CHAPTER9

RESPONSIBILITYACCOUNTING

91ResponsibilityVersusControl
Themanagerofthemeatdepartmentmighthaveresponsibilityforsuch
thingsasdeterminingnormalstocklevelsforvarioustypesofmeat,ordering
tomaintainthoselevels,selectingnewemployees,supervisingtheworkof
employees,andmonitoringtheadequacyandaccuracyofweighingequipment,
thepricingofpackageditems,andtheadequacyandstateofrepairof
storageequipment.Threefactorssuggestthatsuchadepartmentcould,at
best,operatesuccessfullyasacostcenterinaresponsibilityaccounting
system:(1)severelimitsonthetypesofcostsactuallycontrollablebythe
manager;(2)themanager'sinabilitytocontrolprices;and(3)theextentto
whichdecisionsandactionsofothermanagersatthatstoreaffectthesales
volumeinthemeatdepartment.
Themeatmanagermightdeterminethequantityofmeatofeachkind
requiredtomeetthespecialdemandsofcustomersinthearea;butthecost
isdeterminedbysomehigherlevelmanagerwhoisresponsibleforacentral
purchasingfunctiontoserveallstoresinthearea.Themanagermight
determinehowmanyemployeesofeachtypeareneededandwheneachshould
work;butwageratesforeachclassofemployeesareprobablyestablishedat
ahigherlevel.Eventhetotalnumberofhoursworkedinthedepartment
mightdependonahigherleveldecisionaboutthehoursduringwhichthe
entirestorewillbeopen.(Alocalmanagermaybeabletodecidethat
personalservicewillnotbeavailableinthemeatdepartmentatalltimes,
asisthecaseinsomesupermarketsthatremainopenfor24hoursbutprovide
personalserviceinsomedepartmentsforonlysomeofthosehours.)
Manycosts"related"tothemeatdepartmentarejointcosts(e.g.,heat,
light,power,depreciationonstoreequipment,wagesofcheckoutclerks,
rent,janitorialservice)thatshouldnotbeinareportthatmightbeused
toevaluatethemanager'sperformance.Thus,ifthemeatdepartmentis
designatedaresponsibilitycenter,alimitednumberofcostsarelikelyto
befullycontrollableatthemanager'slevelandhenceproperlyincludiblein
areportintendedtoreflecttheresultsofdecisionsbythatdepartment's
manager.
Althoughmanagersinindividualstoresmighthaveauthoritytoestablish
pricesforspecifictypesandcutsofmeat,somecentralunitwithinthe
chainwillmandatemanypricesbecausesucharequotedinareawide
advertisementsforthechain.Thisfactorspeaksdirectlyagainst
designatingthedepartmentasaprofitcenter.Asimilarconclusionflows
fromthefactthatthesalesvolumeinthedepartment,nomatterhowgoodthe
manager'splansandsupervisionofhisownarea,canbegreatlyinfluencedby
theabilitiesofmanagersofotherdepartmentsandoftheentirestore.(How
goodmustthequalityofserviceandproductbeinthemeatdepartmentina
particularstoreinachaininordertooffsetthelossofcustomersbecause
repeatedstockoutsoccurduetopoorforecastsbytheproduceandgeneral
91

grocerymanagers?Exceptinthecaseofadvertisedspecials,towhatextent
dotoday'sshopperspatronizestoresindifferentlocationsfordifferent
itemsonanormalshoppinglist?)
Insummary,whileitmightbepossibletoinstitutesometypeof
responsibilityaccountinginthesettingofanindividualstoreofachainof
supermarkets,suchamoverequiresconsiderableanalysistodeterminethe
itemscontrollablebyanindividualmanager,andthispreliminaryanalysis
suggeststhatcostcenters,notprofitcenters,wouldbethemost
appropriate.
NotetotheInstructor:Thepurposeofthisquestionisasmuchtoset
thestudentthinkingabouttheimplicationsofafamiliarsituationasitis
totestthestudent'sgraspofthebasicconceptsintroducedinthechapter.
Wehavefoundthequestionusefulingettingthestudenttorecognize(1)the
magnitudeofcommoncostsinaseeminglyuncomplicatedsituation,and(2)the
needforindepthstudyofaspecificsituationbeforeembarkingonsome
seeminglysimpleplanforimplementingthebasicconceptspresentedinthe
text.We'vealsousedsomeaspectsofthisquestiontoanticipatethe
quantity/pricedistinctionraisedinconnectionwithstandardcosts(Chapter
12)andtoemphasizetherelationshipsbetweenresponsibilityaccountingand
previouslydiscussedmatterssuchasbudgetinganddecisionmaking.
92FirstUnionsAllocations
"Interrelationshipsofthesebusinesssegments"presumablymeansthat
FirstUnionprovidessimilarproductsandservicesinfourdifferentbusiness
segments:ConsumerBank,CapitalManagement,CommercialBank,andCapital
Markets.Allocationsofcoststoproductlinesarethereforeinexactbecause
muchofthecostiscommontoseveralproductlines.Havingcentralized
serviceandstafffunctions(probablybookkeeping,administration,legal,and
thelike)presentsthesameproblembecausesuchcostsarelargelycommonto
bothsegmentsandgeographicalareas.

93ResponsibilityCenters

Universities
(a)Withinuniversitiesitmightbepossibletoidentifyseveral
responsibilitycenters:individualcolleges,thebookstore,thehousing
office(andpossiblyindividualhousingunits),themedicalcenter,thefood
service,thelibrary,andthecomputercenter.Inanyoneofsuchcenters,
however,therewillbemanycostsnotcontrollablebytheindividual
responsibleforthecenter,andmanycasesofonlysemicontrollability.For
example,thevolumeofbusinessdoneinthebookstoreisprimarilyafunction
ofenrollmentandtextbookschosenbyfacultymembers,neitherofwhichis
underthecontrolofthebookstore'smanager.Similarly,theoccupancyrate
ofhousingunitsisprimarilyafunctionofenrollment,whichisnot
controllablebythehousingmanager.Similarsituationsexistforthefood
service,themedicalcenter,andthecomputercenter.Nevertheless,some
costsarecontrollablebythemanagerofeachofthesegmentsmentioned,and
suchcostscouldbeusedforperformancereporting.
(b)Itmightbepossibletoestablishresponsibilitycenterswithinthe
variouscolleges,perhapsalongdepartmentallines.Inaddition,theremay
becertainserviceunitswithinthecollege(e.g.,aBureauofBusiness
Research,acomputercenter,alibrary,acentralsecretarialandclerical
service)thatcouldberesponsibilityunits.Forindividualresponsibility
centerswithinacollege,stillfewercostswillbecontrollablebythose
92

units,andmanymorecostswillbejoint.
(c)Thelikelihoodofestablishingresponsibilitycenterswithinindividual
departmentsofacollegeisverylow.Somefewcostsmightbepartially
controllableatthedepartmentlevels(e.g.,studentandfacultysalaries,
travel,supplies)butatnolowerlevel.Forexample,few,ifany,costsare
likelytobecontrollableatthelevelofasinglecourseoffered.Themajor
costforagivencoursewouldprobablybethesalaryoftheprofessor,and
thatcostwouldbenotonlyanallocationoftheprofessor'stotalsalary,
butalsonotunderthecontrolofthepersonresponsibleforthecourse(the
professor).
NotetotheInstructor:Youmaywanttogointomoredetailonthe
typesofcostsincurredinatypicaluniversitysituationandthenormal
universitybudgetingprocedures.
94ResponsibilityReporting
Ifeachproductlinehasamanagerandindividualsalespeopleare
assignedtospecificproductlines,salessalariesneednotbeanallocated
costinresponsibilityreportsbyproductline.Withoutsuchspecialization,
thecostofsalespeoplewouldappeartobecontrollableby(andhence
assignedtotheresponsibilityreportof)ahighlevelsalesexecutive.
Whetherornotthesuggestedchangeinreportingshouldoccurdependson
whethertheindividualresponsibleforeachproductlineorcostcategorywas
givencontroloftheemploymentandsupervisionofthesalespeople.
95ArcherDanielsMidlandOperations
ADMprobablyhadmanyprofit/investmentcentersunderitsformermode
ofoperation.Itprobablyhasmanyfewernow.Itmightwellhaverevenue
centers(assuggestedbythestatementabout"onesalesorganization")andit
almostcertainlyhasmorecostcenters.However,whetherADMismoreorless
centralizednowisanopenquestion.Managersmightstillhaveagreatdeal
ofresponsibilityandfreedomtomakedecisions.Butfewermanagerswill
haveprofit/ROIresponsibilityunderthenewoperatingconditions.
96EvaluatingaPerformanceMeasure
(a)Inmostcases,factorsbeyondtheprofessor'scontrolsignificantly
affectenrollmentsinaparticularclass.Forexample,theuniversity,
college,ordepartmentmighthavestatedobjectivesforminimum/maximum
enrollmentsforall(orsomespecific)courses.Too,enrollmentlevelsare
influencedbywhetheracourseisrequiredorelectiveand,withrespectto
thelatter,bywhatalternativesareavailable.Asageneralrule,an
individualprofessorislikelytoexercisecontrolofthenumberofenrollers
onlyinelectivecourses,andthenonlywithrespecttothemaximum
enrollment.Butenrollmentsinelectivecoursesarealsoinfluencedbythe
numberofelectivesavailableandtheextentofstudentinterestinspecific
electiveswithoutregardtowhoisteachingthecourse.
(b)Inthoseinstanceswhereaprofessor'sactions/performancecould
influenceenrollments,useofthesuggestedperformancemeasurecould
motivateaprofessortogivehighergradesthanwarranted,goslowerthanis
reasonable,ortakeotheractionsthatwouldreducetheeducationalvalueof
his/hercourse.(Thosesamebehaviorsmightwelloccurwhentheresultsof
93

studentevaluationsareknowntobeamajorfactorinevaluatinga
professor'sperformance.)
NotetotheInstructor:Thisquestionpromptsstudentinterestbecause
itisrelevanttotheirexperience.Hence,youmightwishtostimulateclass
discussionbyaskingaboutalternativeperformancemeasures.Some
alternativesthathavebeensuggestedincludestudentperformanceoncommon
examinations(inmultiplesectioncourses),whichignoresthepotential
differencesinstudentabilityfromclasstoclass;evaluationsbasedon
observationbyachairorhead;andstudents'subsequentperformanceon
professionalexaminations(CPA,CMA).Itisimportantthatthediscussion,
atsomepoint,raisetheissueofinnatedifferencesamongstudentsina
particularsection,takingaparticularsubject,orenrolledataparticular
institution.
97Pricing,Timing,Allocations,andPublicRelations
Theconceptsofcapacityandcommoncostsarerelevanthere.In
effect,thecommentatorisassertingthatthecompanymustprovidecapacity
(operatorsonduty)inordertodoitsjob.Providingcapacityhasacost
thatiscommontoallservicesperformedusingthecapacity,andcommoncosts
mustbepaidforbysomeone.
Someminimumlevelofcapacityisneededtohandleemergencycalls,
requestsforservices,andsoon.Othercallsrequiringoperatorassistance
(directoryassistance,persontoperson,andotherspecialtypesofcalls)
canbehandledwithsomeexpansionofthatbasiclevelofcapacity,butthe
costsofcapacityexpansionremaincommontoalloperatorassistedservices.
Howcapacitycostswillberecovereddoesnotchangethefactoftheir
commonness.
Thecommentatorfocusesonachargeafterthreefreecallsfordirectory
assistance.Onecouldjustaseasilyarguethatallsuchcallsshouldbe
charged.(Thetimingoftheinstitutionofthechargecouldbeafactorin
thecommentator'sposition,becausesuchcallswereallfreeformanyyears.)
Essentially,thecommentatorisarguingthatthecommoncostofall
directoryassistancecallsshouldberecoveredfrom(allocatedto)other
usersofoperatorassistedservices.
NotetotheInstructor:Youmightwishtodrawananalogytothe
capacitycostsofamultipleproductmanufacturerandtheassociated
allocationandpricingproblems.Theanalogyisnotperfectbecausethe
manufactureroperatesinamorecompetitiveenvironment,buttheproblemis
presentformostcompanies.
Youmightalsowishtobringuptheissueofregulation,andthe
statementthat"MaBell"isreapingthebenefitofthechargeisworthsome
discussion.Someonemustpaythecommoncosts,andit'slikelythat
customerswillpayinonewayoranother.Implicitinthecommentsisthe
beliefthatstockholdersshouldpaythecostthroughlowerreturns.Fora
regulatedcompany,lowerreturnstostockholderswillusuallygeneraterate
increasesorreductionsinservice.Forregulatedorunregulatedcompanies,
lowerreturnswilldiscourageinvestmentandresultinhigherpricesor
reducedservices.Hence,inaregulatedindustry,customerswillpaythe
costinonewayoranother.Theonlyquestioniswhetherthecustomerswill
paythroughausechargeorinhigherbasicservicerates.
98BalancedScorecardInaNotforProfitOrganization
94

Thebalancedscorecardsemphasisonnonfinancialdimensionsofperformance
arequiteapplicabletonotforprofitorganizations.Eventhoughthe
organizationis"notforprofit,"theremustbesomemeasureoffinancial
successforsurvival.ForUWSENE,thefinancialobjectivesstressedthecost
effectivegenerationoffundswhilelearningandgrowthobjectivesemphasized
employeedevelopmentandalignmentwithorganizationalgoals.Thecustomer
perspectivefocusedonthedefinitionofthecustomer:thedonor,theagency
receivingthesupport,orthecommunity.UWSENEchosetousethedonorasthe
customerandfocusedonrecognitionandeaseofgiving.Theinternalbusiness
processobjectivesfocusedonhowtodeliverthefinancialandcustomer
objectives.
TheactualmeasureschosenbyUWSENEcanbefoundinHarvardBusinessSchool
case197036"UnitedWayofSoutheasternNewEngland(UWSENE)."
99AlternativeAllocationBases(5minutes)

MarketBrand

SurveyPromotionDevelopmentTotal

(a)Revenues,20%,45%,35%$50,000$112,500$87,500
$250,000
(b)Squarefeet,20%,30%,50%$50,000$75,000$125,000
$250,000
Thisbasicexerciseshowsthatdifferentallocationbasesgive
differentallocations.DepartmentAreceivedthesameallocationsbecause
itsshareofeachbasewasthesame.Theothersdifferedbecausetheir
sharesdiffered.
910BasicAllocationMethods(1015minutes)
1.Actualcostallocations:Costtobeallocated=$610,000(fixedcostsof
$390,000+variablecostsof$220,000).
GroceriesMeatDairy
Percentageofactualuse40%25%35%
x$610,000=allocations$244,000$152,500$213,500
2.Dualallocations:Costtobeallocatedequalsthebudgetedfixedcost+
totalinvoicesbudgetedvariablerate($400,000+10,500$20)=$610,000.
Budgetedvariablerate=$200,000/(4,000+2,500+3,500)=$20per
invoice

95

GroceriesMeatDairy
Budgetedvariablecosts,
$20xactualinvoices
$84,000$52,500$73,500
Budgetedfixedcosts
$400,000xpercentagesof
expectedlongtermuse120,000120,000160,000
Totalallocations$204,000$172,500$233,500
3.Thedualratemethod,combinedwithallocatingonlybudgetedcosts,
ratherthanactualcosts,isbetter.Allocatingactualcostsimposesthe
burdenofservicecenterinefficienciesontheprofitcenters.Allocating
allcostsbasedonactualusealsoresultsinacenter'sallocationdepending
ontheusethatothercentersmakeoftheservice.Allocatingfixedcosts
basedonexpectedlongtermusemakesbettersensebecausethecompany
acquiredthecentralcapacitybasedonexpectedlongtermuse.
911PerformanceReport(1520minutes)
Thereportshouldlookaboutasfollows.
Variance
BudgetActualOver(Under)
Materials$32,900$33,800$900
Directlabor34,20034,500300
Indirectlabor15,25014,220(1,030)
Supplies5,6005,450(150)
Smalltools4,2004,340140
Maintenanceequipment5,7004,950(750)
Totals$97,850$97,260$(590)
912StepdownAllocationMethod(RelatedtoAppendix)(1520minutes)
1.PersonnelAdministrationARCHHD
Directcosts$400,000$600,000
Personnel(400,000)240,000$40,000$120,000
Administration*(840,000)600,000240,000
Totals$640,000$360,000
*.50/.70x$840,000,.20/.70x$840,000
Thetotalallocatedtothetwooperatingdepartmentsequalsthetotal
costtobeallocated($640,000+$360,000=$1,000,000).Thedifferencein
theresultsofapplyingthedifferentallocationmethodsstemsfromthehigh
percentageofservicethatPersonnelgivestoAdministration.Thisisnot
consideredinthedirectmethod,butitisinthestepdownmethod.
2.ThecontrollerdecidedtoallocatethecostsofthePersonnelDepartment
firstbecausethelargestpercentageofitsservicesisperformedforthe
otherservicedepartment(Administration).Administrationuses60%of
Personnelservices,whilePersonnelusesonly30%oftheservicesperformed
byAdministration.
913ReciprocalAllocation(Extensionof912)(1520minutes)
LetP=PersonneladjustedcostsandA=Administrationadjustedcosts.
P=$400,000+0.30A
A=$600,000+0.60P
96

P=$400,000+0.30x($600,000+0.60P)
P=$580,000+0.18P
0.82P=$640,000
P=$707,317
A=$1,024,390[$600,000+(0.60x$707,317)]

ARCHHDTotal
Personnelcosts
$707,317x.10$70,732
$707,317x.30$212,195
Administrationcosts
$1,024,390x.50512,195
$1,024,390x.20204,878
Totalallocations$582,927$417,073
$1,000,000
Thedifferencebetweentheseallocationsandthestepdownisnearly
$58,000(ARCHlowerandHDhigherthaninstepdown).The$111,400($640,000
$528,600)differencebetweenthestepdownanddirectmethodsisalso
striking.
Boththestepdownandreciprocalmethodsincreasetheallocationtothe
ArchitecturalDepartmentbecausetheyindirectlyallocatemorePersonnelcost
toArchitectural,throughtheintermediateallocationtoAdministration.The
ArchitecturalDepartmentistheheavieruserofAdministration,butunderthe
directmethoddoesnotreceiveanallocationthatreflectsthetotalcostof
AdministrationbecauseitdoesnotincludethecostthatPersonnelincursfor
thebenefitofAdministration.
914AllocationsActualVersusBudgetedCosts(510minutes)
Thetitleoftheassignmentsuggeststhealternativeofusingbudgeted
costsinsteadofactualcosts.Moreover,itwouldbeagoodideatomakethe
allocationsbasedonexpectedlongtermuseoftheResearchDepartment's
capacityinsteadofonactualuse.Ifupperlevelmanagersunderstandthat
thefixed,indirect(totheoperatingdepartments)natureofresearchcosts
makestheirallocationarbitrary,theywillprobablynotpenalizeorreward
themanagersofsegmentsunfairly.However,thesegmentmanagersmightnot
seeitthatwayandmightlosesomemotivation.Underthepresentallocation
scheme,theFertilizermanager'sallocationwasincreasedbytwofactorsthat
hecannotcontrol:higherthanbudgetedcostsofresearchandacancelled
projectfortheSeedDepartment.Thisisnotagoodsituation.
915AssignmentofResponsibility(510minutes)
Iftheproductionmanagercandecidehowandwhentocomplywith
rushorderrequestsfromthesalesmanager,probablynothingiswrongexcept
thattheproductionmanagerdoesn'tunderstandtheimplicationsofhisorher
decisions.Iftheproductionmanagerisrequiredtomeettherushorder
requests,asmightbeinferredfromthestatementthatthesalesmanager
"ordered"schedulechanges,what'swrongisthatthereportingsystem
incorrectlyreportsproductioncostsascontrollablebytheproduction
manager.(Thatis,actionsofthesalesmanageraffecttosomeextentthe
totalproductioncostsincurred.)Whencompliancewithrushorderrequests
isrequired,thereporttothesalesmanagershouldincludecosts
identifiableasresultingfromsuchcompliance(theidletimeofdirect
97

laborersandcostsofsetupchanges).Theextenttowhichovertimepremium
shouldbeassignedtothesalesmanagerdependsonhowmuchflexibilitythe
productionmanagerhasinmeetingpreviouslyscheduledproductionneeds.
916TransferPricesandGoalCongruence(510minutes)
Itisinthebestinterestoftheoperatingmanagertogooutside;she
paysalowerpriceandherperformancelooksbetter(andisbetter).The
managerofthestenographicpool,acostcenter,doesnotreallycarewhether
theoperatingmanagerstaysinsideornot;thepoolmanager'sperformance
willbeunaffectedifperformanceisevaluatedbyreferencetobudgeted
costs.
Unlessthestenographicpoolisworkingatfullcapacity,thetransfer
priceshouldbeloweredtomakeitprofitablefortheoperatingmanagerto
keepherbusinessinside.Ifthepoolisatfullcapacity,intheshortrun
operatingmanagerscanbeencouragedtoseekthelowestcost.However,once
thestenographicpoolisoperatingbelowcapacity,thetransferpriceshould
againbesetatorbelowtheoutsidemarket.
NotetotheInstructor:Thisexerciseprovidesastraightforward
situationinwhichatransferpriceworksagainstthebestinterestofthe
firm.Studentsshouldrecognize,fromwhattheylearnedinChapter5,that
itisinthecompany'sbestinterestthatthestenographicservicesbe
"bought"inside.Pointingthisoutgivesanopportunitytocommentonthe
basicsimilaritiesoftheapproachtakeninChapters5and9,thattheuseof
allocationsisunwiseinmanagerialaccounting,bothfordecisionmakingand
performanceevaluation.
917BasicVarianceAnalysis(1015minutes)
1.and2.Budgetedcontributionmarginwas$16($30$14),actual
contributionmarginwas$17($31$14).

ActualActualVolumePlanned

ResultsatPlannedPriceResults
38,000x$1738,000x$1640,000x$16
$646,000$608,000$640,000
$38,000$32,000
favorablepriceunfavorablevolume
variancevariance
$6,000
favorabletotalvariance
Alternatively,
Salesvolumevariance=$16x(38,00040,000)=$32,000unfavorable
Salespricevariance=38,000x($31$30)=$38,000favorable
918Relationships(510minutes)
1.12,000
Actualunitsales11,000
Salesvolumevariance$3,000U
dividedbybudgetedCM,$18$15$3
Numberofunitsunderbudget1,000
98

Budgetedunitsales12,000
2.$18.30
Budgetedprice$18.00
Salespricevariance$3,300F
dividebyunitsactuallysold11,000
Pricevarianceperunit(favorable)0.30
Actualpriceperunit$18.30
3.Budget$36,000,12,000x($18$15),
Actual$36,300,11,000x($18.30$15)or$36,000budgetedplus$3,300
favorablepricevarianceminus$3,000unfavorablevolumevariance.
NotetotheInstructor:Thisexerciseteststhestudent'sunderstanding
oftherelationshipsamongbudgetedresults,actualresults,andvariances.
Requirements1and2relyontheformulas,
Salesvolumevariance=budgetedmarginxdifferencebetweenbudgetedand
actualsales
Salespricevariance=actualvolumexdifferencebetweenbudgetedandactual
margin

919PriceandVolumeVariances(15minutes)

Beforebeginning,weneedtwocalculations.Thebudgetedsellingpricewas
$14($210,000/15,000)andbudgetedandactualvariablecostwas$10
($150,000/15,000).
1.15,500cans
Actualvariablecosts$155,000
Dividedbyvariablecostperunit$10
Actualunitvolume15,500
2.$13.70
Actualsalesindollars$212,350
Dividedbysalesinunits,fromrequirement115,500
Equalssellingpriceperunit$13.70

99

3.
ContributionMargin
ActualatActualVolumeandPlanned

ResultsPlannedUnitMarginResults
15,500x($14$10)
$57,350$62,000$60,000
$4,650$2,000
pricevariancevolumevariance
unfavorablefavorable
$2,650
totalvariance
unfavorable
Alternatively,
salesvolumevariance=(15,50015,000)x$4=$2,000favorable
salespricevariance=($13.70$14.00)x15,500=$4,650unfavorable
920DevelopmentofPerformanceReport(20minutes)
PerformanceReport

J.Harrison
Sales$487,000
(a)Costofgoodssold262,000
Grossprofit225,000
Operatingcosts,direct:
(b)Advertising$26,000
Travel17,000
(c)Depreciation1,000
(d)Officeexpenses21,50065,500(e)
Productprofit$159,500
(a)Theexcesscostofgoodssoldresultedfromproductionproblemsandare
nottheresponsibilityofthesalesmanager.
(b)Theallocatedadvertisingexpensesarenotcontrollablebythesales
manager.
(c)Depreciationonfurnitureandfixturesinthesalesmanager'sofficeis
hisresponsibility,butnotthedepreciationonthebuilding.
(d)Theofficeexpensesreportedtothesalesmanagershouldnotinclude
theallocatedcostsoftheofficeofthesalesvicepresident.
(e)Noadministrativecostsshouldbereportedtothesalesmanagerbecause
thosecostsareallocatedandarepresumablynotunderhiscontrol.
921CostAllocation(45minutes)
1.DirectMethod
TrimmingCuttingTotal
Purchasing(60%/80%;20%/80%)$225,000$75,000$300,000
Administration(20%/70%;50%/70%)142,857357,143500,000
Totals$367,857$432,143$800,000
2.StepdownMethod
AdministrationPurchasingTrimming
910

Cutting
Directcost$500,000$300,000
Administration(30%,20%,50%)(500,000)150,000$100,000
$250,000
Purchasing(60%/80%;20%/80%)(450,000)337,500
112,500
Totals$437,500
$362,500
Thetotalallocatedisstill$800,000($437,500+$362,500),butthereis
adifferenceof$69,643intheamountsallocatedtoeachoperatingdepartment
usingthestepdownmethodasopposedtothedirectmethod.

NotetotheInstructor:Todrawattentiontothedifferencesthatcan
resultfromtheorderinwhichtheservicedepartmentcostsareallocated,
youmightwishtoshowtheresultsyouwouldhaveobtainedhadyouallocated
Purchasingcostsfirst.
PurchasingAdministrationTrimming
Cutting
Directcost$300,000$500,000
Purchasing(20%,60%,20%)(300,000)60,000$180,000$
60,000
Administration(20%/70%;50%/70%)(560,000)160,000
400,000
Totals$340,000
$460,000
Thedifferencebetweentheallocationstotheoperatingdepartmentsusing
thetwostepdownalternativesis$97,500.
3.ReciprocalMethod

LetP=adjustedcostsforPurchasingandA=adjustedcostsfor
Administration.
P=$300,000+0.30A
A=$500,000+0.20P
P=$300,000+0.30x($500,000+0.20P)
P=$450,000+0.06P
0.94P=$450,000
P=$478,723
A=$595,745[$500,000+(0.20x$478,723)]

TrimmingCuttingTotal
Purchasingcosts
$478,723x.60$287,234
$478,723x.20$95,745
Administrationcosts
$595,745x.20119,149
$595,745x.50297,872
Totalallocations$406,383$393,617$800,000

Theresultshereareclosertothoseunderthedirectmethodthanto
thoseofthestepdownmethod.Thedifferencebetweentheseallocationsand
thestepdownis$1,117.Thedifferencebetweenthereciprocalanddirect
methodsis$38,526.Thedifferencesdependstrictlyonthenumbersselected
anditisnotpossibletogeneralizeabouthowclosethereciprocalresults
willbetothedirectmethodresultsorresultsofthestepdownmethodusing
911

anysequence.

922PerformanceReportingAndAllocations(15minutes)
1.Incomestatement

IndoorOutdoorTotal
Sales$800,000$700,000$1,500,000
Directcosts240,000240,000480,000
Controllableprofit560,000460,0001,020,000
Indirectcosts*320,000280,000600,000
Income$240,000$180,000$240,000
*Allocations=($800,000/$1,500,000)x$600,000=$320,000and
($700,000/$1,500,000)x$600,000=$280,000.Or,therateofindirectcost
persalesdollaris40%,$600,000/$1,500,000,whichmultipliedby$800,000
and$700,000givesthesameallocations.
2.Themanageroftheoutdoordepartmentdidnothingtoboostthecompany's
income.Theincreaseinoutdoor'sincomecameaboutonlybecausethe
increaseinindoorsalescausedittoabsorbmoreindirectcosts.Theindoor
departmentincreaseditscontrollableprofitby$100,000($560,000
$460,000),whichaccountsfortheentireincreaseinincome.
923ResponsibilityforRushOrders(1015minutes)
NotetotheInstructor:Studentswilldescribetheissuesinvarious
ways.Amorebasicquestioniswhetherthecompany'sobjectivesarebeing
servedunderoneoranothermethodofattemptingtoresolvetheconflict.
Theproblemdoesn'tstatewhoisheldresponsiblefortheincreasedcosts
associatedwithrushorders.Thattheproductionmanageriscomplaining
suggeststhatheisbeingheldresponsible,buthemightbecomplainingjust
becauseoftheaggravationinmeetingthesalesmanager'srushorders.
1.Theproductionmanagershouldnotbeheldresponsibleforexcesscosts
unlessheisgivenabudgetforthem.It'snothisfaultthatrushorders
occur.Whatneedstobedecidediswhethertherushordersarejustified,
whethermeetingsuchordersisascriticalasthesalesmanagersaysitis.
(Competitorsmightnotoffersuchserviceandcustomersmightbetaking
advantageofagoodthing.)
Ifacceptingrushordersisjustifiedfromthestandpointofthe
objectivesofthefirm,whichmayincludeprovidingrapidservice,then
neithermanagercanbechargedwiththeexcesscostsexceptarbitrarily.The
salesmanagerwouldnormallybeheldresponsibleforsuchcosts;butifthe
company'spolicyrequirestherapidfillingofrushorders,itwouldseem
unfairnottoprovideforsuchcostsinhisbudget.
2.Thememoshouldsuggestthatthefirststepindevelopingthebestcourse
ofactionistoanalyzethecostsinvolvedin(a)fillingtheordersrapidly,
(b)carryingmoreinventory,and(c)notfillingorderssorapidly(the
possiblelostsalesandcontributionmargin).Ifthiscanbedonewith
acceptableaccuracy,apolicycouldbeestablishedthatwouldprovideenough
flexibilitytoallowthesalesmanagertodealwithsomecasesas
circumstanceswarranted.Thus,newcustomersmightbegivenrushservice,
withtheunderstandingthatsuchservicewouldnotcontinue,exceptin
unusualcasesofneedoratgreatercost.

912

Itisnotthefaultoftheproductionmanagerthatrushorderscost
more,unlessheisnotproducing,atbudgetedlevels,themixofproducts
thathasbeenpreviouslybudgeted.Ifheisdeviatingfromtheproduction
budget,thereissomelegitimacytocharginghimwithexcesscostsifthe
rushorderscouldhavebeenfilledfromnormalproductionaccordingtothe
budget.
924PerformanceMeasurement(1520minutes)
1.Whilethesalesmanagerexceededthebudgetfortotalsales,contribution
marginwouldhavebeenhigheriftheactualmixhadbeenclosertothat
planned.Actualresultswere:

AlphaBetaGammaTotal
Sales$500,000$400,000$200,000$1,100,000
Variablecosts(50%,45%,30%)250,000180,00060,000490,000
Contributionmargin$250,000$220,000$140,000$610,000
Contributionmarginwas$15,000lessthanplannedbecauseoftheunfavorable
changeinthesalesmix,andthesalesmanagerdidnotperformaswellas
wouldhavebeenexpectedgiventhatheexceededthesalesbudget.The
weightedaveragecontributionmarginbasedonbudgetedsalesis62.5%.Had
the$1,000,000ofactualsalesbeeninthenormalmix,contributionmargin
wouldhavebeen$687,500.
2.Thememoshouldnotethatthecurrentperformancemeasuredoesnot
encouragegoalcongruencebecauseitfailstoconsidertherelative
profitabilitiesofdifferentproducts.Thesalesmanagercouldconcentrate
onthemoreeasilysoldproducts,whichmightwellbelowmarginitems.The
salesmanager'sperformanceshouldbejudgedbyameasureofprofitability
suchasrevenuesminusbudgetedvariablecostsofproductionandactual
sellingcosts.(Usingactualproductioncostswouldpassoninefficiencies
ofproduction.Thesalesmanagershould,however,beresponsibleforselling
costs.)
925BehavioralProblem(510minutes)
Apparently,thelowerchargepercopyresultingfromthelowervariable
costhasstimulateduse.Wecannotbesurethatthereisunnecessarycopying
beingdone,butwecansurmiseitgiventhatvolumewas8,000copiesperday
beforethenewcopierwasbought.Ifthemanagerinchargebelievesthat
copyingisexcessive,heorshecouldsimplyraisethepercopycharge,
makingitatransferprice.Thiscouldbeaccompaniedbydroppingthe
allocationofthefixedcosts.Itmightalsobethatthecopyingis
justified,sothatitmightbewisetoacquiremorecapacity.Testingthis
hypothesisrequireschargingmorethanvariablecostpercopy.
Theproblemhere,asinsomanycases,isthebehaviorofmanagersunder
aparticularsystemofresponsibilityaccounting(andcostallocation).As
thechapterstates,animportantobjectiveofchargingusers(througheither
costallocationortransferprices)isencouragingdesirablebehavior.The
chapteralsoarguesthatdualrates(asusedbyWatson)arebetterthan
singlerates,buttherecanbeundesirableconsequencesofusingdualrates
whenthevariablecomponentisextremelylow.
926HospitalAllocationsandDecisions(1520minutes)

913

1.Currentreimbursements
MedicalSurgicalTotal
Admissions,given$126,000$162,000$288,000
Records($800,000x.20x.30)48,000
($800,000x.80x.90)576,000624,000
Totals$174,000$738,000$912,000
2.Newreimbursements
MedicalSurgicalTotal
Admissions($588,000x.70x.30)$123,480
($588,000x.30x.90)$158,760
$282,240
Records($820,000x.20x.30)49,200
($820,000x.80x.90)590,400
639,600
Totals$172,680$749,160
$921,840
Reimbursementsincreaseby$9,840($921,840$912,000),whichexceedsthe
$8,000costincrease.
3.Thehospitalbenefitsfromthechangebyincreasingitsreimbursement
fromthirdpartiesforindirectcosts.Patientsofthathospitalmightalso
benefitifthepricesofservicesarereducedbecauseofthehigher
reimbursements.However,someonewillhavetobearthehighercostof
thirdpartyreimbursements,whethertheburdenfallsontaxpayersfor
servicessupportedbygovernmentoronparticipantsininsuranceplans.
NotetotheInstructor:Thedistinctivefeatureofthisproblemisthat
makingthechangeisaneconomicallysounddecisionforthehospitalbecause
thehospitalwouldincreaseitsreimbursementsbymorethanitscostswould
increase.Theproblemdemonstratesanumberofpoints.First,itconfirms
thatallocationscaninfluencebehavior.Second,itconfirmsthat,byvirtue
ofitseffectonbehavior,anallocationcanhaveeconomicconsequences.
Third,itdrawsattentiontothepotentialeffectsofprogramsorcontracts
thatincludereimbursing(sharing)indirectcosts.Fourth,itpresentsthe
opportunitytodiscussthedifferencebetweenthemicroandmacroeffectsof
adecision.
927Allocations,ExpenseReimbursement,andEthics(10minutes)
1.Probably$740,theactualcost,thoughthecompanywouldhavepaid$760
forthebusinesstripalone,theroundtripfaretoLosAngeles.Arequest
tobereimbursedformorethanonehasspentwouldcertainlyberejected.

2.Thereareseveralpossibilities,noneofwhichcouldbecalledcorrect.
Theharshestistoallownothingonthegroundsthatyoureallytookthetrip
toplaygolfandthebusinessportionwasaruse.(Scroogehimselfwould
havetroublewiththat.)Amorereasonableapproachistoallocatethetotal
costbasedonthetimespent(60%business,40%pleasure),giving$444($740
x60%)tobereimbursed.Thisapproachallocatesthespecialpricereduction
(forstayingoveraweekend)betweenthebusinessandpersonalportionsof
thetrip,thoughthereductionmightnothaveoccurredwithoutthepersonal
sidetrip.Itisalsoreasonabletoargueforareimbursementof$595.The
personalpartofthetripwouldhavecost$145,$105(LosAngelestoSan
Francisco)plus$40($420SanFranciscotoAtlantaminus$380LosAngelesto
Atlanta).Thereimbursementwouldthenbethe$595differencebetweenthe
$740actualcostandthe$145personalcost.
914

Otherreasonableapproachesaretoallow$530(the$740actualcostless
the$210roundtripfarefromLosAngelestoSanFrancisco)oreven$550(the
$760roundtripfarelessthe$210).

NotetotheInstructor:Itshouldbeinterestingtoseehowstudents
answerthefirstquestion.Whilethisproblemdemonstratesagainthe
allocationproblem,italsooffersexposuretoabusinessdecisionthat
studentsarelikelytoencounter.Thoseinstructorsinterestedin
consideringethicalissuesinclasswillwanttoexplorethedecisionsfacing
boththeemployeeandthesupervisor.

928Step

DownAllocation(RelatedtoAppendix)(2025minutes)
GeneralAd
PersonnelministrationMachiningAssemblyTotal
DPtransactions20,00030,00040,00010,000100,000
Percentoftotal20%30%40%10%100%
No.ofemployees1003006001,000
Pct.oftotal10%30%60%100%
Directcostsbeforeallocation$1,000,000$1,500,000$2,500,000
Pct.oftotal40%60%100%
DataGeneralAd
ProcessingPersonnelministrationMachiningAssembly
Directcosts$150,000$100,000$200,000$1,000,000$1,500,000
DataProcessing(150,000)30,00045,00060,00015,000
Personnel(130,000)13,00039,00078,000
GeneralAdministration(258,000)103,200154,800
Totals$1,202,200$1,747,800
929PerformanceReportforaCostCenter(1520minutes)

MonthlyCostReport,CastingDepartment
July20X1
Controllablecosts:
Materials$32,800
Directlabor66,800
Indirectlabor2,380
Variablepower(9,500x$0.05)475
Variablemaintenance(800x$0.80)640
Other9,350
Totalcontrollablecosts$112,445
Noncontrollablecosts:
Fixedpower($130,000x.10)$13,000
Fixedmaintenance($24,000x.15)3,600
Totalnoncontrollablecosts16,600
Totalcosts$129,045
NotetotheInstructor:Thepointintherevisedperformancereportis
notthatcostsarelowerthanoriginallyreported,butthattheyaremore
reasonablyreported.Therevisedreportdifferentiatesbetweenthe
controllableandnoncontrollablecosts.Asthechaptersuggests,because
theyareawareofthenoncontrollablecosts,thedepartmentalmanagersmight
helptokeepthosecostslowerthantheymightotherwisebe.
930VariancesinaServiceBusiness(25minutes)
915

JuniorStaff
ActualActualHoursatPlanned
ResultsPlannedRateResults
($40x26,000)
$988,000$1,040,000$1,200,000
$52,000$160,000
ratevariancevolumevariance
unfavorableunfavorable
$212,000
totalvariance
unfavorable
SeniorStaff
($80x15,000)
$1,260,000$1,200,000$960,000
$60,000$240,000
pricevariancevolumevariance
favorablefavorable
$300,000
totalvariance
favorable
Insummary,juniorstaffworkedlessthanplannedandatlowerrates,
showingunfavorablevariancesbothforrateandvolume.Seniorstaffworked
morethanplannedandathigherrates,showingafavorableoverallvariance.
Insomesituations,therateandvolumevariancesareprobablyrelatedinthe
sensethattheratechangecausesanoppositechangeinvolume.Thatmight
notbethecaseforaCPAfirm.Wecanonlyspeculateaboutthecauses.
Perhapsthefirmdevelopedagreatdealmoreworkrequiringhigherlevel
people.
931PerformanceReportinaServiceCompany(1520minutes)
1.RevisedPerformanceReportfortheLitigationDepartment

FebruaryMarch
Revenues$140,600$148,400
Lessdirectcosts:
Staffsalariesexpense76,80077,400
Travelandsuppliesexpense7,8008,100
Totaldirectcosts84,60085,500
Controllableprofit56,00062,900
Lessallocatedindirectcosts:
Occupancyandutilitiesexpense9,80010,900
Generalofficeexpense15,40021,800
Totalindirectcosts25,20032,700
Income$30,800$30,200
2.ControllableprofitwashigherinMarchthaninFebruary,indicatingthat
theLitigationDepartmentactuallydidbetterinMarch.Theincreasein
allocatedoccupancyexpenseresultedfromadecisionmadebythetopmanagers
ofthefirm,notbySaunders.Butatleastallmanagerssharedtheincrease
onaconsistentbasisnotaffectedbytheiractions.Theallocationof
generalofficeexpenseismoretroublesomeforperformancereporting.The
costallocatedtotheLitigationDepartmentincreasednotonlybecauseofthe
LitigationDepartment'sincreasedactivity,butalsobecauseofdecreased
activityintheotherdepartments.
916


932ProductLineIncomeStatements(35minutes)
1.Thefirststepistofindthenumberofeachproductsold.
Saws:4,000($500,000x40%)/$50
Drills:7,500($500,000x30%)/$20
Sanders:3,750($500,000x30%)/$40
MifflanToolCompany
IncomeStatementforJanuary20X3

TotalSawsDrillsSanders
Sales$500,000$200,000$150,000$150,000
Costofsales(1)307,500120,000112,50075,000
Grossprofit$192,500$80,000$37,500$75,000
Shippinganddelivery(2)23,0008,0007,5007,500
Contributionmargin$169,500$72,000$30,000$67,500
Fixedcosts(3)140,000
Incomebeforetaxes$29,500
(1)Saws=4,000x$30
Drills=7,500x$15
Sanders=3,750x$20
(2)Saws=4,000x$2
Drills=7,500x$1
Sanders=3,750x$2
(3)Rent,salaries,andotherexpensesof$40,000,$70,000,and$30,000
2.Attheexpectedmixthesalesofeachproductwouldhavebeenasfollows:
Saws:3,000($500,000x30%)/$50
Drills:5,000($500,000x20%)/$20
Sanders:6,250($500,000x50%)/$40

MifflanToolCompany
ExpectedIncomeStatementforJanuary20X3

TotalSawsDrillsSanders
Sales$500,000$150,000$100,000$250,000
Costofsales290,00090,00075,000125,000
Grossprofit$210,000$60,000$25,000$125,000
Shippinganddelivery23,5006,0005,00012,500
Contributionmargin$186,500$54,000$20,000$112,500
Fixedcosts140,000
Incomebeforetaxes$46,500
3.Calculationsofweightedaveragecontributionmarginandgrossprofit
ratesareasfollows.

ExpectedPercentages:TotalSawsDrillsSanders
Sellingprice$50.00$20.00$40.00
Costofsales30.0015.0020.00
Grossprofit$20.00$5.00$20.00
Grossprofitpercentage40%25%50%
Mixpercentage30%20%50%
Weightedaverage42%12%5%25%
Grossmargin,above$20.00$5.00$20.00
917

Lessshippinganddelivery2.001.002.00
Contributionmargin$18.00$4.00$18.00
Contributionmarginpercentage36%20%45%
Weightedaverage37.3%10.8%4.0%22.5%
ActualPercentages:TotalSawsDrillsSanders
Grossprofitpercentage40%25%50%
Actualsalesmix40%30%30%
Weightedaverage38.5%16%7.5%15%
Contributionmarginpercentage36%20%45%
Weightedaverage33.9%14.4%6.0%13.5%
Theeffectofthechangeinmixwastoreducethegrossmarginpercentage
to38.5%from42%,3.5percentagepoints.Thisresultedina$17,500dropin
grossmargin($500,000x3.5%).Thepercentageofshippinganddelivery
expensesdroppedfrom4.7%($23,500/$500,000)to4.6%($23,000/$500,000).
This0.1%decreasegainedanadditional$500ofcontributionmarginand
profit.
SomestudentswilldealonlywiththechangeintheWACM(37.3%expected
versus33.9%actual),adropof3.4percentagepoints,givingthe$17,000
profitshortfall($500,000x3.4%).Whetherornotvariablecostsare
discussedindividually,thepresidentcanbetoldthattheshiftinmixwas
unfavorablebecausethelowestmarginproduct,drills,increaseditsshare
andthehighestmarginproduct,sanders,reduceditsshare.
933SelectinganAllocationBase(15minutes)
1.$300,000[$3,000,000x(20,000/200,000,thesumofthefirstandsecond
floorspace)]
2.$225,000(7.5%x$3,000,000)
Totalrentalvalue:
Firstfloor(25x100,000)$2,500,000
Secondfloor($15x100,000)1,500,000
Total$4,000,000
Housewares'Department($15x20,000)$300,000
Percentage($300,000/$4,000,000)7.5%

3.Bisson'smethodmakesmoresensebecauseitrecognizesthevalueand,
indirectly,thecostofthespacethatherdepartmentoccupies.Rentalvalue
isthereforeabettermeasureofbenefitsreceivedthanisfloorspace.
NotetotheInstructor:Somestudentsmightaskwhythecompanycan
rentspaceworth$4,000,000for$3,000,000.Severalpossibilitiessuggest
themselves.Oneisthattheleasemightbeafewyearsold,reflectinglower
rentalvalues.Anotheristhatabasketpurchase,suchasrentinganentire
buildinginsteadofsomespaceononefloorortheother,oftenyields
savings.
934AllocationsandDecisions(1015minutes)
1.No,becauseprofitwouldfallby$30,000.
Revenue(20,000x$30)$600,000
Variablecostsexcludingcorporatecharge
918

(20,000x$27)$540,000
Corporatecharge($600,000x.15)90,000630,000
Incrementalloss($
30,000)
Alternatively,workingwithperunitamounts,$30$27($30x.15)=
$1.50
2.Yes,profitforthecompanyasawholewouldincreaseby$60,000
($600,000$540,000incrementalvariablecosts).
935PerformanceMeasures(2025minutes)
PreliminaryNotetotheInstructor:Thisproblemshowshowimportantit
isformanagementtostateitsobjectivesclearlysothatmeasuresof
subsequentperformancewillmotivateactionsconsistentwiththose
objectives.Throughout,thisproblembringsoutthedisadvantagesofusinga
singleperformancemeasure.Onewaytoapproachtheproblemistoconsider
what"bad"actionsamanagermighttakethatwouldappeartobe"good"based
onthecriterionbeingusedtomeasureperformance.
(a)Themeasuremightbeeffectiveifonecoulddetermineandimplementan
adequatenotionofwhatismeantby"nolongerrequiringtreatment."If
dischargefromahospitalisthestatisticusedtoimplementthenotion,the
dangersare(1)prematuredischargeofpatientsand(2)concentrationon
patientsrequiringlittletreatment.Themeasureisfaultywithoutsome
recognitionthatthe"treatment"foreachpatientisnotthesame.
(b)Theusefulnessofthismeasuredependsontheintendedbeneficiariesof
theprogram.Thesuggestedmeasurecouldencourageconcentrationontheeasy
cases,manyofwhomcouldprobablyfindjobsontheirownwithinashort
periodoftime.Whilesuchpersonscanusehelp,theneedislikelytobe
greaterelsewherenamely,withthechronicallyunemployedandunderemployed.
Aswiththepreviouspart,themeasurefailstorecognizethatunemployed
personsarenotallequallyunemployable.
Anotherconsiderationisthetypeofjobthatwillbefound.Itisnot
asignificantgaintoplaceapersoninadeadendjobthatheorshecould
probablyhavefoundanyway.Moreover,ifthatdoescometopass,the
turnoverratewillprobablybehigh,whichwillmakethedirectorlookeven
betterbecauseoftheincreaseinunemploymentthatwilloccuraspersonsgo
throughseveralpoorjobswithperiodsofunemploymentaftereachjob.
Consequently,someconsiderationofthelengthoftimepersonsremainonthe
jobsfoundforthemisneededtoimprovethemeasure.
(c)Aswiththepreviousquestion,theissueisdefiningtheobjectivesto
beaccomplished.Iftheobjectiveistoeliminateasmuchsubstandard
housingaspossible,themeasuremaybeusefulaslongasadequatebuilding
codesareestablished.Whilesuchapolicymightbeeffectiveintermsof
numbers,however,itmightnotgetatthemorecriticalproblemsofbad
housing.
Theperformancemeasureisweakiftherealtargetoftheprogramis
elimination(ormajorrehabilitation)ofmajorslumareas.Themeasurecould
encourageconcentrationoneasyrehabilitationprojects,suchashouses
havingoneortwoeasilycorrecteddeficienciessuchasmissingglassor
screens,oraleakyroof.Becausethemeasurefailstorecognizethe
relativedifficultyofbringingindividualhousesuptostandards,houses
withmoredifficultdefects(perhapsstructuralproblems)mightbeignored.
919

(d)Hoursofoperationisaninputmeasure,withnoconsiderationofoutput
orothercost(likewastedmaterials).Exceptundertheunlikely
circumstancesthatthemachineproducesatasteadyratewheneveritis
turnedonandanoperatorispresent,theperformancemeasureshould,insome
way,considerbothoutputandothercostsforwhichtheoperatoris
responsible.
(e)Areasonableobjectiveforasalespersonistoincreasetheaverage
ordersizewhilemaintaining(orincreasing)thenumberofcustomersserved.
Themeasureistryingtogetattwothingsatonce,buttheratioformofthe
measurecouldencouragesalespeopletoconcentrateonthecustomerswhoare
likelytogivelargeorders,perhapsignoringthosewithsmallerorders.
ClassesthathavebeenthroughChapter8willbeawarethatmaximizinga
ratio(IRRinthatchapter)isgenerallyinferiortomaximizingadollar
amount(NPV).Moreover,thesuggestedmeasureignorestheprofitabilityof
thesales,sothatsalespeoplemightpushthehighvolume,lowmargin
productsattheexpenseofmoreprofitableones.
936EvaluationofCompensationPlans(2025minutes)
1.Themoraleandharmonyproblemmaybecausedatleastpartiallybyhaving
salespeoplelikeMcTavishmakinglargecommissionswhiletakingactionsnot
inthecompany'sinterest.Thatfactcouldalsoexplaintheprofitability
problems.Thecommissionsarebasedsolelyongrosssales($270,000x8%=
$21,600commissionforMcTavish,and$200,000x8%=$16,000forChristy).
Butthereturntothecompanyfromtheeffortsofthetwosalespeopleis
quitedifferent,asshownbelow.

McTavishChristy
Grosssalesorders$270,000$200,000
Salesreturns*18,5008,000
Netsales251,500192,000
Costofgoodssold139,50068,400
Grossmargin112,000123,600
Commissions21,60016,000
Contributionmargin90,400107,600
Discretionaryexpenses19,20021,500
Incrementalprofit$71,200$86,100
*Thecompanyearnsnothingandmayevensufferalossifthereturned
goodsmustberesoldatreducedprices)
McTavishisreceivinglargercommissions,butthereturntothecompany
onhiseffortsissmallerthanthereturntothecompanyonChristy's
efforts.ThehigherlevelofdiscretionaryexpensesincurredbyChristydoes
notoutweighthehigherreturnproducedonsaleshemade.Moreover,
McTavish'scustomersreturnmerchandiseatagreaterratethandoChristy's
($8,000/$200,000=4%forChristy,versus$18,500/$270,000=6.9%for
McTavish).
Consideringonlythequantitativedataintheaboveanalysis,itappears
thatChristyisunderpaidrelativetoMcTavish.Ifevenafewoftheabove
facts(suchasthevariablecostofsales)areknowntothesalesforce,it
isunderstandablethatdisharmonycouldexistamongitsmembers.The
performancemeasureusedcurrently,dollarsofgrosssales,encouragesa
salespersontoignorealltheotherfactorsthataffectthecompany'sreturn
920

onthosesales.(Forexample,perhapsMcTavishisprovidingloosecredit
terms,overselling,orusinghighpressuretactics,allofwhichwouldprompt
thehigherreturnrate.Healsomightbeconcentratingoneasytosellitems
and/oreasytosellcustomers,orperhapsheisignoringsmallercustomers.
Christy,ontheotherhand,mightbedoingmoredevelopmentwork,callingon
companiesthatarenotnowcustomersinthehopeofincreasedbusinessinthe
future.)
2.Thisproblemisagoodexampleoftheuseofaperformancemeasurement
(andrewardsystem)thatconcentratesononlyonephaseofresponsibility.
Thesalespeoplearebeingevaluatedandrewardedinawaythatfailsto
reflecthowtheiractionscaninfluenceprofitability.Onealternativewould
betobasecompensationonincrementalprofit,suchascomputedin
requirement1.(Ofcourse,thecommissionpercentagewouldhavetobe
adjustedtoachieveapproximatelythesametotalcosttothecompany.)
Anotheralternativeistopayabasesalaryplusbonusesformeetingspecific
targetsconsideredimportanttospecificobjectivesofthecompany(e.g.,
numberofnewaccountsobtained,percentagesofrepeatbusinessheld).Ata
minimum,theplanshouldberevisedtorecognizemerchandisereturnedby
customers.
937AllocationsandEthics
1.Thedirectcostsofthemailingwerethecostsof(a)postage,(b)
stationery,(c)printingthecoverletterandthematerialcontainingthe
"fivehealthtips,"andperhaps(d)stuffingandaddressingenvelopes.
Mailingcostswouldprobablyalsoincludeobtainingamailinglistof
prospectivedonorsandmaintainingthemailinglistofpastdonors.If
permanentemployeesregularlydothestuffingandmailingandmaintainmaster
mailinglists,atotalcostforthemailingwouldprobablyincludean
allocationofthesalariesoftheseemployees.Inaddition,thecharityis
likelytopurchasemailinglistsofprospectivedonors,andthetotalcost
forthemailinginquestionislikelytoincludeanallocationofthis
purchasecost.
Thecharity'sfourmajorcostcategoriesare(a)researchprograms,(b)
publiceducationprogramsassociatedwithfundraisingappeals,(c)fund
raising,and(d)administrativeexpenses.Thetotalcostofthemailing,as
describedabove,isprobablyallocatedbetweenthesecondandthirdofthose
costcategories,withthepubliceducationcategorycarryingmostofthe
cost.Themailingqualifiesforthatcategorybecauseoftheinclusionofthe
"healthtips."
2.Thedecisiontosupportornotsupportthischarityisapersonalmatter
thatmightormightnotbeinfluencedbytheinformationprovidedinthe
mailing.Acharitythatdevotesonly21%ofitsfundsspecificallytothe
charitablepurposeforwhichitclaimstoexistisunlikelytogarnersupport
frommostpeople.However,anindividualwhoispersonallyawarethatmost
ofthecharity'spubliceducationprogramsaremajorundertakingshavingonly
aperipheralrelationshiptofundraisingmightnotreactnegativelytothe
fundraisingconnectioninthecategorythatuses43%ofthecharity'sfunds.
Moreover,anindividualhavingapersonalinterestinthecharitablepurpose
perhapsbecauseamemberofthefamilyhadalreadybenefited,orhopedto
benefit,fromthecharity'sworkmightdisregardwhatotherscouldconclude
weredisproportionateexpendituresonfundraisingandadministration.
938RevenueVariancesforanAirline(20minutes)
921

ActualActualVolumePlanned
ResultsatPlannedPriceResults
$44.0x(66%/60%)
$45.6$48.4$44.0
$2.8$4.4
unfavorablepricevariancefavorablevolumevariance
$1.6
favorabletotalvariance
NotetotheInstructor:Thisassignmentrequiresthatstudents
understandthattheloadfactorcanserveasameasureofunitvolume.Itis
alsoworthmentioningthatbecausevariablecostsperpassengerare
relativelylowforanairline,analyzingrevenueinsteadofcontribution
marginissensible.(Mostofthevariablecostsforanairlinevarywiththe
numberofflights.)

939PerformanceReporting

AlternativeOrganizationalStructure(40
minutes)
1.IncomeStatementforMarch20X2,byMarkets

TotalDomesticForeign
Sales$1,300,000$1,000,000$300,000
Lessvariablecosts:
Costofsales(scheduleA)820,000630,000190,000
Sellingcosts(scheduleB)31,00024,0007,000
Totalvariablecosts$851,000$654,000$197,000
Contributionmargin$449,000$346,000$103,000
Directfixedcosts:
Selling$74,000*$36,000$38,000
Administrative60,00025,00035,000
Totaldirectfixedcosts$134,000$61,000$73,000
Marginearnedbymarket$315,000$285,000$30,000
Common(indirect)costs:
Fixedmanufacturingcosts$190,000
Fixedadministrativecosts12,000**
Totalcommoncosts$202,000
Income$113,000
*$105,000$31,000
**$72,000$60,000
2.IncomeStatementforMarch20X2,byProduct

TotalABC
Sales$1,300,000$500,000$400,000$400,000
Lessvariablecosts:
Costofsales$820,000$300,000$280,000$240,000
Selling31,00015,0008,0008,000
Totalvariablecosts$851,000$315,000$288,000$248,000
Contributionmargin$449,000$185,000$112,000$152,000
Directfixedcostsproduction48,00048,000
Productprofit$401,000$137,000$112,000$152,000
Common(indirect)costs:
Selling$74,000
Administrative72,000
Production142,000*
922

Totalcommoncosts$288,000
Income$113,000
*$190,000$48,000
ScheduleAVariableManufacturingCosts
(1)(2)(3)(4)(5)(6)(7)
VariableVariableVariable
CostDomesticCostForeignCostTotal
ProductRatioSales(2)x(3)Sales(2)x(5)(4)+(6)
A60%$400,000$240,000$100,000$60,000$300,000
B70%300,000210,000100,00070,000280,000
C60%300,000180,000100,00060,000240,000
Totals$630,000$190,000$820,000

ScheduleBVariableSellingExpenses
(1)(2)(3)(4)(5)(6)(7)
VariableVariableVariable
CostDomesticCostForeignCostTotal
ProductRatioSales(2)x(3)Sales(2)x(5)(4)+(6)
A3%$400,000$12,000$100,000$3,000$15,000
B2%300,0006,000100,0002,0008,000
C2%300,0006,000100,0002,0008,000
Totals$24,000$7,000$31,000
940CostAllocations,TransferPrices,andBehavior(25minutes)
NotetotheInstructor:Thisproblemprovidesampleopportunityto
discuss(1)waysofencouragingordiscouragingtheuseofresources,and(2)
theneedtofitthetransferpricingmethodstothecompany'sobjectives.
(a)Computercostscouldbeallocated(orpriced)inseveralwaysthat
encourageuse.Thefollowingpossibilitiesarelistedinthegeneralorder
inwhichtheywouldprobablyencouragemoreuse:nochargeatall;nocharge
foruse,butallocationoffixedcost;chargeforuseatbudgetedvariable
cost,withorwithoutallocationoffixedcosts.
*Allocatingthefixedcostandcharginglittleornothingforusemight
encouragemoreusethanwouldnochargeatall.Managersmightbemore
inclinedtotakeadvantageofaserviceiftheyfeltthattheywere"paying
foritanyway."Ifthere'sachargefortimeused,theallocatedfixedcost
shouldnotbeaffectedbyuse.
*Chargingnothingforuse,orchargingatbudgetedvariablecost(which
wouldbeverylow)wouldmaketheservicecheap,butperhapstoocheap.This
mightbetruewithorwithouttheallocationofthefixedcomponent.
*Ifthecompanynowhasexcesscapacityincomputertime,charging
somethingmorethantheverylowbudgetedvariablecostcouldencourage
lowerlevelemployeestousetheservice,thoughuseshouldbemonitoredfor
overuse.
*Becauseincreasedusecouldexceedexistingcapacityandacquiringa
second(orlarger)computerwouldproducealargeincreaseincost,
executivesshouldarrangeformonitoringofusesothatthetransferprice
canbereconsideredatregularintervals.
923

(b)Maintenancecostsarebeingallocatedintheworstpossiblewaynamely,
basedonactualcostsandproportionofactualcurrentuse.Asthechapter
suggests,managersmayhaverealizedthatincreaseduseaffectstheircosts
severelyifothermanagersrefrainfromusingtheservice.Andthe
allocationisapparentlyhighenoughtomotivateproductionmanagerstowait
formaintenanceuntilmachinerybreaksdown.
The$10budgetedvariablecostperhourcouldbeusedtochargefor
hoursworked,andthe$200,000fixedcostcouldbeignoredorallocatedbased
onsomeideaoflongrunuseofmaintenanceservices.Ifa$10perhour
chargeproducesademandforservicethatputsastrainonthemaintenance
department,thepricecouldbeadjustedupward.Onerecommendationisto
studytherelationshipsbetweentheamountofmaintenanceworkdone,the
frequencyofbreakdowns,andthelivesofthemachinery.
Thecostofmaterialsandsuppliesusedbythemaintenancedepartmentis
notmentioned.Thesecouldbechargedtotheotherdepartmentsatcost,with
hoursworkedbeingusedtopricelaborandsomevariableoverhead.The
resultingvariablecostperhourwouldbesomewhatlessthan$10ifthecost
ofmaterialsisincludedinthe$10perhour.
(c)Consultingcostsareapparentlyallocatedinamannerthatisproducing
toomuchuseoftheservice.Eithertheallocationistoosmallorthereis
noallocationatall.Afree(orveryinexpensive)servicemighthavebeena
goodideaseveralyearsago,butitisapparentlynotsuchagoodideanow.
Thetimemayhavecometobeginpricingtheseservicessoastodiscourage
frivoloususe,ifthatisindeedthecase.Thissituationillustratesthe
needtoreconsidertransferpricingmethodswhencircumstances,including
objectives,change.
Oneapproachistoaskmembersoftheconsultingstaffhowmuchoftheir
worktheyidentifyasimportantandhowmuchisaresultofmanagers'not
wantingtodothingsthemselvesthattheywellcoulddo.(Forexample,one
motiveforamanagerseekingtheapprovaloftheconsultingstaffisto
avoid,oratleastspread,theblameifsomethinggoeswrong.)Objective
answerstosuchaquestionarehardtoget,ifonlybecausetheconsulting
staffhasitsownobjectives,oneofwhichcouldbetheaccumulationofpower
withgrowthinsize.Inanycase,thegoalofanychangeinpolicyisto
chargeanamountsufficienttodiscourageexcessiveuse.
941AllocationsandBehavior(1520minutes)
NotetotheInstructor:Thisassignmentprobessomeofthedifficulties
inachievinggoalcongruenceandmoststudentswillbeabletocomeupwith
reasonableanswerstorequirements1and2.Fewerwillseethattheone
possiblesolutionisprobablytouseavariationofthedualratemethod,
eventhoughthereisnoissueofexpectedlongtermuse.Onemightsaythat
amonthislongterminthissituation,becausethetrafficmanageris
essentiallyacquiringadditionalcapacityeachmonth.
1.Themanagersofthedistributioncenterswouldhavelittleorno
incentivetomakegoodestimates.Theircostsareunaffectedbyhow
inaccuratetheirestimatesare.Itishardtotellwhethertheywouldtend
tooverestimateorunderestimatetheirneeds.
2.Allocationsbasedonactualmileagealsoprovidelittleornoincentive
toestimateaccurately.Noristhereanybasisforsuggestingwhetherthere
924

wouldbeatendencytooverestimateortounderestimate.
3.Onereasonablesolutionistouseathreepartcharge,asfollows:
*Allocatetotalexpectedfixedcosts,includingtheoutsidetruckers'
guarantee,basedontheamountsestimatedbyeachmanager.Thispartofthe
chargewoulddiscourageoverestimation.
*Chargetheaveragevariablecost(fleetandoutside)basedonactualuse.
*Chargearelativelyhighamountforactualmilesinexcessofthe
estimateasanincentivetoavoidunderestimation.Determiningtheamountto
chargecouldbedifficult,butitshouldbehighenoughtodiscourage
underestimation.
Thesituationcouldalsobehandledwithmultipletransferprices,with
differentpricesforestimateduseandforuseinexcessoftheestimated
amount.
942AllocationsandManagers'Bonuses(20minutes)
1.Allocateasshownbelow.
DryGoodsHousewares
Bonuses
($60,000/$75,000)x$7,500$6,000
($15,000/$75,000)x$7,500$1,500

925

2.AllocateasthemanagerofHousewaressuggests.
DryGoodsHousewaresTotal
Sales$250,000$500,000$750,000
Totaldirectcosts166,000437,000603,000
Controllableprofit84,00063,000147,000
Indirectcosts:
Salessalaries*36,00012,00048,000
Other8,00016,00024,000
Totalindirectcosts44,00028,00072,000
Profit$40,000$35,000$75,000
Bonuses
($40,000/$75,000)x$7,500$4,000
($35,000/$75,000)x$7,500$3,500

*[$60,000/($60,000+$20,000)]x$48,000=$36,000;($20,000/$80,000)x
$48,000=$12,000.
3.TheDryGoodsmanagerwillsaythatGrove'smethodisbetter;the
Housewaresmanagerwillsaythatindirectsalessalariesseemmoreclosely
relatedtodirectsalessalariesthantosales,sotheHousewaresmanager's
proposalisprobablythemorereasonableofthetwo.
4.Grovecouldallocatethebonusesbasedontherelativecontrollable
profitsofthedepartments.TheresultsareDryGoods$4,286
[($84,000/$147,000)x$7,500],andHousewares$3,214[($63,000/$147,000)x
$7,500].Theadvantageofthismethodisthatitavoidstheallocation
problem,butoneoranothermanagercouldstillarguethathis/hersegment
requiredlessservice.Thiswouldleadtothedemandthatallocationsshould
bemadeto"properlyreflect"costswhichweknowtobeimpossibletodo.

943PerformanceReport(3540minutes)

Thereportthatfollowsisinthousandsofdollars.

SportingNot
HousewaresClothingGoodsAllocatedTotal
Sales$900$1,200$400$2,500
Costofgoodssold5006801801,360
Grossprofit$400$520$220$1,140
Otherexpenses:
Salaries(1)$33$54$28$75$190
Advertising(2)27361250125
Rent(3)424216100
Depreciation20161248
Generalandadministrative250250
Miscellaneous(4)32491680177
Totalexpenses$154$197$84$455$890
Departmentalprofits$246$323$136
Profitforstore$250

(1)Originalamountsreducedby$0.03persalesdollar
($75,000/$2,500,000).
Housewares:$60,000($900,000x$0.03)
Clothing:$90,000($1,200,000x$0.03)
SportingGoods:$40,000($400,000x$0.03)

(2) Originalamountsreducedby$0.02persalesdollar($50,000/$2,500,000)
926


(3)$1.05persquarefootforhousewaresandclothing,$0.80persquare
footforsportinggoods.Theoriginalrentswereall$1.00persquare
foot($100,000/100,000).

(4)Originalamountsreducedbythedollaramountsgiveninitem(g).
NotetotheInstructor:Allocatingrentbasedonrelativevaluesof
thespacemightnotoccurtostudents.Itisalsoworthpointingoutthat
thecostallocationsforrentalsoequalthecurrentmarketrents(an
unlikelyoccurrence).Youmightwishtodiscussthepossibilityofcharging
thedepartmentswiththefairmarketvalueofthespacetheyoccupy,asan
alternativetoallocatingthecosts.

944TransferPricesandBehavior(35minutes)

1.Increaseof$1,000permonth
Reducedmaintenancecosts(500hoursat$10)$5,000
Increasedvariablecosts(4,000x$1)4,000
IncreaseinmonthlyprofitofDepartmentA$1,000

2.Decreaseof$3,000permonth
Lostrevenue(500hoursat$10)$5,000
Reducedvariablecosts(500hoursat$4)2,000
Decreaseinmonthlyprofitofmaintenancedepartment$3,000

3.Decreaseof$2,000permonth,thesumofthechangestotheindividual
departments
Increaseinvariableproductioncosts(requirement1)$4,000
Decreaseinvariablemaintenancecosts(requirement2)2,000
Decreaseintotalmonthlyprofit$2,000
4.(a)8,000hours
Thecurrenttransferpriceof$10perhouryieldsan$8,000profitafter
variablecostsof$4perhourandfixedcostsof$40,000.Thecurrent
levelofactivitycanbecalculatedasfollows,assumingXtobethe
level
ofactivity.
$10X$4X$40,000=$8,000
$6X=$48,000
X=8,000
Wecanalsodeterminethe8,000hoursbyusingtherevisedpriceand
costsbecausetherevisedpricesweredesignedtomaintainthecurrent
levelofprofit.

$12X$5X$48,000=$8,000
$7X=$56,000
X=8,000
(b)$4,500.Oneapproachistocalculatetheprofitusingthenew
volumes
andcosts.
927

Billedservices[(8,000hours500hours)x$12]$90,000
Variablecosts(7,500x$5)37,500
Contributionmargin52,500
Fixedcosts48,000
Profit$4,500

Anequallyvalidbutmorecomplexapproachistodealonlywithchanges.
Gains:
Additionalrevenuefromservices(7,500hoursx$2)$15,000
Cost(atpreviouscostlevel)savedonservices
nolongerperformedforDepartmentA(500x$4)2,000$17,000
Losses:
RevenuesfromservicingDepartmentA,atoldprices
500x$105,000
Additionalvariablecostsatnewlevel(7,500x$1)7,500
Additionalfixedcosts8,00020,500
Decreaseinprofit$
(3,500)
NotetotheInstructor:Thisproblemillustratesonedifficultyin
usingprofitcentersevenwhennooutsideserviceiscontemplated.The
chargebythemaintenancedepartmentishighenoughtoencouragethemanager
ofDepartmentAtoreducehisuseoftheserviceattheexpenseofincreasing
hisvariableproductioncosts.(Itisinhisbestinteresttodoso.)The
managerofthemaintenancedepartmentwouldprobablynotwanttoreducethe
pricetothismanager,lestheorshebeforcedtogivethesamereductionto
allotherdepartments.Onesolutionwouldbeforahigherlevelmanagerto
orderthemanagerofDepartmentAtoretainthecurrentprocess;butsuchan
action,iftakenveryoften,wouldcertainlyreduceifnoteliminatethe
valueoftheprofitcenterconceptasamotivatingdevice.
945CostAllocation(2530minutes)
1.$238,750tocleanersand$1,671,250totheothers
DirectPercentage
LaborHoursofTotalx$1,910,000=Allocation
Cleaners50,00012.5$238,750
Allothers350,00087.51,671,250
Totals400,000100.0$1,910,000

2.$208,450tocleanersand$1,701,550totheothers
DirectPercentage
LaborHoursofTotalx$1,580,000=Allocation
Cleaners50,00012.5$197,500
Allothers350,00087.51,382,500
Totals400,000100.0$1,580,000

928

Percentage
RecordkeepingofTotalx$180,000=Allocation
Cleaners6,0004.0$7,200
Allothers144,00096.0172,800
Totals150,000100.0$180,000

NumberPercentage
ofPartsofTotalx$150,000=Allocation
Cleaners1002.5$3,750
Allothers3,90097.5146,250
Totals4,000100.0$150,000

CleanersAllOthersTotals
Laborbased$197,500$1,382,500$1,580,000
Recordkeeping7,200172,800180,000
Parts3,750146,250150,000
Totals$208,450$1,701,550$1,910,000

3.Labor

BasedMultipleBases
Directcosts$16.50$16.50
Indirectcosts*7.966.95
Totalcasecost$24.46$23.45
*$238,750/30,000=$7.96(rounded)frompreviousassignment;
$208,450/30,000=$6.95(rounded)
Thecostofcleanersislowerunderthemultipleallocationbecausecleaners
arerelativelyheavierinlaborhoursthanintheotheractivities.
NotetotheInstructor:Youmightwishtoreinforcethepointthatall
costswillstillbeallocatedsomewhere,sothatthelowercalculatedcostof
cleanerswillbeoffsetbyhighercostsforotherproducts.Whetherthe
$1.01differenceismaterialheredependsonthedecisionoranalysisat
hand.The
principalpointisthatthewayinwhichallocationsaremadeinfluencesthe
reportedcost,whichcould,inturn,influencedecisions.
946CostAllocationsinaUniversity(1520minutes)
Thecurrentsystemisaboutasbadaspossible.Allocatingactualcosts
overperiodsasshortasamonthmakesperunitandmonthlycharges
fluctuate,notonlywiththeuseagivenschoolordepartmentmakesofthe
service,butalsowiththeusethatotherunitsoftheuniversitymakein
thatmonth.Theproblemcouldhavebeenavoidedhadthedean(1)knownin
advancehowthechargeswerecomputed,and(2)persuadedfacultymembersto
docopyinginmonthsofpeakuse.Ofcourse,ifotherdeansactedthesame
way,themachineswouldprobablyrunonlyafewmonthsoftheyear.
Oneofthefollowingtransferpricingschemesispreferable.
1.Chargeonlyforthecostofpaper(variablecost),at$.02($700/35,000).
2.Chargeat$.057percopy,theaveragecostduringanormalmonth($8,600/
150,000).
3.Chargeonlyforpaperforindividualcopiesandchargetheschoolsor
departmentswithfixedcostsonsomeotherbasis,forexample,in
proportiontotherelativeuseoftheservice.
929

4.Setapricesomewhatabovevariablecost,perhapsevenaboveaverage
total
costperunit(e.g.,$.07or$.08percopy).Thischargeshould
discourageoverusebetterthantheothersmentioned.Overusemightlead
toincreasedfixedcostsforadditionalmachinesandsalaries.
NotetotheInstructor:Thisproblemoffersaparticularlygoodbasis
fordiscussionoftherelationshipbetweencostallocationsandtransfer
prices,andtheextenttowhichalternativetransferpricingschemescanbe
interpretedtotransformcostcentersintoartificialprofitcenters.Oneof
thecommonallocationschemesinvolvesallocatingcostsonthebasisofthe
volumeofservicesusedbythecostreceivingdepartments,asisthecase
withtheprinting/duplicatingdepartmentintheproblem.Wehavesuggested
somerefinementsoftheallocationscheme,butnoneofthealternativestake
onthecharacterofatransferpricesoastoturntheservicingdepartment
intoanartificialprofitcenter.

947AllocationofCosts

DistributionChannels(3035minutes)
1.Theallocationsforadvertising,sellingexpenses,andgeneralexpenses
areopentoquestion.It'spossiblethatsomeexpensescouldbeidentified
withoneortheothergroupofcustomers.Forexample,advertisingintrade
publicationsreadonlybywholesalersoronlybyretailers,ifsuch
publicationsexist,couldbeassigned,ratherthanallocated.It'spossible
thatsomepersonsengagedintheactivitiesdescribedunder"selling
expenses"coulddevotefulltimetooneortheothergroupofcustomers.
Thebasesactuallybeingusedmayormaynotbereasonable;physical
volumeofsalesdoesnotbearthesameratioofwholesaletoretailasdoes
salesindollars.(Pricestowholesalersare20%lessthanthoseto
retailers.)Thisfactcastsdoubtontheproprietyofusingsalesdollarsto
allocateadvertisingandgeneralexpenses.Itwouldbearbitrarytoallocate
suchcostsbasedonunitvolume,andthedifferenceinpricesmakesiteven
morearbitrarytousesalesdollars.
Theratioofcostofsalesforeachgrouptototalcostofsales(44.4%
forwholesalebusiness,55.6%forretail)isareliableindicatorofthe
volumeofbusinessthatisaccountedforbyeachgroup.Sincethesame
productsaresoldtobothgroups,itmaybemorelegitimatetousethese
ratiosthanthesalesratiosof40%and60%.
Allocatingsellingexpensesotherthanadvertisingisquestionable.The
costsofdeliverymayreasonablybeallocatedbynumberofdeliveries,but
whethereachindividualorderisdeliveredseparatelyisnotknown.Thecost
ofcheckingcreditwouldseemtoberelatedmoretothenumberofcustomers
ineachgroupthantothenumberoforders.Presumably,acustomer'scredit
isnotcheckedatthetimeofeachorder,especiallyalongtimecustomerfor
whomcollectionexperiencewasgood.Someorderprocessingcostsare
associatedwiththenumberoforders,buttherearelikelytobefixed
elementsthatcannotbeallocatedexceptarbitrarily.Moreover,the
complexityofanorderwouldprobablyhavesomeinfluenceonthetime
requiredtoprocessit,andit'spossiblethattheordersfromonegroupof
customersaremoredifficulttoprocessthanthosefromtheother.
(Retailersmightorderfeweritemsonmoreorders,apossibilitysupportedby
thefactthatretailershavetwiceasmanyordersaswholesalers,sincethey
havetwothirdsofthesellingexpensesallocatedtotheirbusiness.)

930

Salespeople'sexpensesassociatedwithtravel,visitingcustomers,and
securingorderswouldseemtohavelittlerelationshiptothenumberof
ordersreceived.It'spossiblethatavisitgenerallyresultsinanorder,
butitwouldberelativelyeasytodeterminethenumberofvisitstothetwo
groups.Evenusingthenumberofvisitsasanallocationdevicewouldbe
arbitrarybecausetheexpensesassociatedwithsalespeople'sactivitiescan
beexpectedtobejointwithrespecttocustomersunlesseachsalesperson
coversonlyonegroup.Ifeachsalespersondoescoveronlyonegroup,the
expensesareassignableandshouldbeidentifiedwiththeappropriategroup.
2.Basedontheinformationavailable,noneoftheadvertising,selling,and
generalexpenseshavebeenallocatedonthestatementbelow.
WholesalersRetailersTotal
Sales$2,000,000$3,000,000$5,000,000
Costofsales$1,600,000$2,000,000$3,600,000
Salescommissions60,00090,000150,000
Managers'salaries18,00018,00036,000
Totalassignablecosts$1,678,000$2,108,000$3,786,000
Contributiontounallocatedcosts$322,000$892,000$1,214,000
Unallocatedcosts370,000
Income$844,000
3.Someoftheotherinformationthatwouldbehelpfulhasbeenreferredto
inrequirement1.Analysesofvariouscostsmightturnupamountsthatcan
bedirectlyassignedtooneofthegroups.Advertisinginpublicationsthat
reachonlyonegroupisoneexample.Salespeoplewhocallonlyononekind
ofcustomerisanother.Thecostofrunningcreditcheckscouldbebetter
relatedtothenumbersofcustomersinthegroupsiftheyareontheaverage
ofequalcreditstanding.
Analysescouldbemadeofcertainkindsofactivitiestotryto
establishfixedandvariablecomponentsofthecost.Thecostofpaperand
suppliesusedinprocessingordersisprobablydirectlyassignable,butit
mightnotbeworthwhiletogotosuchlengthsiftheamountsofassignable
costdiscoveredaresmall.Norwouldextensivevolumecoststudiesbewise
ifthevariablecomponentsofthecostsbeingstudiedareinsignificant.
948AllocationsandBehavior(1520minutes)
1.$3.0millionbeforeand$2.925millionafter,adifferenceofonly
$75,000.
BeforeAfter
Indirectcostperunit$120$117
Times25,000unitsequalstotalindirectcost$3,000,000$2,925,000

931

2.Preliminarycalculations
Increaseinmaterialcosts[($85$80)/$80]6.3%
Decreaseindepartmentallaborcosts[($24$18)/$24]25.0%
Approximatetotalnewlaborcost($2,000,000x90%)$1,800,000
Totalindirectcost,approximations:
Original($2,000,000x500%)$10,000,000
New($1,800,000x650%)$11,700,000
Increase($1,700,000/$10,000,000)17.0%
Decreaseinunitcostofproduct[($224$220)/$224]1.8%
Decreaseinindirectcostallocatedtoproduct
($120$117)/$120,or($3,000,000$2,925,000)/$3,000,0002.5%
Theresultsaredisappointingbecausea25%decreaseinlabortimeand
costyieldedonlya1.8%decreaseintotalunitcostoftheexampleproduct.
Severalfactorsinteractedtooffsetthelaborsavings.Themostobvious
interaction,suggestedintheproblem,istheincreaseinmaterialcost
(6.3%)thataccompaniedthesavingsinlabor.Lessobvious,because
allocatedindirectcostsdiddecline,isa17%increaseintotalindirect
costs.
Alessthanproportionatedeclineintotalandallocatedoverheadisto
beexpectedbecausesomeindirectcostsarefixed.Theincreaseintotal
indirectcostssuggeststhatsomeindirectcostsarerelatedtoactivities
otherthanlabor.Forexample,theuseofnew,moreexpensivematerialsand
partscouldbringincreasesincostsofpurchasing,inspecting,safeguarding,
andothermaterialrelatedactivities.Theresultsofthelaborreduction
effortssuggestthatthecompanymightbenefitfromathoroughstudythat
identifiesitscostdrivers.

949ActivitybasedAllocationsandBehavior(Extensionof10

48)(1520
minutes)
1.Ratecalculations
Related
ActivityIndirectCosts/AmountofActivity=Rate
Labor$4,940,000$1,740,000$2.8391
Recordkeeping$420,0001,200,000$0.3500
Materials$5,650,000$24,000,000$0.2354
Engineering$370,0002,000$185.0000
2.AllocationtoDepartmentZandproductline
DepartmentZ

ActivityRateActivityAllocation
Labor$2.8391$450,000$1,277,595
Recordkeeping0.3500200,00070,000
Materials0.2354$2,125,000500,225
Engineering185.000015027,750
Total$1,875,570
Materialsandcomponents$85
Directlaborat$1218
Indirect($1,875,570/25,000)75
Totalcost$178
3.Thevalueofthenewallocationschemeisnotthatitgivesalowercost
932

perunitforZ'sproduct($178asopposedto$220),butthatitchargesthe
departmentwithindirectcostsinproportiontoitsuseofspecificservices.
Thetextnotesthatallocationschemescanencourage(ordiscourage)specific
typesofbehavior.Forthecompanytobenefitfromthenewallocation
scheme,however,bothoperatingmanagersanddesignengineersmustunderstand
whatactivitiesdriveindirectcosts.Onlywithsuchunderstandingisit
possibletorecognizewhattradeoffsbetweenlaborandmaterialcostare
likelytobenefitthecompany.TheTektronixexampleinthetextdiscussed
motivatingdesignengineerstoreducethenumberofpartsand,insodoing,
reducematerialsrelatedindirectcosts.Ifoperatingmanagersunderstand
therelationshipsamonglabor,materials,andindirectcosts,theywillbe
betterabletoanalyzechangesproposedbydesignengineers.
950PerformanceMeasurementinanAutomobileDealership(2530minutes)
1.Theschemeisdisadvantageousforthenewcarmanagerbecausehis
performanceisdirectlyaffectedbysomethingnotunderhiscontrol.The
usedcarmanagermightsettheofferingpricessolowthatitbecomes
difficulttosellnewcars.(Theofferingpricescouldbelowbecause,as
indicatedinthecase,usedcarsalesmaybeslowandthelotfull.)There
isadisadvantagefortheusedcarmanagerifthetransferpriceisthe
tradeinallowancegivenbythenewcarsalesman.Ifthetradeinallowance
ischargedtotheusedcarmanager,theprofitsonusedcarsaleswillbe
affectedbythesalestransactionseffectedbythenewcarmanager.
2.Althoughthenewcarmanagerisfreetogoelsewheretoobtainapricehe
considersreasonableforaspecifictradein,itseemsquitepossiblethat
thisopportunitywillbeusedasabargainingpointbythenewcarmanagerto
promptanequalofferinternally.Thetwomanagerscouldspendsomuchtime
bickeringthattheyneglectother,moreprofitablework.Evenifthenewcar
managerdecidestotakethetradedincartoanoutsidebuyer,hewillbe
takingtimeawayfromhisprimarytaskofsellingnewcars;heis,ineffect,
goingintotheusedcarbusiness.Nevertheless,theopportunitytodealwith
anoutsidebuyerdoestendtoeliminatetheinfluenceoftheusedcarmanager
onthenewcarmanager'sperformancemeasure.
Thenewproceduredoesnotreallyencouragetheusedcarmanagerto
quotepricesotherthanwouldhavebeenquotedundertheoldprocedureexcept
inoneinstance.Ausedcarmanagerinneedofcarsisencouragedtoquotea
pricethatisinexcessofthemostlikelypriceavailableoutsidethefirm.
Ifthesalespricesonusedcarsaresetbycompetitivepressures,theend
resultforthetotalcompanyisasmallerinflowofresources.Generally,
theproceduresdescribedinthecasedonotreallyencouragethetwomanagers
toworktogetherforthebenefitofthetotalfirm.
NotetotheInstructor:Thebusinessmanagerofalargeautomobile
dealershiprelatedtotheauthorsthemethodusedtocompensatethat
company'snewandusedcarmanagers.Thecompanyevaluatesthetwomanagers
togetherratherthanseparately,becauseithadhadagreatdealoftrouble
usingthekindofsystemdescribedinrequirement2ofthecase.Theowner
oftheagencyfinallydecidedthattheprofitcenterconceptwassimplynot
workable.
951HomeOfficeAllocationsandDecisions(35minutes)
1.ThemanageroftheMiamiofficeisbestoffwitha5%reduction.

933

SellingPriceDecrease

5%10%
Sales*
$2,400,000x95%x120%$2,736,000
$2,400,000x90%x135%$2,916,000
Costofsales
$1,200,000x120%1,440,000
$1,200,000x135%1,620,000
Grossmargin$1,296,000$1,296,000
Othercosts:
Salariesandcommissions:
Fixed**$130,000$130,000
Variable410,400437,400
Rent,utilities,insurance86,00086,000
Homeofficecharge,at8%ofrevenue218,880233,280
Totaloperatingcosts$845,280$886,680
Profit$450,720$409,320

*Thefirstadjustmentisthereductioninsellingprice;thesecondisfor
theexpectedincreaseinvolume.Theunitpricechargedbythehome
officestaysthesame,socostofsalesincreasesbythepercentage
increaseinvolume.
**Totalsalariesandcommissionsincurrentbudget$490,000
Lessvariableportion($2,400,000x15%)360,000
Fixedportionofsalariesandcommissions$130,000

NotetotheInstructor:Aglanceattheequalgrossmarginsunderthe
twoplansshouldcausethestudenttorejectthe10%decreasebecausethe
highersalesdollarsareknowntoproducehighercommissionsandhomeoffice
charges.Moststudentswillnotrecognizethispointandwillcompletethe
incomestatementasindicatedabove.
2.Thecompanyisbestoffwitha10%reduction.Theallocatedcosts,
includingthoseinthetransferpriceforgoods,causethedifferingresults
betweenrequirements1and2.

SellingPriceDecrease

0%5%10%
Sales$2,400,000$2,736,000$2,916,000
Variablecostofsales*960,000
$960,000x120%1,152,000
$960,000x135%1,296,000
Commissions,15%360,000410,400437,400
Totalvariablecosts1,320,0001,562,4001,733,400
Contributionmargin1,080,0001,173,6001,182,600
Directfixedcosts:
Salariesascomputedinpart1130,000130,000130,000
Rent,etc.86,00086,00086,000
Totaldirectfixedcosts216,000216,000216,000
Contributiontocompany$864,000$957,600$966,600

*$2,400,000x40%=$960,000.Thefixedcostsincludedinthetransfer
pricearenotrelevanttotheanalysis.The$960,000variablecostsatthe
budgetedvolumearemultipliedbytheratiosoftheexpectedvolumetothe
budgetedvolumetodeterminethevariablecosts.Thedirectfixedcostsare
notneededhere,andtheanalysiscouldstopwithcontributionmargin.
Thedifferenceinincomesbetweenthe5%and10%reductionsisnot
large,soa5%reductioncouldbeagoodidea.Moreover,therewould
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probablybesomeincreasesincostsnotconsideredhereifMiamivolumewere
toincreaseby20%or35%.The5%reductiondoesshowalargeincreasein
contribution,sothatsomereductionalmostcertainlymakessense.
NotetotheInstructor:Thepointofthecaseisobvious:allocated
costscangetinthewayofmakinggooddecisionsbecausethe"paying"
managerseesthem,quitecorrectlyfromhisorherpointofview,as
incremental.Yetsuchcostsarenotincrementaltothefirm.Inthiscase,
variablecostsappeartoHoldentobe73%ofsales(50%forcostofsales+
15%commissions+8%forhomeofficecharges).Fromthecompany'spointof
view,variablecostsareonly55%ofsales(40%forproductioncostsand15%
forcommissions).Hence,anydecisioninvolvingholdingprices
constantsuchasthedecisiontoincreaseadvertisingtospurunit
volumemightbemadeincorrectly.Forexample,ifdollarvolumecouldbe
raisedby$500,000whileholdingpricesconstant,Holdenwouldprobablybe
willingtospendupto$135,000todoso,becausethatamountequalsthe
presentcontributionmarginonsales[$500,000x(100%73%variablecost)].
Fromthecompany'sviewpoint,theopportunitytoincreasesalesby$500,000
withoutchangingpriceswarrantsanexpenditureofupto$225,000[$500,000x
(100%55%variablecosttothefirm)].
952IncurredCostsandPerformance(1520minutes)
Theresolutionoftheproblemproposedinthememosmayvarysomewhat,
buteachmemoshouldcoverthesubstanceofthefollowingitems.
1.Therefinerymanagerhasnocontroloverthe$3difference;hecanget
thehelpheneedsat$7perhourandshouldnotbechargedat$10perhour.
Heshouldbechargedthe$7perhourbecausehedoesneedthehelp(forwhich
heknowshewouldhavetopay$7)andisnotjusttakingonexcessworkers.
2.Thereasonforthecompany'spolicyofemployingthedriversyearround
attheirwinterratesisimportantindevelopingareasonablewaytoassign
thecostsassociatedwiththatpolicy.Either(1)topmanagersconsiderthe
arrangementtobeeconomicallysound,or(2)themanagersperceivean
obligationtothedrivereventhoughyearroundemploymentatthehigherrate
isnoteconomicallysound.
Supposethemanagerofthefueloildistributiondepartment,andhis
superiors,believethatitisbettertokeepthedriversonallyearbecause
notdoingsowouldresultinthelossofqualifiedworkers,extensivehiring
andtrainingcosts,andhigheroperatingcosts.Itcouldbearguedthatthe
managerofthefueloildistributiondepartmentisreceivingalargebenefit
fromtherefinerymanagerwhoisprovidingthesummeremployment.Under
thesecircumstances,itwouldseemreasonabletochargethefueloil
distributionmanagerwiththe$3perhourdifferencebetweenthewagespaid
andthewagesatwhichtherefinerymanagercouldobtainqualifiedhelp.
Suppose,ontheotherhand,thatthecompany'stopmanagersknowitis
economicallyunsoundtoprovideyearroundemploymentattheusualpaybut
theybelievethecompanyhasanobligationtodoso.Themanageroffueloil
distributionhasnocontroloverthepractice,isnotdirectlyresponsible
forthedifferenceinwages,andshouldnotbechargedwiththewage
differential($3).Managersatamuchhigherlevelhavemadethedecision,
andtherefinerymanagershouldnotbeheldresponsibleforthe$3difference
either.Onepossibilityundertheseconditionsistoleavethe$3perhour
differenceunallocated.Althoughmanymanagersandaccountantswouldobject
tothatsuggestion,adherencetotheprincipleofcontrollabilitywould
935

precludechargingthedifferencetoeithertherefinerymanagerorthe
distributionmanager.Thedistributionmanagermightgetsomebenefitfrom
havingthedriversemployedyearround(becauseofreducedturnover,better
morale,lowercostsofhiringandtraining,etc.),butitisassumedthat
thosebenefitswerenotsufficienttojustifythedecisiontoprovide
yearroundemploymentonsolelyeconomicgrounds.

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