other manager.

In summary, NRV tends to be better for decision management. Allocation by

pints might be better for decision control if cooperation and risk sharing among
profit centers are not important.

P 8-15: Solution to Vigdor Wood Products (35 minutes)

[Decision making regarding joint products do not depend on joint cost
allocations]

a. The following table demonstrates that all joint products should be processed
further, except B691 and B722.

Max.
Net cash net Total
Tons Intermed. Finished Costs flow of cash net
per Sales Sales beyond further Further flow/ cash
Outputs batch Price Price split off process'g Process? unit flow
A342 1 $75 $88 $12 $76 yes $76 $76
A453 2 68 82 12 70 yes 70 140
B691 4 62 73 12 61 no 62 248
B722 3 60 71 12 59 no 60 180
C132 6 40 57 12 45 yes 45 270
Total $914

b. Each batch yields net cash flows after the split-off point of $914. Therefore,
Vigdor should process trees if the joint processing cost is $800. Each batch yields
net cash flows of $114.

1 So product A’s profits don’t improve when B’s price increases.

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8-18 Instructor’s Manual, Accounting for Decision Making and Control
c. Vigdor should continue to process trees as long as the joint processing cost is
below $914 and the selling prices of the intermediate and finished wood products
and the costs beyond the split-off point do not change.

d. The following table calculates the profit per ton of each wood product after
allocating the joint cost

i. based on tons produced:

Tons Percent of Allocated Profit/ton Profit/ton

per total Cost per before after
Outputs batch tons ton allocation allocation
A342 1 0.0625 $50.00 $76 $26.00
A453 2 0.1250 50.00 70 20.00
B691 4 0.2500 50.00 62 12.00
B722 3 0.1875 50.00 60 10.00
C132 6 0.3750 50.00 45 -5.00
Total per batch 16 1.0000

ii. The following table calculates the profits per ton of each wood product after
allocating the joint cost based on net realizable value from each wood product:

NRV % of Allocated Profit/ton

Per total Cost per After
Outputs Batch tons ton allocation
A342 $76 0.0832 $66.52 $9.48
A453 140 0.1532 61.27 8.73
B691 248 0.2713 54.27 7.73
B722 180 0.1969 52.52 7.48
C132 270 0.2954 39.39 5.61
Total per batch 914 1.0000

e. No.

f. The allocation of the $800 did not affect the decisions in parts (a) – (c). All these
decisions do not require the allocation of joint costs.

P 8-16: Solution to Advanced Micro Processors (35 minutes)

[Allocating joint costs can distort relative profitability]

a. To prepare the income statements, notice that the fixed selling and distribution
costs per unit are based on budgeted volumes. Since the fixed S&D expenses are
period costs, the entire amount of these costs ($360,000 and $120,000) are written
off as expenses in the current year. Also, AMP is allocating the chip fabrication
joint cost of $270,000 based on the number of good chips in the batch ($15 per

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Instructor’s Manual, Accounting for Decision Making and Control 8-19
 chip). Using this allocated cost per chip, the following income statements for the
current year show that DUALxl microprocessors had income of $3,090,000 and
MAXV microprocessors had a loss of $58,000.

DUALxl MAXV
Revenue $8,280,000 $775,000
Chip fabrication expense 1,035,000 465,000
Variable selling and distribution costs 3,795,000 248,000
Fixed selling and distribution costs 360,000 120,000
Net income (loss) $3,090,000 ($58,000)

b. The $15 chip fabrication cost is the only product cost that is included in
inventory. The variable and fixed selling and distribution costs are period
expenses. The following table reports the inventory values of the two
microprocessors in inventory.

DUALxl MAXV
Units in inventory 3,000 5,000
Cost of units in inventory at $15 per chip $45,000 $75,000

c. The income statements in part (a) report that the DUALxl chips are making over
$3 million of profit while the MAXV chips are showing a loss of $58,000. But
this is misleading because of the way AMP is allocating the joint chip fabrication
costs of $270,000 per batch. Each type of microprocessor is being allocated the
same $15 of joint cost.
Instead of allocating the joint fabrication costs based on the number of
good chips produced (either DUALxl or MAXV), had AMP allocated the
$270,000 per batch using net realizable value (NRV), MAXV would show a profit
of $260,319 instead of the $58,000 loss (see below). This illustrates that any
allocation of joint costs other than NRV can distort relative profitability.

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 DUALxl MAXV TOTAL
Net realizable value:
Selling Price $ 120 $ 25
Variable selling and distribution costs 55 8
NRV per unit $ 65 $ 17
Number of units sold 69,000 31,000
NRV $4,485,000 $527,000 $5,012,000
% of total NRV 89.49% 10.51% 100%
Allocation of $270,000 batch cost $241,610 $28,390 $270,000
Chip fabrication cost per unit $20.1342 $4.7316

Revenue $8,280,000 $775,000

Allocated chip fabrication expense 1,389,260 146,680
Variable selling and distribution costs 3,795,000 248,000
Fixed selling and distribution costs 360,000 120,000
Net income $2,735,740 $260,320

Therefore, to avoid the erroneous conclusion that AMP is losing money on the
MAXV chips, management should consider allocating the joint chip fabrication
cost of $270,000 using net realizable value.

P 8-17: Solution to Jason Rocks (40 minutes)

[Joint costs can distort decision making]

a and b. The total cost per unwashed and washed ton of each type of stone:

Tons Allocated Joint

Type of % of daily per Allocated Cost/unwashed Total cost/
Stone production day Joint Cost ton washed ton

#1 10% 50 $7,500 $150 $158

#2 20% 100 15,000 150 158
#3 20% 100 15,000 150 158
#4 35% 175 26,250 150 158
#5 15% 75 11,250 150 158
Total 100% 500 $75,000

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Instructor’s Manual, Accounting for Decision Making and Control 8-21
c. The reported profit per ton of each type of unwashed stone:

Cost/ton
Unwashed
Price/ton & Reported
Type of Stone Unwashed Delivered Profit
#1 $210 $157 $53
#2 185 157 28
#3 150 157 -7
#4 145 157 -12
#5 160 157 3

d. The reported profit per ton of each type of washed stone:

Cost/ton
Washed
Price/ton & Reported
Type of Stone Unwashed delivered Profit
#1 $219 $165 $54
#2 192 165 27
#3 170 165 5
#4 155 165 -10
#5 165 165 0

e. All of the stones should be sold because each stone’s selling price (either washed
or unwashed) is far in excess of the out-of-pocket cost needed to wash and deliver
the stone. The following table provides the incremental cash flow per ton from
delivering either washed or unwashed stones:

Delivery
Net cash & Net cash
Price/ton Delivery flow/ton Price/ton washing flow/ton
Type of Stone Unwashed Cost/ton Unwashed Washed cost/ton Washed
#1 $210 $7 $203 $219 $15 $204
#2 185 7 178 192 15 177
#3 150 7 143 170 15 155
#4 145 7 138 155 15 140
#5 160 7 153 165 15 150

After comparing the net cash flow per ton of washing or not washing each stone,
the following table provides the firm-value maximizing decision for each stone:

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8-22 Instructor’s Manual, Accounting for Decision Making and Control
 Type of Stone Sell stone as:
#1 Washed
#2 Unwashed
#3 Washed
#4 Washed
#5 Unwashed

f. Given the facts as described in the problem, Jason Rocks should stop operating
the quarry in the long run. Increasing the daily joint cost from $75,000 to $85,000
does not change any of the marginal decisions regarding which stones to wash
and which ones not to wash. The decision to further process each stone is
determined entirely by the selling prices and the incremental costs to process
further. These are not changing. However, the increase in the joint cost to
$85,000 now makes the entire operation unprofitable as detailed in the following
table.

Washing Delivery Net realizable

Tons Price Revenue Cost cost Value
#1 50 $219 $10,950 $400 $350 $10,200
#2 100 185 18,500 0 700 17,800
#3 100 170 17,000 800 700 15,500
#4 175 155 27,125 1,400 1,225 24,500
#5 75 160 12,000 0 525 11,475
Total $79,475
Joint cost 85,000
Net Loss -$5,525

However, some of the joint cost includes historical cost depreciation and allocated
costs. Jason Rocks might still be cash flow positive in the short-run and will still
want to operate. But in the long-run, when the equipment has to be replaced, they
will have to shut down, unless selling prices have changed.

P 8–18: Solution to Bank Service Centers (40 minutes)

[Reciprocal cost allocations]

To begin, write down the three equations for service department costs.
(1) E = $8.9 + 0.15 E + 0.10 C + 0.08 A
(2) C = $1.8 + 0.06 E + 0.04 A
(3) A = $6.4 + 0.32 E + 0.25 C + 0.12 A

where E = EDP’s total reciprocal cost

C = Copy Center’s total reciprocal cost
A = Accounting’s total reciprocal cost.

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Instructor’s Manual, Accounting for Decision Making and Control 8-23
 These three equations in three unknowns can be solved by linear algebra or matrix
algebra. Both solutions are illustrated. The linear algebra solution is provided first.
Substitute equation (2) into equations (1) and (3) to get two equations in two
unknowns:

(1) E = 8.9 + 0.15 E + 0.10 [1.8 + 0.06 E + 0.04 A] + 0.08 A

0.844 E = 9.08 + 0.084 A
(3’) A = 6.4 + 0.32 E + 0.25 [1.8 + 0.06 E + 0.04 A] + 0.12 A
0.87 A = 6.85 + 0.335 E

With two equations and two unknowns, solve equation (3’) for A and substitute
into (1’):
(3”) A = 7.874 + 0.385 E
(1’) 0.844 E = 9.08 + 0.084 [7.874 + 0.385 E]
E = $12.002
Substitute the value of E back into equation (3”) and solve for A:
(3”) A = 7.874 + 0.385 (12.002)
A = $12.495
Finally, substitute the values of A and E back into equation (2) and solve for C:
(2) C = $1.8 + 0.06 (12.002) + 0.04 (12.495)
C = $3.020

The values of A, C, and E can also be calculated using matrix algebra. Rewrite
equations (1-3) after collecting like terms:
(1) +0.85 E - 0.10 C - 0.08 A = $8.9
(2) -0.06 E + 1.00 C - 0.04 A = $1.8
(3) -0.32 E - 0.25 C + 0.88 A = $6.4

This system of three equations in three unknowns can be expressed in matrix form
as:
 +0.85 -0.10 -0.08   E   $8.9 
 -0.06 +1.00 -0.04   C  =  $1.8 
 -0.32 -0.25 +0.88   A   $6.4 
Solving for the vector of unknowns gives:

-1
E  +0.85 -0.10 -0.08   $8.9 
C =  -0.06 +1.00 -0.04   $1.8 
A  -0.32 -0.25 +0.88   $6.4 
The inverse matrix is:
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8-24 Instructor’s Manual, Accounting for Decision Making and Control
 -1
 +0.85 -0.10 -0.08   1.232 0.153 0.119 
 -0.06 +1.00 -0.04  =  0.093 1.023 0.055 
 -0.32 -0.25 +0.88   0.474 0.346 1.195 
Substituting the solution of the inverse into the preceding equation and solving
yields:

E  $12.002 
C =  $3.020 
A  $12.495 
The same values for E, C, and A are generated by matrix algebra as from linear
algebra. The amounts for E, C, and A are then allocated to the service departments and
operating divisions using the percentages given in the problem resulting in the following:

Cost to
Total Div
EDP Copy Accounting Div. A Div. B Div. C Cost A,B,C
EDP $1.80 $0.72 $3.84 $2.28 $1.56 $1.80 $12.00 $ 5.64
Copy Center $0.30 $0.00 $0.76 $0.76 $0.66 $0.54 $ 3.02 $ 1.96
Accounting $1.00 $0.50 $1.50 $3.75 $3.00 $2.75 $12.49* $ 9.50
$27.51 $17.10
* $.01 rounding difference.

Notice that the amounts allocated to the three operating divisions exactly equals
the total costs in the three service departments, $17.10 million.

P 8–19: Solution to Ferguson Metals (40 minutes)

[Joint cost allocation distorting product line profitability]

From finance we know that the financing and investment decisions should not be
commingled. The decision as to how to finance the new joint venture should be
separated from the decision to divest the Lead Division. The decision to sell the Lead
Division should be based on a comparison of its net present value to the outside offer
price. Ferguson should raise the capital for the new venture in the capital markets at their
cost of capital, around 12%, and continue to operate both the copper and lead divisions.
Lead shows low profits only because joint costs are being allocated based on
tonnage. In fact, the lead is being transferred at 42¢ per pound [$42,000/(50 tons/batch ×
2,000 pounds/ton)]. This suggests that the internal transfer price is distorting Lead
Division’s profits. If metal costs are allocated based on net realizable value, the Lead
Division’s ROI increases, as shown below.

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Instructor’s Manual, Accounting for Decision Making and Control 8-25
 Net Realizable Value
(in 000's)
Lead Copper Total
Net income (Table 2) $300 $2,700
+ transferred cost* 4,200 2,100
Net Realizable Value $4,500 $4,800 $9,300
% 48.4% 51.6%
Allocated cost of mining** $3,048 $3,252 $6,300
Income based on NRV $1,452 $1,548
ROI 14% 11%

* Transferred cost represent the revenues received by the Mining Division from the Lead and
Copper Divisions. For example, from Table 1, revenue from Mining for lead is $42,000 / batch
× 100 batches = $4.2 million.

**Note: $6.3 million includes Mining's profits. The $6.3 million being allocated as a joint cost
is the total revenue to the Mining Division [i.e., from Table 1, ($42,000/batch + $21,000/batch)
× 100 batches]. If only Mining's costs are allocated, substitute $5.7 million for the $6.3
million. $5.7 million = 100 batches × ($22,000 + $16,000 + $11,000 + $8,000).

The preceding analysis illustrates that under a different cost allocation scheme,
the Lead Division becomes more profitable than Copper. But, selling the Lead Division
could still be a positive net present value project. The table below calculates the annual
cash flows forgone from selling the Lead Division:

Lead sales $6,600

- Other costs 500
- Fixed costs 800
- Outside metal purchases ($5,000 - 4,200) 800
Contribution forgone 4,500
less: Sale of impure lead† 1,700
Net cash flow forgone from selling
Lead Division $2,800
† $1.7 million = $0.17 × 50 tons/batch × 100 batches/year × 2,000 pounds/ton

Assuming 12 percent is the appropriate, risk-adjusted cost of capital to value the

Lead Division’s cash flows and assuming an infinite life for the Lead Division, then the
value of the Lead Division to Ferguson is $23.3 million ($2.8 million ÷ 12%). If the
Lead Division is only expected to last ten years, then the net present value of the cash
flows drops to $2.8 million/year × 5.650 = $15.82 million. Clearly, the $5 million offer
for the Lead Division is far below its net present value to Ferguson and should be
rejected.

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8-26 Instructor’s Manual, Accounting for Decision Making and Control
P 8–20: Solution to the Doe Company (40 minutes)
[Joint costs with several downstream joint products]

A diagram of the process is:

Allocation of joint costs between sliced and crushed pineapples:

Sliced Crushed
Sales value 42,000 @ $4 (Sliced) $168,000 (18,000 @ $3) $54,000
18,000 @ $.5 (Juice) 9,000 ______
$177,000 $54,000
Less: Selling cost of juice $3,500
Additional costs (Dept. 3) 40,000
(Dept. 4) 25,500 69,000
(Dept. 2) 15,000
Net realizable value at split-off $108,000 $39,000

Estimated Net Allocation of

Realizable Value Percent Joint Costs
$120,000
Sliced Pineapple $108,000 73.47 88,164
Crushed Pineapple 39,000 26.53 31,836
$147,000 100.00 $120,000

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P 8-21: Solution to RBB Brands (40 minutes)
[Analyzing step-down allocations]

Charging the investment centers for their utilization of the service departments is a
change in one leg of the three-legged organizational stool. The first question to raise is:
“If it ain’t broke, why fix it?” Taking this perspective requires a broader analysis of the
question than just focusing more narrowly on which form of the step-down method be
used.
Starting to charge the two investment centers for centrally supplied services has a
number of consequences:
• This is a change in the divisions’ performance evaluation scheme. The divisions’
reported profits will be lower. Since the divisional senior managers are paid 1 percent of
divisional profits, allocating the service department costs to the divisions reduces
bonuses. Unless there is an offsetting change in the compensation scheme, the divisional
managers are worse off. The divisions may lose their better senior managers if their total
compensation falls below what they can earn elsewhere. (This is another case where a
change in one leg of the three-legged stool requires other changes.)
• Prior to allocating the service departments, the two divisions treated them as free.
Now they will pay for the services on a per hour basis. This will cause each division to
more closely evaluate the costs and benefits of using the centrally supplied service
departments. Allocating the maintenance and engineering faces the divisions with a
positive "price" which causes them to reduce their consumption from what it would be
under a zero "price" (no cost allocations). "Pricing" the internal service helps allocate a
scarce resource. At a zero "price," demand will almost always exceed supply. In the
absence of allocations, senior management will be confronted with complaints to increase
the amount of service via larger budgets and must devise non-price priority schemes to
manage the queue waiting for service.
• Both allocation schemes are likely to lead to a “death spiral” if the divisions can
buy similar services outside the firm. Consider the hourly rates of the two service
departments based on the two allocation schemes:

Step down Method Used

Start with Start with Average Cost to
Maintenance Engineering Firm
Cost per engineering hour $36.15 $30.68 $25.00
Cost per maintenance hour $10.53 $13.08 $9.00

No matter which allocation scheme is used, one of the two service hourly charge
rates is significantly above the average cost to the firm. It might be possible that an
external supplier will undercut the firm’s service department. This will cause the
remaining RBB users to bear more of the service department’s fixed costs, thereby
further raising the hourly rate. More business will go outside causing further rate
increases. In the end, RBB loses any synergies of providing the service in house.
• The controller proposes two alternative ways of allocating service department
costs: starting with maintenance and starting with engineering. Household Products will
bear lower allocated costs of $48.54 million versus $49.38 million if they start with

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8-28 Instructor’s Manual, Accounting for Decision Making and Control
engineering. Our division will bear $840,000 less allocated costs if the controller adopts
the method in Table 3. Therefore, you should argue for starting with engineering. One
rational for them starting with engineering is that this results in less distorted cost per
engineering hour and engineering is more important to RBB than maintenance, if one is
to be outsourced.
• If the internal transfer prices of the service departments are substantially above
the external market price for substantially equivalent services, this probably indicates that
the inside service departments are inefficient at supplying these services.

P 8-22: Solution to Karsten Mills (40 minutes)

[Adopting new technologies even though product costs are higher]

This question introduces a problem all firms face: how to handle a new plant or
machine that offers better technology, but at a higher cost.

a. Overhead rates:
Old New
Plant Plant
Overhead costs excluding depreciation $15,000,000 $21,000,000
Depreciation $ 6,000,000 $21,000,000
Total overhead costs $21,000,000 $42,000,000
÷ Number of yards per year 6,000,000 7,000,000
Total overhead costs per yard $3.50 $6.00
b. Cost of job A6106
Old New
Plant Plant
Direct materials $ 800 (× 85%) $ 680
Direct labor 600 (× 85%) 510
Overhead (100 yards) 350 600
Total cost $1,750 $1,790
c. Some of the suggested solutions:

(i) For transfer pricing purposes, merge the historical costs of the plants into
one cost pool and calculate a single overhead rate for the two plants:
Old Plant New Plant Merged Cost Pool
Number of yards per year 6,000,000 7,000,000 13,000,000
Total overhead costs $21,000,000 $42,000,000 $63,000,000
Overhead cost/yard $4.84
If this were all that was done, then the two sales managers would want the
new plant producing their products because both direct labor and direct
material costs are lower in the new plant (while the overhead rates have
been equated). Therefore, some additional scheme must be devised to

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Instructor’s Manual, Accounting for Decision Making and Control 8-29
 equalize direct costs. The simplest way to do this is to "tax" each job in
the new plant at 1/.85 of the job's direct cost. The problem with this
procedure is that this "tax" would have to be backed out of the cost
accounts because it does not represent any actual accounting cost incurred
by the firm.
The advantage of this solution is that it neutralizes the incentives
of the two sales departments to have one of the plants produce only their
product. The disadvantage is it destroys information. By averaging across
plants, any opportunity cost difference across plants is destroyed.
(ii) Change the overhead rate in the old plant to reflect the higher opportunity
cost of providing the new capacity. Accounting depreciation presumably
is an estimate of the opportunity cost of providing the fixed capacity.
Since the old plant has 6/7 the capacity of the new plant, then use 6/7 of
the new plant's depreciation as an estimate of the old plant's depreciation.
By similar logic, use the new plant's entire cost structure including direct
costs and overhead (excluding depreciation) to cost all jobs, whether at the
new or old plant. In this way, all jobs are costed (and transferred) using
the most recent costs of adding capacity.
The problem generated by this method is that the sum of the profits
in the two sales departments is less than total firm profits. This occurs
because products produced at the old plant but costed as if produced at the
new plant contain more depreciation than the firm actually incurs.
The advantage of this method is that it sends cost signals to the
sales managers that are more in line with the opportunity cost of replacing
capacity.
(iii) Have the plants specialize by product but don't change the accounting
system for computing transfer prices. The manager who happens to get
his/her products manufactured in the old plant is given a bottom-line
charge on his/her profit statement each year that eliminates the cost
advantage of the old plant.
(iv) Evaluate departments as cost centers, not profit centers. This removes
incentives to worry about costs. But now, sales can no longer have
decision rights over pricing. If they do, they will set price where marginal
revenues equal zero, not where marginal revenue equals marginal cost,
because sales sees a zero transfer price.
(v) Transfer some of the construction cost of the new plant to the old plant.
By doing this, you raise the overhead rate at the old plant and lower it on
the new plant. The amount transferred does not have to equalize the
overhead rates at both plants because then the variable cost differences
would favor the new plant. Only that amount of initial cost that causes
total unit costs to come into line need be transferred.
The interesting aspect of this problem is that there is no obvious right answer.

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P 8–23: Solution to Four Service Centers (40 minutes)
[Reciprocal cost allocations]

To begin, write down the four equations for service department costs.
(1) S1 = $4.8 + 0.05 S1 + 0.08 S2 + 0.09 S3 + 0.12 S4
(2) S2 = $7.3 + 0.11 S1 + 0.03 S2 + 0.16 S3 + 0.13 S4
(3) S3 = $6.5 + 0.19 S1 + 0.14 S2 + 0.04 S3 + 0.02 S4
(4) S4 = $5.9 + 0.22 S1 + 0.31 S2 + 0.16 S3 + 0.09 S4

where S1 = S1’s total reciprocal cost

S2 = S2’s total reciprocal cost
S3 = S3’s total reciprocal cost
S4 = S4’s total reciprocal cost

The simplest solution of these four equations in four unknowns uses matrix
algebra. Rewrite equations (1)-(4) after collecting like terms:
(1) 0.95 S1 - 0.08 S2 - 0.09 S3 - 0.12 S4 = $4.8
(2) - 0.11 S1 + 0.97 S2 - 0.16 S3 - 0.13 S4 = $7.3
(3) - 0.19 S1 - 0.14 S2 + 0.96 S3 - 0.02 S4 = $6.5
(4) - 0.22 S1 - 0.31 S2 - 0.16 S3 + 0.91 S4 = $5.9

This system of three equations in three unknowns can be expressed in matrix form
as:
 0.95 -0.08 -0.09 -0.12   S1  $4.8 
 -0.11 0.97 -0.16 -0.13   S 2  $7.3 
 
 -0.19 -0.14 0.96 -0.02   S 3  $6.5 
    
 -0.22 -0.31 -0.16 0.91   S 4  $5.9 

Solving for the vector of unknowns gives:

S1 0.95 0.08 0.09 0.121 $4.8

     
S2 0.11 0.97 0.16 0.13 $7.3
      
S3 0.19 0.14 0.96 0.02 $6.5
 0.22 0.31 0.16 0.91 
 
S4   
$5.9
The inverse matrix is:

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Instructor’s Manual, Accounting for Decision Making and Control 8-31
 1
 0.95 -0.08 -0.09 -0.12  1.148 0.176 0.167 0.180 
 -0.11 0.97 -0.16 -0.13  0.229 1.149 0.246 0.200 
 
 -0.19 -0.14 0.96 -0.02  0.269 0.212 1.117 0.090 
   
 -0.22 -0.31 -0.16 0.91  0.403 0.471 0.321 1.226 

Substituting the solution of the inverse into the preceding equation and solving yields:

 S1  $8.949 
 S 2  $12.265 
  
 S 3  $10.637 
   
 S 4  $14.695 

The amounts for S1, S2, S3, and S4 are now allocated to the service departments
and operating divisions using the percentages given in the problem resulting in the
following:

Allocated Costs
Cost to
Total Div
S1 S2 S3 S4 Div. A Div. B Div. C Cost A,B,C
S1 $0.447 $0.984 $1.700 $1.969 $1.253 $1.432 $1.163 $8.949 $3.848
S2 0.981 0.368 1.717 3.802 1.717 2.453 1.226 12.265 5.396
S3 0.957 1.702 0.425 1.702 2.553 0.851 2.446 10.637 5.850
S4 1.763 1.910 0.294 1.323 3.233 3.380 2.792 14.695 9.405
$46.546 $24.500

Notice that the amounts allocated to the three operating divisions exactly equals
the total costs in the three service departments, $24.5 million.

P 8-24: Solution to Beckett Manufacturing (40 minutes)

[Changing the order of departments in step-down allocations]

a. Step-down method where Maintenance is the first service department allocated

and Administration is the second service department to be allocated

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 Small Large
Maintenance Administration Components Components
Allocation Percentages:
Maintenance 0.00% 31.58% 42.11% 26.32%
Administration 0.00% 0.00% 23.53% 76.47%

Allocated Costs:
Maintenance $0 $300,000 $400,000 $250,000
Administration $0 $0 $204,000 $663,000
Total $604,000 $913,000 $1,517,000

b. Step-down method where Administration is the first service department allocated

and Maintenance is the second service department to be allocated

Small Large
Maintenance Administration Components Components
Allocation Percentages:
Administration 5.56% 0.00% 22.22% 72.22%
Maintenance 0.00% 0.00% 61.54% 38.46%

Allocated Costs:
Administration $31,500 $0 $126,000 $409,500
Maintenance $0 $0 $604,000 $377,500
Total $730,000 $787,000 $1,517,000

c. The allocated cost per square foot and the allocated cost per employee resulting
from using the step-down method where Maintenance is the first service
department allocated and Administration is the second service department to be
allocated (part a).

Cost of Maintenance to be allocated $950,000

Square feet in allocation base 950,000
Cost per square foot of Maintenance $ 1.00

Cost of Administration to be allocated $867,000

Number of employees in allocation base 289
Cost per employee of Administration $ 3,000

d. The allocated cost per square foot and the allocated cost per employee resulting
from using the step-down method where Administration is the first service
department allocated and Maintenance is the second service department to be
allocated (part b).

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 Cost of Maintenance to be allocated $981,500
Square feet in allocation base 650,000
Cost per square foot of Maintenance $ 1.51

Cost of Administration to be allocated $567,000

Number of employees in allocation base 306
Cost per employee of Administration $ 1,853

e. The cost per square foot of Maintenance in part (d) increases for two reasons: the
numerator increases because besides Maintenance’s own cost of $950,000,
Maintenance is allocated $31,500 of Administration cost; and the denominator
falls because there are fewer square feet in the allocation base since
Administration is no longer in the allocation base. Likewise, the cost per
employee of Administration decreases in part (d) for two reasons: the numerator
decreases because now only Administration’s own cost of $567,000 is allocated
(there are no Maintenance costs allocated to Administration) and the denominator
increases because Maintenance’s square footage of 50,000 square feet is included
in the allocation base.

P 8-25: Solution to Littleton Medical Center (40 minutes)

[Direct vs. step down allocations]

a. Direct allocation method

Department
Service Departments Cost Clinics Hospital Total
Human resources $1,200 2,000 3,000 5,000
Accounting $1,600 6,000 4,000 10,000
Janitorial/Maint. $2,400 150,000 400,000 550,000
Total $5,200

Service Departments
Human resources $1,200 40.00% 60.00% 100.00%
Accounting $1,600 60.00% 40.00% 100.00%
Janitorial/Maint. $2,400 27.27% 72.73% 100.00%

Human resources $480.00 $720.00 $1,200.00

Accounting $960.00 $640.00 $1,600.00
Janitorial/Maint. $654.55 $1,745.45 $2,400.00
Total allocated cost $2,094.55 $3,105.45 $5,200.00

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 b. Step down method

Service
Departments Dept cost HR Acctg Jan/Main. Clinics Hospital Total
HR $1,200 50 150 2,000 3,000 5,200
Accounting $1,600 50 100 6,000 4,000 10,100
Janitorial/Maint. $2,400 8,000 9,000 150,000 400,000 550,000
Total $5,200

STEP DOWN ALLOCATION:

Human resources $1,200 0.96% 2.88% 38.46% 57.69% 100.00%
$11.54 $34.62 $461.54 $692.31 $1,200.00

Accounting $1,611.54* 0.99% 59.41% 39.60% 100.00%

$15.96 $957.35 $638.23 $1,611.54

Janitorial/Maint. $2,450.57** 27.27% 72.73% 100.00%

$668.34 $1,782.23 $2,450.57
Total allocated cost $2,087.23 $3,112.77 $5,200.00

* $1,611.54 = $1,600 + $11.54

**$2,450.57 = $2,400 + $34.62 + $15.96

c. The step down method better captures some of the utilization of one service
department by the others. For example, Accounting and Janitorial/Maintenance
are charged for their use of HR, and Janitorial/Maintenance is charged for its use
of Accounting. So, under the step down method, most of the service departments
do not treat the other service departments as free. Another advantage of the step
down method is that it provides management additional discretion as to where to
allocate the costs. Besides choosing the allocation bases to use, they also have
discretion in how to order the service departments.

P 8–26: Solution to Aurora Medical Center (45 minutes)

[Choosing the best way to allocate service costs for cost reimbursement]

a. The following table presents three alternative service department cost allocations:
panel A is the direct allocation, Panel B is the step-down method starting with
accounting first, and Panel C is the step-down method starting with IM first.
Since Medicare reimburses for clinic costs but not hospital costs, then AMC
should choose the allocation scheme that allocates the most costs to the clinic.
Panel B (step-down starting with accounting) results in the highest amount of
service costs being allocated to the clinic.

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Instructor’s Manual, Accounting for Decision Making and Control 8-35
 Administrative Department
Accounting IM Total

Panel A. DIRECT ALLOCATIONS

Service provided to:
Hospital 64.71% 43.75%
Clinic 35.29% 56.25%

Cost allocated to:

Hospital $2,458,824 $2,100,000 $4,558,824
Clinic $1,341,176 $2,700,000 $4,041,176
TOTAL $8,600,000

Panel B: STEP DOWN (Accounting first)

Service provided to:
IM 2.30%
Hospital 63.22% 43.75%
Clinic 34.48% 56.25%

Cost allocated to:

IM $87,356
Hospital $2,402,299 $2,138,218 $4,540,517
Clinic $1,310,345 $2,749,138 $4,059,483
TOTAL $8,600,000

Panel C: STEP DOWN (IM first)

Service provided to:
Accounting 33.33%
Hospital 64.71% 29.17%
Clinic 35.29% 37.50%

Cost allocated to:

Accounting $1,600,000
Hospital $3,494,118 $1,400,000 $4,894,118
Clinic $1,905,882 $1,800,000 $3,705,882
TOTAL $8,600,000

b. Using the step-down method and starting with accounting results in

approximately $18,000 more cost assigned to clinics than under the next best
allocation scheme: direct allocations. This results in roughly $18,000 more cash
inflow for AMC assuming Medicare reimburses AMC for 100 percent of its
reported costs. The disadvantage of step-down is it’s more complicated than the
direct method. However, spreadsheet programs once set up are very inexpensive
to operate.

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P 8–27: Solution to Grove City Broadcasting (45 minutes)
[Allocating the cost of a shared resource and incentives]

a. Both the radio and TV managers will reject the Sports Wire because neither of
them generates sufficient additional revenues to pay the entire $30,000 price for a
single user. The table below shows that each station’s incremental revenue is less
than the Sports Wire fee.

Increased revenues of
Radio:
Added listeners 1,500
Revenue per listener ×$0.005
Added revenue per ad $ 7.50
Number of ads per month 3,550
Additional radio revenue $26,625

TV:
Added viewers 500
Revenue per viewer ×$0.008
Added revenue per ad $ 4.00
Number of ads per month 3,200
Additional TV revenue $12,800
Total increased revenues $39,425

b. If both buy the Sports Wire for $35,000, the combined increase in advertising
revenue is $39,425 and Grove City Broadcasting has increased net cash flow of
$4,425 per month. The owner would purchase Sports Wire.

c. The allocated cost of the Sports Wire using the number of stories is:

Radio TV Total
Stories used 826 574 1,400
% of stories 59% 41% 100%
Sports Wire cost allocated $20,650 $14,350 $35,000
Additional revenues $26,625 $12,800 $39,425
Incremental profits (loss) $ 5,975 ($1,550) $ 4,425

d. The cost of a Sports Wire story in the first month is:

Total cost of Sports Wire $35,000

Number of stories used ÷ 1,400
Cost per Story $ 25.00

e. Since the TV manager is losing money on the Sports Wire, she will start cutting
back on her usage. This will reduce the amount of the allocated cost she bears.
At the same time her audience size also shrinks back as do her advertising rates.

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Instructor’s Manual, Accounting for Decision Making and Control 8-37
 This causes the radio manager to bear a larger percentage of the Sports Wire.
Probably after a few months, TV is hardly using any of the Sports Wire and radio
is receiving most of the cost, at which point radio is losing money and will ask
that the Sports Wire be dropped. Thus, a “death spiral” is induced by this
allocation scheme.

f. A number of allocations don’t work:

A fifty-fifty split ($17,500 to each) will cause the TV station to lose money.

Allocating the incremental cost of $5,000 just to the TV station causes the radio
station to lose money.

One way to allocate the wire service cost is to use net realizable value:

Radio TV Total
Added revenues from Sports Wire $26,625 $12,800 $39,425
% of added revenue 67.5% 32.5% 100%
Allocated cost $23,625 $11,375 $35,000
Net profit after allocated cost $ 3,000 $ 1,425 $ 4,425

This scheme has the advantage that both stations make money from the Sports
Wire and both will continue to use the Wire. However, the above solution
assumes that the owner of Grove City has the same specialized knowledge as the
two station managers and that the data exist to allocate the Sports Wire costs each
month. For example, as audience size changes for reasons unrelated to the Sports
Wire in the future, how does one continue to use net realizable value?

P 8–28: Solution to Barry’s Fashions (45 minutes)

[Direct versus step-down allocations]

a. Information Management expense allocated to the Mall Store using the direct
allocation.

Downtown Mall
Store Store Total
Number of lines printed 120 90 210
Fraction of lines printed 0.571 0.429
Amount allocated $0.857 $0.643 $1.500

b. Allocated cost per line printed for Information Management using the direct
allocation method.

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8-38 Instructor’s Manual, Accounting for Decision Making and Control
 Downtown Mall
Store Store Total
Number of lines printed 120 90 210
Info. Mgmt. expenses $1.500
Allocated cost per line printed $0.007

c. Information Management expense allocated to the Mall Store using the step-down
allocation method.

Fraction of Allocation Base Used by Downstream

Departments or Stores
Operating Human Downtown Mall
Expense Resources Maintenance IM Store Store
Human resources $0.400 0 0.050 0.014 0.388 0.548
Maintenance $0.900 0 0 0.087 0.348 0.565
Info. Management $1.500 0 0 0 0.571 0.429

Allocated Service Department Costs

Allocate HR first $0.400 $0.020 $0.006 $0.155 $0.219

Allocate
Maintenance second $0.920 $0.080 $0.320 $0.520

Allocate IM third $1.586 $0.905 $0.680

Total allocated to $1.381 $1.419

stores

d. Allocated cost per line printed for Information Management using the step-down
allocation method.

Downtown Mall
Store Store Total
Number of lines printed 120 90 210
Info. Mgmt. expenses $1.586
Allocated cost per line printed $0.008

e. The step-down method (part d) results in a high cost per line because being the
last service department in the step-down order, IM is allocated some of the other
service department costs. Thus, the numerator is higher and the denominator is
the same, causing the allocated cost per line to be higher. Answering the second
question depends on several factors. These include:

• Simplicity. The direct allocation is simple to compute and easy to explain.

Given that most of each service department is consumed by the two stores
(i.e., there are few large internal transfers among the three service

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Instructor’s Manual, Accounting for Decision Making and Control 8-39
 departments) ignoring these internal transfers does not radically distort the
opportunity costs of a store using a particular service department.

• Taxes. Are any taxes likely to be affected by the different allocations? Given
the two stores are in the same tax jurisdiction and there are no inventory
valuations involved, taxes are unlikely to be a consideration.

• Resource utilization. Allocating IM based on lines printed is in effect a

transfer pricing method for lines printed. Equivalently, lines printed are being
taxed. Fewer lines will be printed with the higher transfer price in part d
($0.008) than in part b ($0.007). Which of these two numbers best captures
the opportunity cost imposed on Barry Fashions when one more line is
printed? Moreover, the transfer price of the other two service departments is
affected by placing IM last. The other two transfer prices will be lower by
placing IM last. Thus, the likelihood of inducing a death spiral in each service
department is affected.

• Control and Compensation. The reported profits of the two stores will differ
depending on which service department allocation method is chosen. If
compensation depends on reported profits after service department
allocations, the store managers’ pay will be impacted positively or negatively.
However, given the magnitude of the difference ($0.001 x 120 million lines)
is relatively small, the control/compensation effects are likely trivial.

Given the above factors, it appears that in this situation the direct allocation
method is best.

P 8–29: Solution to Janitorial Services (45 minutes)

[Reordering stepdown cost allocations]

a. The cost per square foot Janitorial Services currently charges its customers:

Departments being allocated

S3 costs Percent
S4 0.02
S5 0.08
D1 0.19
D2 0.24
D3 0.23
D4 0.17
Total % 0.93
Total square feet 650,000
Square feet in allocation base 604,500
S3 total cost ($100,000) $19.62
Cost/square foot $3.25

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8-40 Instructor’s Manual, Accounting for Decision Making and Control
b. Revised cost of Janitorial Services (S3) when placed at the end of the step-down
process.

Costs Allocated to:

S2 S4 S5 S3
Costs from S1 $1.25 $2.00 $1.00 $1.25
Costs from S2 0.69 2.74 1.37
Costs from S4 4.102 0.373
Costs from S5 5.574
Cost of Service Dept (only) 32.00 29.00 18.00 17.00
Total Cost of Service Dept $33.25 $31.69 $25.84 $25.56

c. Cost per square foot:

Departments being allocated

S3 costs Percent
D1 0.19
D2 0.24
D3 0.23
D4 0.17
Total % 0.83
Total square feet 650,000
Square feet in allocation base 539,500
S3 total cost ($100,000) $25.562
Cost/square foot $4.74

d. Senior managers might change the order of the service departments being
allocated in the step-down method either to better reflect the actual opportunity
costs being incurred by the firm, or for strategic reasons. By making Janitorial
Services last in the chain, it raises the implicit transfer price, and hence increases
the likelihood users will seek cheaper alternative sources of these services either
by outsourcing them or performing the janitorial services themselves. This could
lead to a death spiral that would ultimately eliminate Janitorial Services as an
internally provided service. Thus, senior management might want to eliminate
this service department without formally having to announce its closing,
especially if it were unionized and managers want to avoid a direct conflict with
the union.

2 $4.10 = (.11 / (1.00 -.08 -.07)) × ($29.00 + $2.00 + $0.69)

3 $0.37 = (.01 / (1.00 - .08 - .07)) ×($29.00 + $2.00 + $0.69)

4 $5.57 = (.14 / (1.00 - .07 - .12 - .16)) × ($18.00 + $1.00 + $2.74 + $4.10)

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P 8-30: Solution to Jones Consortium (50 minutes)
[Allocating a common cost and incentives to cooperate]

a. For the consortium to be viable, it must meet the quantity and geography
requirements of the vendor while reducing the pesticide costs to every member.
The expected group demand of 360,000 gallons is within the stated requirements
for purchases and all members are within a 10-mile area, so the vendor's
requirements are met.
Everyone can end up saving money if and only if the total costs expected
for purchasing through the consortium are less than the total costs expected by
purchasing outside of the consortium, suggesting the existence of potential
savings to be shared by each member of the consortium.
The total expected outside costs are:

Gallons Price per Gallon Total Cost

Jones 25,000 $11.30 $ 282,500
Gilbert 35,000 11.20 392,000
Santos 50,000 11.12 556,000
Singh 100,000 10.90 1,090,000
Chen 150,000 10.70 1,605,000
Total 360,000 $3,925,500

Within the consortium, the guaranteed maximum cost is the management

fee plus the pesticide cost, $275,000+360,000 × $10.00 = $3,875,000. Therefore,
costs are expected to be less within the consortium than outside it, providing an
expected savings of $3,925,500 -$3,875,000 = $50,500. Some may interpret the
requirement that all members pay the same price for materials as implying that the
maximum guaranteed price to be paid for materials within the consortium must be
less than the cheapest outside price paid by any member. Since the $10 per gallon
cost guaranteed to the consortium is less than Chen's $10.70 expected outside
cost, this requirement would also be met.

b. Neither method would work. Under equal allocation, Jones Orchard would pay
$275,000 ÷ 5 + 25,000 × $10 = $305,000 within the consortium, versus $282,500
outside of it.
Since all members of the consortium have agreed to pay the same for
materials purchased through the consortium, allocating by percentage would serve
to provide all members with identical average costs per gallon. Under this
allocation scheme, the average cost per gallon for the consortium would be
(360,000 × $10.00 $275,000) ÷ 360,000 = $10.764. Since this is greater than
Chen's outside cost of $10.70 per gallon, this cost allocation scheme would also
fail. The complete set of allocations follows:

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8-42 Instructor’s Manual, Accounting for Decision Making and Control
 Equal Allocation
Under equal allocation, each member would be allocated $275,000 ÷ 5 = $55,000
of the management fee. At a maximum cost of $10 per gallon for materials, Jones
and Gilbert would pay more within the consortium than outside it:

Consortium Outside
Materials + Fee = Cost vs Cost
Jones $250,000 $55,000 $305,000 $282,500
Gilbert $350,000 $55,000 $405,000 $392,000
Santos $500,000 $55,000 $555,000 $556,000
Singh $1,000,000 $55,000 $1,055,000 $1,090,000
Chen $1,500,000 $55,000 $1,555,000 $1,605,000

Percentage Allocation
Under percentage allocation, each member of the consortium would be allocated
the management fee based upon his or her portion of the total group purchases.
All members are better off except Chen, whose consortium cost of $1,614,583 is
greater than his outside cost of $1,605,000:

Consortium
Materials + (Total Fee × Proportion) = Cost
Jones $250,000 $275,000 25/360 $ 269,097
Gilbert $350,000 $275,000 35/360 $ 376,736
Santos $500,000 $275,000 50/360 $ 538,194
Singh $1,000,000 $275,000 100/360 $1,076,389
Chen $1,500,000 $275,000 150/360 $1,614,583

c. Potential Savings. In this problem, the question of allocating the management fee
to the individual consortium members is conceptually similar to allocating the
joint chicken costs as presented in the text. Just as the wings of the chicken are
"free" with each chicken, membership in the consortium is free with the existence
of the consortium. The management fee can be treated as a joint cost. Once in
the consortium, each member is entitled to purchase materials at a cost that will
not exceed $10 per gallon. The anticipated materials cost for each member,
therefore, can be treated as the costs beyond the split-off point. The total
consortium purchases are “disassembled” into five components: Jones's 25,000
gallons, Gilbert's 35,000 gallons, and so on. Once the joint costs and the costs
beyond split-off have been identified, the opportunity costs of not buying from the
consortium must be defined. The opportunity costs are the potential savings lost
by continuing to purchase from outside the consortium once the consortium is in
existence. The total incurred by each farmer in purchasing outside the
consortium, therefore, serves the same function in this example as revenue served
in the chicken example. In this case, allocating by this potential savings will
guarantee that all members are expected to save money by forming the
consortium. The numbers work out as follows:

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Instructor’s Manual, Accounting for Decision Making and Control 8-43
 Total Jones Gilbert Santos Singh Chen
Outside cost $3,925,500 $282,500 $392,000 $556,000 $1,090,000 $1,605,000
Consortium cost 3,600,000 250,000 350,000 500,000 1,000,000 1,500,000
Opportunity cost $ 325,500 $ 32,500 $ 42,000 $ 56,000 $ 90,000 $ 105,000
Percentage of
opportunity cost 100% 9.985% 12.903% 17.204% 27.650% 32.258%
Fee $ 275,000 $ 27,458 $ 35,483 $ 47,312 $ 76,037 $ 88,710
Materials 3,600,000 250,000 350,000 500,000 1,000,000 1,500,000
Consortium cost $3,875,000 $277,458 $385,483 $547,312 $1,076,037 $1,588,710
Outside cost 3,925,500 282,500 392,000 556,000 1,090,000 1,605,000
Savings $ 50,500 $ 5,042 $ 6,517 $ 8,688 $ 13,963 $ 16,290

d. At first glance, it would seem that the allocation schemes presented in (b) should
be adequate. These methods fail, however, when examined within the context of
the members' cost and demand expectations, thereby causing Jones to consider the
more complex ability-to-pay scheme of (c). Despite the fact that the ability-to-
pay scheme is promising, they do not appear likely to succeed due to their
reliance on what is essentially private information. Since the amount of pesticides
demanded by each farmer varies greatly, equal allocation is intuitively the least
satisfying of the three general cost allocation methods presented. Equal
allocation, however, relies only on public information: the amount of the
management fee and the number of members in the consortium. This information
can be easily shared by all members and can be determined at the formation of the
consortium.
Allocation by percentage of total demand would appear to be the most
direct way to solve any problems created by differences in quantities demanded.
But allocating by percentage places greater reliance on private information than
equal allocation in that the anticipated number of gallons required by each farm,
and hence the relative proportions of quantities required, is self-reported and not
verifiable a priori. This would not be a problem if the consortium could allocate
the management fee after all purchases for the period were made. In that case,
allocations could be based on actual purchase data that all members should have
direct access to.
Evaluating the feasibility of the ability-to-pay method requires data on
what each farmer would have paid absent the consortium. Since there is really no
definitive ex post method to measure the accuracy of these self-reported
expectations, there is opportunity to use private information to "game the system."
Without a way to objectively determine and/or verify each farmer's cost
information, there are strong incentives, once it is known that common costs are
allocated based upon ability to pay, for members to attempt to increase savings
through the understatement of expected outside costs. Since the savings offered
by the consortium are relatively small ($50,500 ÷ $3,875,000 = 1.3%), it would
not take very much misreporting to render it untenable.

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P 8-31: Solution to IVAX (55 minutes)
[Allocating service department costs]

a. Direct allocation method:

O1 O2 Total
HR % 57.89% 42.11% 100.00%
Janitorial/Maintenance % 33.90% 66.10% 100.00%

O1 O2 Total
HR allocations $347.37 $252.63 $600.00
Janitorial/Maintenance
allocations $271.19 $528.81 $800.00
$618.55 $781.45 $1,400.00

b. Step-down allocation (Human Resource first)

Janitorial/
Maintenance O1 O2 Total
HR % 5.00% 55.00% 40.00% 100.00%
Janitorial/Maintenance % 33.90% 66.10% 100.00%

HR allocations $30.00 $330.00 $240.00 $600.00

Janitorial/Maintenance
allocations $281.36 $548.64 $830.00
$611.36 $788.64 $1,430.00

c. Step-down allocation (Janitorial/Maintenance first)

Human
Resources O1 O2 Total
Janitorial/Maintenance % 1.67% 33.33% 65.00% 100.00%
HR % 57.89% 42.11% 100.00%

Janitorial/Maintenance
allocations $13.33 $266.67 $520.00 $800.00
HR allocations $355.09 $258.25 $613.33
$621.75 $778.25 $1,413.33

d. Cost per employee:

i) Direct Allocation:
$600,000 / 950 employees = $631.58
ii) Step-down – Human Resources first:
$600,000 / 1,000 employees = $600
iii) Step-down – Janitorial/Maintenance first:

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Instructor’s Manual, Accounting for Decision Making and Control 8-45
 ($600,000 + 13,333) / 950 = $645

e. Cost per square foot:

i) Direct Allocation:
$800,000 / 590 sq. ft. = $1,355.93
ii) Step-down – Human Resources first:
$830,000 / 590 = $1,406.78
iii) Step-down – Janitorial/Maintenance first:
$800,000 / 600 = $1,333.33

f. In considering how to (or even whether to) allocate the two service department
costs, management should consider:
 Taxes. Will the allocations affect IVAX’s tax liability?
 Decision Making. How are key decisions in the firm, such as pricing and
outsourcing affected by the allocated service department costs? If the purpose
of the cost allocation is to provide accurate estimates of opportunity cost, then
either one of the two step down methods more accurately captures the
resource consumption pattern than the direct allocation method.
 Decision Control. If the purpose of the allocation is to change managers’
incentives (control) as to how they consume the service departments, then the
allocation method with the highest tax rate will result in less of this
department being utilized by the other divisions.

Case 8–1: Solution to Carlos Sanguine Winery (60 minutes)

[Product line profitability in the presence of joint costs]

The basic error that management is making in this case is allocating a joint cost,
the grape costs, and then using these allocated numbers to assess product line
profitability. Any decisions based on allocated joint costs are at risk of being wrong
because the net realizable value (NRV) method for allocating grape costs is not being
used.
Tables 1 and 2 both contain grape costs allocated by gallons, not NRV.
Therefore, these analyses do not measure the incremental contribution to cash flows if a
product is dropped. If table wines are dropped, grape costs of $250,000 ($3.57/case) are
not saved. The firm still is paying $1,900,000 for grapes. All that will happen is that the
$250,000 that is being allocated to the table wines will now be absorbed by the remaining
premium wines. Or, if this juice is sold to the bulk purchasers, then $100,000 ($250,000
– $150,000) will be absorbed by the premium wines.
To assess the table wines’ product line profitability, Exhibit A displays the
incremental cash flows contributed by the table wines.

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8-46 Instructor’s Manual, Accounting for Decision Making and Control
 Exhibit A
Cash Flows Contributed by Table Wines

Revenues $ 490,000

Less: Incremental costs of processing the

juice beyond pressing
Packaging costs $140,000
Labor costs1 35,000
Selling & distribution1 35,000
Manufacturing overhead2
($50,300 × 25%) 12,575 222,575

Incremental cash flows of producing $267,425

1 This is the worst-case assumption in that all of the costs are assumed to be incurred to produce table
wines.

2 General winery costs are not incremental with respect to table wines. Producing table wines generates
incremental costs equal to the variable cost of the production facilities.

From Exhibit A we see that the table wines are contributing positive cash flows.
In fact, the cash flows of $267,425 exceed the amount by which the firm can sell the
unprocessed juice ($150,000). The only question is whether these incremental cash flows
(the $117,425 = 267,425 – 150,000) justify not selling the facilities. Exhibit B compares
these two alternatives.

Exhibit B
Evaluating the Keep vs. Sell Alternatives

Two Alternatives Single Cash Flow Annual Cash Flows

1. Keep producing: Annual cash flows $267,425

2. Shut down:
Sale of equipment $350,000
Annual cash flows ________ 150,000
Incremental cash flows $350,000 $117,425

If we continue to produce, we forgo the $350,000, but we gain an additional $117,425 per
year of cash flows. It would take a (real) before-tax cost of capital in excess of 30
percent to make the shutdown the better of the two decisions.5

5 If the annual cash flows are treated as a perpetuity, then the discount rate, r, that
equates the present value of the two alternatives is:
Chapter 8 © The McGraw-Hill Companies, Inc., 2011
Instructor’s Manual, Accounting for Decision Making and Control 8-47
 Therefore, the best alternative is to keep producing. The president erroneously
believes that he can save the grape costs if they shut down. Also, he believes that some
of the fixed manufacturing overhead (in particular the winery costs) will be saved. But
both of these are allocated costs.
One way to avoid the misleading impression that the table wines are unprofitable
is to allocate grape and common winery costs based on net realizable value (relative
profitability) of the two products. This method does not distort the products’ relative
profitability. Exhibit C computes product profitability using net realizable value to
allocate grape and manufacturing overhead costs.

Exhibit C

Product Profitability Using Net Realizable

Values to Allocate Grape Costs

Product Contribution Premium Wines Table Wines Total

Revenues $4,400,000 $490,000 $4,890,000

Less variable costs:
Packaging (1,000,000) (140,000) (1,140,000)
Labor (200,000) (35,000) (235,000)
Selling and distribution (266,666) (23,333) (289,999)

Manufacturing overhead (46,800) (12,575) (59,375)

Contribution $2,886,534 $279,092 $3,165,626

% of total contribution 91.1837% 8.8163% 100%

Allocated grape costs $1,732,490 $167,510 $1,900,000

Allocated fixed manufacturing overhead $390,3801 $37,7452 $428,125

Product line profitability:

Contribution $2,886,534 $279,092 $3,165,626
Less allocated or fixed costs:
Grapes ($1,732,490) ($167,510) ($1,900,000)
Manufacturing overhead (390,380) (37,745) (428,125)
Selling & distribution (133,334) (11,667) (145,001)
Product Line profits $ 630,330 $ 62,170 $ 692,500

$267,425 150, 000

 $350, 000 
r r

r = $33%.

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8-48 Instructor’s Manual, Accounting for Decision Making and Control
1
$390,380 = 91.1837% × $428,125

2
$37,745 = 8.8163% × $428,125, where $428,125 = $487,500-$59,375 and $59,373 = 25% ×
$237,500 since 25% of Production Facility costs are variable (see Table 2).

Using net realizable value to allocate grape and manufacturing overhead costs produces a
positive profit for the table wine product line. Notice that the total profits of premium
and table wines of $692,500 is the same as that reported in Table 1 ($750,000 less loss of
$57,500).

Case 8-2: Solution to Wyatt Oil (90 minutes)

[Joint cost allocations can distort investment and operating decisions]

a. Joint distillation costs when distilling Kuwait Export are $180 million + 60
million X ($30 + $2) = $2.1 billion, or $35 per barrel when using physical volume
costing. The net realizable value of the three products is:

Light distillates: $48 x 20 million = $960 million.

Processed heavy distillates = ($48 - $3) x 30 million - $90 million = $1.26 billion.
Sold heavy distillates: $30 x 10 million = $300 million.

So the net realizable value of the three products is $2.52 billion, or $5 of joint
costs for every $6 of net realizable value. The following table shows the
allocation of income by product line under these two methods.

Physical volume Net realizable value

Sold light distillates $260 million $160 million
Processed heavy distillates $210 million $210 million
Sold heavy distillates ($50 million) $50 million
Total $420 million $420 million

Accounting profit/NRV under the two methods is shown in the following table.

Physical volume Net realizable value

Sold light distillates 27.0833% 16.6667%
Processed heavy distillates 16.6667% 16.6667%
Sold heavy distillates -16.6667% 16.6667%

b. No. The net realizable value from 60 million barrels of West Texas Intermediate
is:

Light distillates: $48 x 30 million = $1.44 billion

Processed heavy distillates = ($48 - $3) x 30 million - $90 million = $1.26 billion

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Instructor’s Manual, Accounting for Decision Making and Control 8-49
 for a total NRV of $2.7 billion. Switching should occur when the difference in
crude oil costs equals the difference in net realizable value, which occurs when
the price differential is: 60 million x P = $180 million. Or, when P = $3 per
barrel.

c. With expanded cat cracker capacity, switching should occur when the price
differential is $0.50 per barrel, because the only cost associated with Kuwait
Export is an addition $30 million of variable costs at the cat cracker ($3 per barrel
x 10 million additional heavy distillates.)

d. Yes. John Hanks’ analysis is wrong on several counts. The relevant cost of heavy
distillates is not the accounting cost ($35 under physical costing) but the
opportunity cost—the $30 per barrel selling price of heavy distillates. Second, the
problem should be framed as a capital budgeting exercise. Additional cash flows
of $48 - $30 - $3 = $15 per barrel is available from expanding cat cracking
capacity, which translates into incremental annual cash flows of $150 million.
Given the 15% discount rate and the $900 million cost, this project has a net
present value of about $39 million.

e. No. Simulation analysis shows that the project has a negative net present value of
about $9,000,000. If the price differential between West Texas Intermediate and
Kuwait Export drops, the capital investment will turn out to have a substantial
negative NPV.

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