CHAPTER 14
COST ALLOCATION, CUSTOMER-PROFITABILITY
ANALYSIS, AND SALES-VARIANCE ANALYSIS
14-1Disagree. Cost accounting data plays a key role in many management planning and control decisions. The division president will be able to make better operating and strategy decisions by being involved in key decisions about cost pools and cost allocation bases. Such an understanding, for example, can help the division president evaluate the profitability of different customers.
14-2The salary of a plant security guard would be a direct cost when the cost object is the security departmentof the plant. It would be an indirect cost when the cost object is a product.
14-3Exhibit 14-1 outlines four purposes for allocating costs:
1. To provide information for economic decisions.
2. To motivate managers and employees.
3. To justify costs or compute reimbursement.
4. To measure income and assets for reporting to external parties.
14-4Exhibit 14-2 lists four criteria used to guide cost allocation decisions:
1. Cause and effect.
2. Benefits received.
3. Fairness or equity.
- Ability to bear.
The cause-and-effect criterion and the benefits-received criterion are the dominant criteria when the purpose of the allocation is related to the economic decision purpose or the motivation purpose.
14-5Using the levels approach introduced in Chapter 7, the salesvolume variance is a Level 2 variance. By sequencing through Level 3 (salesmix and salesquantity variances) and then Level 4 (marketsize and marketshare variances), managers can gain insight into the causes of a specific sales-volume variance caused by changes in the mix and quantity of the products sold as well as changes in market size and market share.
146The total salesmix variance arises from differences in the budgeted contribution margin of the actual and budgeted sales mix. The composite unit concept enables the effect of individual product changes to be summarized in a single intuitive number by using weights based on the mix of individual units in the actual and budgeted mix of products sold.
147A favorable salesquantity variance arises because the actual units of all products sold exceed the budgeted units of all products sold.
148The salesquantity variance can be decomposed into (a) a marketsize variance (because the actual total market size in units is different from the budgeted market size in units), and (b) a market share variance (because the actual market share of a company is different from the budgeted market share of a company). Both variances use the budgeted average contribution margin per unit.
149Some companies who believe that reliable information on total market size is not available, choose not to compute marketsize and marketshare variances.
1410Customer profitability analysis highlights to managers how individual customers differentially contribute to total profitability. It helps managers to see whether customers who contribute sizably to total profitability are receiving a comparable level of attention from the organization.
1411Companies that separately record (a) the list price and (b) the discount have sufficient information to subsequently examine the level of discounting by each individual customer and by each individual salesperson.
1412No. A customerprofitability profile highlights differences in current period's profitability across customers. Dropping customers should be the last resort. An unprofitable customer in one period may be highly profitable in subsequent future periods. Moreover, costs assigned to individual customers need not be purely variable with respect to shortrun elimination of sales to those customers. Thus, when customers are dropped, costs assigned to those customers may not disappear in the short run.
1413Five categories in a customer cost hierarchy are identified in the chapter. The examples given relate to the Spring Distributor Company used in the chapter:
•Customer outputunitlevel costs – costs of activities to sell each unit (case) to a customer. An example is producthandling costs of each case sold.
•Customer batchlevel costs – costs of activities that are related to a group of units (cases) sold to a customer. Examples are costs incurred to process orders or to make deliveries.
•Customersustaining costs – costs of activities to support individual customers, regardless of the number of units or batches of product delivered to the customer. Examples are costs of visits to customers or costs of displays at customer sites.
•Distributionchannel costs – costs of activities related to a particular distribution channel rather than to each unit of product, each batch of product, or specific customers. An example is the salary of the manager of Spring's retail distribution channel.
•Corporatesustaining costs – costs of activities that cannot be traced to individual customers or distribution channels. Examples are top management and general administration costs.
1414A process where the inputs are nonsubstitutable leaves workers no discretion as to the inputs (such as, types of materials or labor) to use. A process where the inputs are substitutable means there is discretion about the exact number and type of inputs to produce output.
1415The direct materials efficiency variance is a Level 3 variance. Further insight into this variance can be gained by moving to a Level 4 analysis where the effect of mix and yield changes are quantified. The mix variance captures the effect of a change in the relative percentage use of each input relative to that budgeted. The yield variance captures the effect of a change in the total number of inputs required to obtain a given output relative to that budgeted.
14-16(15-20 min.) Cost allocation in hospitals, alternative allocation
criteria.
1.Direct costs=$2.40
Indirect costs=$11.52 – $2.40 = $9.12
Overhead rate== 380%
2.The answers here are less than clear-cut in some cases.
Overhead Cost Item / Allocation CriteriaProcessing of paperwork for purchase
Supplies room management fee
Operating-room and patient-room handling costs
Administrative hospital costs
University teaching-related costs
Malpractice insurance costs
Cost of treating uninsured patients
Profit component / Cause and effect
Benefits received
Cause and effect
Benefits received
Ability to bear
Ability to bear or benefits received
Ability to bear
None. This is not a cost.
3.Assuming that Meltzer's insurance company is responsible for paying the $4,800 bill, Meltzer probably can only express outrage at the amount of the bill. The point of this question is to note that even if Meltzer objects strongly to one or more overhead items, it is his insurance company that likely has the greater incentive to challenge the bill. Individual patients have very little power in the medical arena. In contrast, insurance companies have considerable power and may decide that certain costs are not reimbursable––for example, the costs of treating uninsured patients.
14-17 (15 min.)Cost allocation and motivation.
Because corporate policy encourages line managers to seek legal counsel on pertinent issues from the Legal Department, any step in the direction of reducing costs of legal department services would be consistent with the corporate policy.
Currently a user department is charged a standard fee of $400 per hour based on actual usage. It is possible that some managers may not be motivated to seek the legal counsel they need due to the high-allocated cost of the service. It is also possible that those managers whose departments are currently experiencing budgetary cost overruns may be disinclined to make use of the service; it would save them from the Legal Department’s cost allocation. However, it could potentially result in much costlier penalties for Environ later if the corporation inadvertently engaged in some activities that violated one or more laws.
14-17 (Cont’d.)
It is quite likely that the line managers would seek legal counsel, whenever there were any pertinent legal issues, if the service were free. Making the service of the Legal Department free, however, might induce some managers to make excessive use of the service. To avoid any potential abuse, Environ may want to adjust the rate downward considerably, perhaps at a level lower than what it would cost if outside legal services were sought, but not eliminate it altogether. As long as the managers know that their respective departments would be charged for using the service, they would be disinclined to make use of it unnecessarily. However, they would be motivated to use it when necessary because it would be considered a “good value” if the standard hourly rate was low enough.
14-18(30 min.)Cost allocation to divisions.
1.
Hotel
/Restaurant
/Casino
/Rembrandt
Revenue / $16,425,000 / $5,256,000 / $12,340,000 / $34,021,000Direct costs / 9,819,260 / 3,749,172 / 4,248,768 / 17,817,200
Segment margin / $ 6,605,740 / $1,506,828 / $ 8,091,232 / 16,203,800
Indirect costs / 14,550,000
Income before taxes / $ 1,653,800
Segment margin % / 40.22% / 28.67% / 65.57%
2.
Hotel
/Restaurant
/Casino
/Rembrandt
Direct costs / $9819260 / $3749172 / $4248768 / $17817200Direct cost % / 55.11% / 21.04% / 23.85% / 100.00%
Square footage / 80,000 / 16,000 / 64,000 / 160,000
Square footage % / 50.00% / 10.00% / 40.00% / 100.00%
# of Employees / 200 / 50 / 250 / 500
# of Employees % / 40.00% / 10.00% / 50.00% / 100.00%
A: Cost allocation based on direct costs:
Hotel
/Restaurant
/Casino
/Rembrandt
Revenue / $16,425,000 / $ 5,256,000 / $12,340,000 / $34,021,000Direct costs / 9,819,260 / 3,749,172 / 4,248,768 / 17,817,200
Segment margin / 6,605,740 / 1,506,828 / 8,091,232 / 16,203,800
Allocated indirect costs / 8,018,505 / 3,061,320 / 3,470,175 / 14,550,000
Segment pre-tax income / $( 1,412,765) / $ (1,554,492) / $ 4,621,057 / $ 1,653,800
Segment pre-tax income % / -8.60% / -29.58% / 37.45%
14-18 (Cont’d.)
B: Cost allocation based on floor space:
Hotel
/Restaurant
/Casino
/Rembrandt
Allocated indirect costs / $7,275,000 / $1,455,000 / $5,820,000 / $14,550,000Segment pre-tax income / $ (669,260) / $ 51,828 / $2,271,232 / $ 1,653,800
Segment pre-tax income % / -4.07% / 0.99% / 18.41%
C: Cost allocation based on # of employees
Hotel
/Restaurant
/Casino
/Rembrandt
Allocated indirect costs / $5,820,000 / $1,455,000 / $7,275,000 / $14,550,000Segment pre-tax income / $ 785,740 / $ 51,828 / $ 816,232 / $ 1,653,800
Segment pre-tax income % / 4.78% / 0.99% / 6.61%
- The segment pre-tax income percentages show the dramatic effect of choice of the cost allocation base on reported numbers:
Denominator / Hotel / Restaurant / Casino
Direct costs / -8.60% / -29.58% / 37.45%
Floor space / -4.07 / 0.99 / 18.41
# of employees / 4.78 / 0.99 / 6.61
The decision context should guide a. whether costs should be allocated, and b. the preferred cost allocation base. Decisions about, say, performance measurement may be made on a combination of financial and nonfinancial measures. It may well be that Rembrandt may prefer to exclude allocated costs from the financial measures to reduce areas of dispute.
Where cost allocation is required, the cause-and-effect and benefits-received criteria are recommended in Chapter 14. The $14,550,000 is a fixed overhead cost. This means that on a short-run basis, the cause-and-effect criterion is not appropriate but Rembrandt could attempt to identify the cost drivers for these costs in the long run when these costs are likely to be more variable. Rembrandt should look at how the $14,550,000 cost benefits the three divisions. This will help guide the choice of an allocation base in the short run.
4. The analysis in requirement 2 should not guide the decision on whether to shut down any of the divisions. The overhead costs are fixed costs in the short run. It is not clear how these costs would be affected in the long run if Rembrandt shut down one of the divisions. Also, each division is not independent of the other two. A decision to shut down, say, the restaurant likely would negatively affect the attendance at the casino and possibly the hotel. Rembrandt should examine the future revenue and future cost implications of different resource investments in the three divisions. This is a future-oriented exercise, whereas the analysis in requirement 2 is an analysis of past costs.
14-19 (25 min.) Cost allocation to divisions.
1.PulpPaperFibers
Segment margin$3,200,000$7,100,000 $9,700,000
Percentages 16.0% 35.5% 48.5%
Allocation: ($9,000,000 ×
16.0%, 35.5%, 48.5%)$1,440,000$3,195,000$4,365,000
- Percentages for new bases of allocation
PulpPaperFibers
Number of employees 300 250 450
Percentages 30% 25% 45%
Floor space (square feet)30,00024,00066,000
Percentages 25% 20% 55%
Divisional administrative$1,200,000$1,800,000$3,000,000
Percentages20%30%50%
Allocation of indirect costs
PulpPaperFibers
Human resource management
($1,800,000 × 30%, 25%, 45%)$ 540,000$ 450,000$ 810,000
Facility
($2,700,000 × 25%, 20%, 55%) 675,000 540,000 1,485,000
Corporate administration
($4,500,000 × 20%, 30%, 50%) 900,000 1,350,000 2,250,000
Total$2,115,000$2,340,000$4,545,000
3. The new approach is preferable because it is based on cause-and-effect relationships between costs and their respective cost drivers in the long run.
Human resource management costs are allocated using the number of employees in each division because the costs for recruitment, training, etc., are mostly related to the number of employees in each division. Facility costs are mostly incurred on the basis of space occupied by each division. Corporate administration costs are allocated on the basis of divisional administrative costs because these costs are incurred to provide support to divisional administrations.
14-20(2030 min.) Customer profitability, service company.
1.(in thousands)
CustomerRevenues /
Customer
Costs / CustomerOperating Income
Avery Group
Duran Systems
Retail Systems
Wizard PartnersSanta Clara College
Grainger Services
Software Partners
Problem Solvers
Business Systems
Okie Enterprises / $ 260
180
163
322
235
80
174
76
137
373 / $182
184
178
225
308
74
100
108
110
231 / $ 78
(4)
(15)
97
(73)
6
74
(32)
27
142
Solution Exhibits 14-20A and 14-20B present the summary results. The two most profitable customers provide 80% of total operating income.
2.The options Instant Service should consider include:
a.Increase the attention paid to Okie Enterprises and Wizard Partners. These are "key customers," and every effort has to be made to ensure they retain IS. IS may well want to suggest a minor price reduction to signal how important it is in their view to provide a cost-effective service to these customers.
b.Seek ways of reducing the costs or increasing the revenues of the problem accounts––Santa Clara College and Problem Solvers. For example, are the copying machines at Santa Clara outdated and in need of repair? If yes, an increased charge may be appropriate. Can IS provide better on-site guidelines to users about ways to reduce breakdowns?
c.As a last resort, IS may want to consider dropping particular accounts. For example, if Santa Clara College will not agree to a fee increase but has machines continually breaking down, IS may well decide that it is time not to bid on any more work for this customer.
3.Major problems in accurately estimating the operating costs of each customer are:
a.Basic underlying records may not be accurate. For example, some technicians include travel time, break time, etc., in their time records to create an appearance of high work effort.
b.Not all costs for individual repair people are easily assignable to individual customers. For example, how is the cost of a trip to pick up parts for three customers assigned among individual customers?
c.Many costs of IS are not related to specific customers. For example, advertising by IS is aimed at a general market rather than being targeted to a specific potential customer.
14-20 (Cont’d.)
Solution Exhibit 14-20A
Panel A: Customers Ranked on Customer-Level Operating Income
CustomerOperating Income
(1) / Customer
Revenue
(2) / Customer
Operating
Income
Divided
By Revenue
(3) = (1) ÷ (2) / Cumulative Customer Operating Income
(4) / Operating Income as
a % of Total
Operating Income
(5) = (4) $300
Okie Ent. / $142 / $ 373 / 38% / $142 / 47%
Wizard P. / 97 / 322 / 30 / 239 / 80
Avery Group / 78 / 260 / 30 / 317 / 106
Software P. / 74 / 174 / 43 / 391 / 130
Business S. / 27 / 137 / 20 / 418 / 139
Grainger S. / 6 / 80 / 8 / 424 / 141
Duran S. / (4) / 180 / (2) / 420 / 140
Retail S. / (15) / 163 / (9) / 405 / 135
Problem S. / (32) / 76 / (42) / 373 / 124
Santa Clara / (73) / 235 / (31) / 300 / 100
$300 / $2,000
14-20 (Cont’d.)
Solution Exhibit 14-20B
Bar Chart of Customer Operating Income
14-21(2025 min.) Customer profitability, distribution.
1.The activity-based costing for each customer is:
/ CharlestonPharmacy / Chapel Hill
Pharmacy
1.Order processing,
$40 × 12; $40 × 10 $ 480 $ 400
2.Line-item ordering,
$3 × (12 × 10;10 × 18) 360 540
3.Store deliveries,
$50 × 6; $50 ×10 300 500
4.Carton deliveries,
$1 × (6 × 24; 10 × 20) 144 200
5.Shelf-stocking,
$16 × (6 × 0; 10 × 0.5) 0 80
Operating costs $1,284 $1,720
The operating income of each customer is:
/ CharlestonPharmacy / Chapel Hill
Pharmacy
Revenues,
$2,400 × 6; $1,800 × 10 $14,400 $18,000
Cost of goods sold,
$2,100 × 6; $1,650 × 10 12,600 16,500
Gross margin 1,800 1,500
Operating costs 1,284 1,720
Operating income $ 516 $ (220)
Chapel Hill Pharmacy has a lower gross margin percentage than Charleston (8.33% vs. 12.50%) and consumes more resources to obtain this lower margin.
- Ways Figure Four could use this information include:
a.Pay increased attention to the top 20% of the customers. This could entail asking them for ways to improve service. Alternatively, you may want to highlight to your own personnel the importance of these customers; e.g., it could entail stressing to delivery people the importance of never missing delivery dates for these customers.
b.Work out ways internally at Figure Four to reduce the rate per cost driver; e.g., reduce the cost per order by having better order placement linkages with customers. This cost reduction by Figure Four will improve the profitability of all customers.
c.Work with customers so that their behavior reduces the total "system-wide" costs. At a minimum, this approach could entail having customers make fewer orders and fewer line items. This latter point is controversial with students; the rationale is that a reduction in the number of line items (diversity of products) carried by Ma and Pa stores may reduce the diversity of products Figure Four carries.
14-21 (Cont'd.)
There are several options here:
•Simple verbal persuasion by showing customers cost drivers at Figure Four.
•Explicitly pricing out activities like cartons delivered and shelf-stocking so that customers pay for the costs they cause.
•Restricting options available to certain customers, e.g., customers with low revenues could be restricted to one free delivery per week.
An even more extreme example is working with customers so that deliveries are easier to make and shelf-stocking can be done faster.
d.Offer salespeople bonuses based on the operating income of each customer rather than the gross margin of each customer.
Some students will argue that the bottom 40% of the customers should be dropped. This action should be only a last resort after all other avenues have been explored. Moreover, an unprofitable customer today may well be a profitable customer tomorrow, and it is myopic to focus on only a 1-month customer-profitability analysis to classify a customer as unprofitable.
14-22 (30–40 min.) Variance analysis, multiple products.
1.
=
Lower-tier tickets=(3,300 – 4,000) $20=$14,000 U
Upper-tier tickets=(7,700 – 6,000) $ 5= 8,500 F
All tickets $ 5,500 U
2.
=
= =
=$11 per unit (seat sold)
14-22 (Cont'd.)
Sales-mix percentages:
Budgeted / ActualLower-tier / = 0.40 / = 0.30
Upper-tier / = 0.60 / = 0.70
Solution Exhibit 14-22 presents the sales-volume, sales-quantity, and sales-mix variances for lower-tier tickets, upper-tier tickets, and in total for Detroit Penguins in 2004.