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# Accounting for Decision Making and Control 9th Edition Test Bank Zimmerman

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Chapter 07
Cost Allocation: Theory

Multiple Choice Questions

1. Which is not a reason for allocating internal costs to cost objects?

A. Managers should be charged for benefits received by departments (or products) under their control

B. US GAAP requires allocation of factory overheads

C. To determine the selling price of products

D. To determine the amount to be reimbursed under a cost-reimbursement contract

E. All of the above are reasons for allocating internal costs to cost objects

2. You are going to dinner with three friends, one who likes steak, another wine, and the third is a vegetarian (which is assumed to be the least expensive). Which is true?

A. How the bill is shared has no effect on what and how much people choose to eat

B. Equal sharing of the bill ensures that people order a similar dollar amount of food

C. The wine-drinker will argue for equal shares, and will drink as fast (and/or as much) as possible

D. The vegetarian will be better off with equal shares

E. None of the above

3. A sound allocation system should:

A. be cheap and easy to administer

B. provide incentives for cost control

C. charge in proportion to amount used or benefit received

D. be perceived as equitable by those who are charged

E. be all of the above

4. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the direct materials and direct labor cost (i.e., the prime cost) per drum?

A. \$1,433.33

B. \$1,413.33

C. \$1,313.33

D. \$1,293.33

E. None of the above

5. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the conversion cost (direct labor and overhead) per drum?

A. \$191.67

B. \$287.40

C. \$311.67

D. \$315.67

E. None of the above

6. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the full cost per drum?

A. \$1,725.00

B. \$1,700.73

C. \$1,625.00

D. \$1,609.00

E. None of the above

7. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

A government agency wants to purchase 200 drums of Xentra at cost plus a flat fee. Which allocation method gives the profit-maximizing result?

A. The current method of determining cost

B. Allocating overheads per machine hour

C. Allocating overheads per direct labor hour

D. Allocating overheads per pound

E. None of the above

8. If Pluton selects the cost allocation method indicated by your answer to Q7-7, how much will profits increase on this order compared with the present system?

A. No change

B. Change by \$31,666.67

C. Change by \$17,571.43

D. Change by \$6,380.95

E. None of the above

9. Which of the following are true about cost allocation?

A. Cost allocation is a form of transfer pricing for indirect costs

B. Cost allocation is an internal tax on services

C. Cost allocation distorts choices that managers would make otherwise

D. Cost allocation should be imposed when marginal cost exceeds average cost of an internal resource

E. All of the above

10. King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to \$4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh.

If KKC uses the simplest algorithm to allocate power costs, which is not true?

A. Kong will be charged \$1.6 million

B. Kang will be charged \$2.18 million

C. Kangs charge will depend on Kongs usage

D. Since the production departments consume the vast majority of the plants power costs, it is not cost-efficient to allocate power costs to the service departments

E. All are true

11. King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to \$4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh.

In the following month, the power generation department costs amounted to \$4.3 million for 51 million kwh. Kong Dept.s usage was the same, but the Kang Dept. increased output to 4.1 million kangs, each using the standard power allowance. If KKC employs an insulating cost allocation mechanism, and fixed costs are shared equally, which is true?

A. Kang will be charged \$1.93 million

B. Kong will be charged \$1.79 million

C. Kong will be charged \$2.07 million

D. Kang will be charged \$2.29 million

E. None of the above

Essay Questions

12. Cost Allocation and Contingency Fees

A lawyer allocates overhead costs based on his hours working with different clients. The lawyer expects to have \$200,000 in overhead during the year and expects to work on clients cases 2,000 hours during the year. In addition, she wants to pay herself \$50 per hour for working with clients. In other words, the lawyers billing rate is the sum of her hourly fee (\$50) and a fee to recover the expected overhead spread over 2,000 hours. The lawyer, however, does not bill all of her clients based on covering overhead costs and her own salary. Some clients pay her on contingency fees. If the lawyer works with a client on a contingency fee basis, the lawyer receives half of any settlement for her client. During the year the lawyer works 1,200 hours that are billable to clients. The remaining hours are worked on a contingency basis. The lawyer wins \$300,000 in settlements for his clients of which she receives half. Actual overhead was \$210,000.

Required:

What does the lawyer earn during the year after expenses?

13. Fixed Costs and Allocated Costs

The maintenance departments costs are allocated to other departments based on the number of hours of maintenance use by each department. The maintenance department has fixed costs of \$500,000 and variable costs of \$30 per hour of maintenance provided. The variable costs include the salaries of the maintenance workers. More maintenance workers can be added if greater maintenance is demanded by the other departments without affecting the fixed costs of the maintenance department. The maintenance department expects to provide 10,000 hours of maintenance.

Required:

a. What is the application rate for the maintenance department?
b. What is the additional cost to the maintenance department of providing another hour of maintenance?
c. What problem exists if the managers of other departments can choose how much maintenance to be performed?
d. What problem exists if the other departments are allowed to go outside the organization to buy maintenance services?

14. Choosing Allocation Bases for Levying Taxes

The town of Seaside has decided to construct a new sea aquarium to attract tourists. The cost of the measure is to be paid by a special tax. Although most of the townspeople believe the sea aquarium is a good idea, there is disagreement about how the tax should be levied.

Required:

Suggest three different methods of levying the tax and the advantages and disadvantages of each.

15. Outsourcing and Overhead

Peluso Company, a manufacturer of snowmobiles, is operating at 70 percent of plant capacity. Pelusos plant manager is considering manufacturing headlights, which are now being purchased for \$11 each (a price that is not expected to change in the near future). The Peluso plant has the equipment and labor force required to manufacture the headlights. The design engineer estimates that each headlight requires \$4 of direct materials and \$3 of direct labor. Pelusos plant overhead rate is 200 percent of direct labor dollars, and 40 percent of the overhead is fixed cost.

Required:

If Peluso Co. manufactures the headlights, how much of a gain (loss) for each headlight will result?

16. Incentive Effects of Cost Allocations

Eastern University prides itself on providing faculty and staff a competitive compensation package. One aspect of this package is a faculty and staff child tuition benefit of \$4,000 per child per year for up to four years to offset the cost of a college education. The faculty or staff members child can attend any college or university, including Eastern University, and receive the tuition benefit. If a staff member has three children in college one year, the staff member receives a \$12,000 tuition benefit. This money is not taxed to the individual staff or faculty member.
Eastern University pays the benefit directly to the university where the staff/faculty members child is enrolled or if the student is attending Eastern, it reduces the amount of tuition owed by the faculty/staff member. The university then charges this payment to a benefits account. This benefits account is then allocated back to the various colleges and departments based on total salaries in the college or department.

Required:

Evaluate the pros and cons of the present university accounting for tuition benefits. What changes would you recommend making?

17. Allocating Overhead versus Direct Tracing

Nixon & Ross, a law firm, is about to install a new accounting system that will allow the firm to track more of the overhead costs to individual cases. Overheads are currently allocated to individual client cases based on billable professional staff salaries. Attorneys working on client cases charge their time to billable professional staff salaries. Attorney time spent in training, law firm administrative meetings, and the like is charged to an overhead account titled unbilled staff salaries.
The following is a summary of the costs for the current year:

Billable professional staff salaries \$4,000,000
Total costs \$12,000,000

The overhead costs were as follows:

Secretarial costs \$1,500,000
Staff benefits 2,750,000
Office rent 1,250,000
Telephone and mailing costs 1,500,000
Unbilled staff salaries 1,000,000
Total costs \$8,000,000

Under the new accounting system, the firm will be able to trace secretarial costs, staff benefits, and telephone and mailing costs to specific clients.
The following are the costs incurred on the Lawson Company case:

Billable professional staff salaries \$150,000
Secretarial costs 25,000
Staff benefits 13,500
Telephone and mailing costs 8,000
Total costs \$196,500

Required:

a. Calculate the current years overhead application rate under the old cost accounting system.
b. How would this application rate change if the secretarial costs, staff benefits, and telephone and mailing costs were reclassified as direct costs instead of overhead, and overhead was assigned based on direct costs (instead of staff salaries)? Direct costs are defined as billable staff salaries plus secretarial costs, staff benefits, and telephone and mailing costs.
c. Use the overhead application rates from (a) and (b) to compute the cost of the Lawson case.
d. Nixon & Ross bills clients 150 percent of the total costs of the job. What will be the total billings to the Lawson Co. if the old overhead application scheme is replaced with the new overhead scheme?
e. Steve Nixon, managing partner, has commented that replacing the old allocation system with the direct charge method of the new accounting system will result in more accurate costing and pricing of cases. Evaluate the new system.

18. Allocating Computer Costs

The Independent Underwriters Insurance Co. (IUI) established a systems department two years ago to implement and operate its information technology system. IUI believed that its own system would be more cost-effective than the service bureau it had been using.
IUIs three departments claims, records, and finance have different requirements with respect to hardware and other capacity-related resources and operating resources. The system was designed to recognize these differing demands. It was also designed to meet IUIs long-term capacity. The excess capacity designed into the system is being sold to outside users until IUI needs it. The estimated resource requirements used to design and implement the system are shown in the following schedule.

Hardware and
Other Capacity- Related Resources
Operating
Resources
Records 30% 60%
Claims 50 20
Finance 15 15
Expansion (outside use) 5 5
Total 100% 100%

IUI currently sells the equivalent of its expansion capacity to a few outside clients.
When the system became operational, management decided to redistribute total expenses of the systems department to the user departments based upon actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows:

Department Percentage
Utilization
Amount
Records 60% \$330,000
Claims 20 110,000
Finance 15 82,500
Outside 5 27,500
Total 100% \$550,000

The three user departments have complained about the cost distribution since the systems department was established. The records departments monthly costs have been as much as three times the costs experienced with the service bureau. The finance department is concerned about the costs distributed to the outside user category, because these allocated costs form the basis for the fees billed to outside clients.
James Dale, IUIs controller, decided to review the distribution method by which the systems departments costs have been allocated for the past two years. The additional information he gathered for his review is reported in Tables 1, 2, and 3. Dale has concluded that the method of cost distribution should be changed to reflect more directly the actual benefits received by the departments. He believes that hardware and capacity-related costs should be allocated to the user departments in proportion to their planned, long-term needs. Any difference between actual and budgeted hardware costs should remain with the systems department.
The remaining costs for software development and operations would be charged to the user departments based upon actual hours used. A predetermined hourly rate based upon the annual budget data would be used. The hourly rates proposed for the current fiscal year are as follows:

Function Hourly Rate
Software development \$30
Operations
Computer related \$200
Input/output related \$10

Dale plans to use first-quarter activity and cost data to illustrate his recommendations. The recommendations will be presented to the systems department and the user departments for their comments and reactions. He then expects to present his recommendations to management for approval.

Required:

a. Prepare a schedule to show how the actual first-quarter costs of the systems department will be charged to the users if James Dales recommended method is adopted.
b. Explain whether James Dales recommended system for charging costs to the user departments will

(i) Improve cost control in the systems department.
(ii) Improve planning and cost control in the user departments.
(iii) Be a more equitable basis for charging costs to user departments.

Table 1

Systems Department Costs and Activity Levels

First Quarter
Annual Budget Budget Actual
Hours Dollars Hours Dollars Hours Dollars
Hardware and other capacity-related costs \$600,000 \$150,000 \$155,000
Software development 18,750 562,500 4,725 141,750 4,250 130,000
Operations
Computer related 3,750 750,000 945 189,000 920 187,000
Input/output related 30,000 300,000 7,560 75,600 7,900 78,000
\$2,212,500 \$556,350 \$550,000

Table 2

Historical Utilization by Users

Operations
Hardware
and Other Software
Development
Computer
Input/Output
Capacity
Needs
Range
Average
Range
Average
Range
Average
Records 30% 0-30% 12% 55-65% 60% 10-30% 20%
Claims 50 15-60% 35 10-25% 20 60-80% 70
Finance 15 25-75% 45 10-25% 15 3-10% 6
Outside 5 0-25% 8 3-8% 5 3-10% 4
100% 100% 100% 100%

Table 3

Utilization of Systems Departments Services for First Quarter
(in Hours)

Operations
Software
Development Computer
Related Input/Output
Records 425 552 1,580
Claims 1,700 184 5,530
Finance 1,700 138 395
Outside 425 46 395
Total 4,250 920 7,900

19. Cost Allocations Can Distort Pricing Decisions

Kraft Foods Group used to sponsor a car in the NASCAR races. Like other major corporations that sponsor sports events, Kraft believes that the publics awareness of its products is enhanced by sponsoring a NASCAR. For the right to have Kraft displayed prominently on the automobile, Kraft pays the racing team an annual fee.
Kraft is organized around a number of business units that are profit centers. Senior management at Kraft believes that since the various business units at Kraft receive the benefits of the NASCAR exposure through greater name recognition, and hence greater sales, the costs of the program should be allocated back to the business units and ultimately to all Kraft products. The cost of the NASCAR program is allocated back to the Kraft business units based on sales revenue. Suppose the allocation is 10 percent of revenues. That is, for every \$1 of revenue, the business unit is allocated \$0.10 of cost from the NASCAR car.
One of Krafts business units sells Velveeta processed cheese in cartons containing 200 32 ounce packages. The following table summarizes possible pricing levels, cartons sold at that price, and costs for the various number of cartons.

Price Number of Cartons Sold Total Cost
\$564 218 \$71,800
562 219 71,900
560 220 72,000
558 221 72,100
556 222 72,200
554 223 72,300
552 224 72,400
550 225 72,500
548 226 72,600

Required:

a. What price-quantity combination maximizes the profits of the Velvetta, ignoring the allocation of NASCAR?
b. If \$0.10 of the NASCAR is allocated for every dollar of Velvetta revenue, what price-quantity combination of Velvetta maximizes profits after allocating NASCAR costs?
c. What price-quantity combination of Velvetta maximizes profits after allocating NASCAR costs using total costs (instead of revenues), where for every dollar of total costs, \$0.20 of NASCAR costs are allocated?
d. Instead of allocating the NASCAR based on revenues, it is allocated based on profits before allocated costs. For every \$1.00 of profits before allocated costs, \$0.30 of NASCAR costs are allocated. Now what price-quantity combination maximizes Velvetta profits after allocating NASCAR costs?
e. Should NASCAR costs be allocated to the business units, and if so, what allocation scheme should be used (revenues, costs, or profits)?

20. Evaluating Decision Alternatives Involving Overhead

Jim Shoe, chief executive officer of Jolsen International, a multinational textile conglomerate, has recently been evaluating the profitability of one of the companys subsidiaries, Pride Fashions, Inc., located in Rochester, New York. The Rochester facility consists of a dress division and a casual wear division. Daneilles Dresses produces womens fine apparel, while the other division, Tesoros Casuals, produces comfortable cotton casual clothing.
Jolsens chief financial officer, Pete Moss, has recommended that the casual wear division be closed. The year-end financials Shoe just received show that Tesoros Casuals has been operating at a loss for the past year, while Daneilles Dresses continues to show a respectable profit. Shoe is puzzled by this fact because he considers both managers to be very capable.
The Rochester site consists of a 140,000-square-foot building where Tesoros Casuals and Daneilles Dresses utilize 70 percent and 30 percent of the floor space, respectively. Fixed overhead costs consist of the annual lease payment, fire insurance, security, and the common costs of the purchasing departments staff. Fixed overhead is allocated based on percentage of floor space. Housing both divisions in this facility seemed like an ideal situation to Shoe because both divisions purchase from many of the same suppliers and have the potential to combine materials ordering to take advantage of quality discounts. Furthermore, each division is serviced by the same maintenance department. However, the two managers have been plagued by an inability to cooperate due to disagreements over the selection of suppliers as well as the quantities to purchase from common suppliers. This is of serious concern to Shoe as he turns his attention to the report in front of him.

Tesoros Casuals (\$000s) Daneilles Dresses (\$000s)
Sales revenue \$500 \$1,000
Expenses:
Direct materials (\$200) (\$465)
Direct labor (70) (130)
Selling expenses (all variable) (100) (200)
Fixed overhead (98) (42)
Variable overhead (40) (45)
Net income before taxes \$(8) \$118

Required:

a. Evaluate Pete Mosss recommendation to close Tesoros Casuals.
b. Should the overhead costs be allocated based on floor space or some other measure? Justify your answer.

21. Allocation of Space Costs

Five departments of National Training Institute, a nonprofit organization, share a rented building. Four of the departments provide services to educational agencies and have little or no competition for their services. The fifth department, Technical Training, provides educational services to the business community in a competitive market with other nonprofit and private organizations. Each department is a cost center. Revenues received by Technical Training are based on a fee for services, identified as tuition.
All five departments have dedicated space as listed in the accompanying table. Common shared space, including hallways, restrooms, meeting rooms, and dining areas, is not included in these allocations. National Training Institute rents space at \$10 per square foot.

Allocation Table
Department Square Footage Percentage of Space Revenue
Administration 13,500 9.0% \$3,600,000
Support services 46,500 31.0 11,000,000
Computer services 12,000 8.0 8,800,000
Technical training 6,000 4.0 1,900,000
Transportation 72,000 48.0 4,700,000
Total allocated 150,000 100.0% \$30,000,000
Common space 50,000

In addition to its assigned space, the technical training department offers training during off-hours using many of the areas allocated to other departments. Technical Training also uses off-site facilities for the same purpose. About 50 percent of its training activities are in off-site facilities, which have excess capacity, charge no rent, and are available only during off-hours.
John Daniels, the administration departments business manager, proposed a rental allocation plan based on each departments percentage of dedicated square footage plus the same percentage of the common space. The technical training department would be charged an additional amount for the space it uses during off-hours that is dedicated to other departments. This additional amount would be based on planned usage per year.
Jane Richards, director of technical training, claims this allocation method will cause her to increase the price of services. As a result, she will lose business to competition. She would rather see the allocation method use the percentage of department revenue in relation to total revenue.

Required:

Comment on Danielss and Richardss proposed rent allocation plans. Make appropriate recommendations.

22. Insulating vs. Non-insulating Methods and Risk Sharing

Encryption, Inc. (EI), sells and maintains fax encryption hardware and software. EI hardware and software are attached to both sending and receiving fax machines that encode/decode data, preventing anyone from wiretapping the phone line to receive a copy of the fax.
Two EI product groups (Federal Systems and International) manufacture and sell the hardware and software in different markets. Both are profit centers. Federal Systems contracts with federal government agencies to manufacture, install, and service EI products. Existing contracts call for revenues of \$1 million per quarter for the next eight quarters.
International is currently seeking foreign buyers. Expected quarterly revenues will be \$1 million, but with equal likelihood revenues can be \$1.5 or \$0.5 million in any given quarter.
Federal Systems and International each have their own products that differ in some ways but share a common underlying technology. Fax encryption is a new technology and offers new markets. Transferring manufacturing and marketing ideas across products and customers provides important synergies.
The variable cost of Federal Systems and International is 50 percent of revenues. The only fixed cost in EI is its Engineering Design group.
Engineering Design is EIs RD group. It designs new hardware and software that Federal Systems and International sell. Quarterly expenses for Engineering Design will be \$0.60 million for the next two years. These expenses do not vary with revenues or production costs.
Engineering Design costs are to be included in calculating profits for the Federal Systems and International groups. Two ways of assigning the Engineering Design costs to Federal Systems and International are (1) group revenues, and (2) an even 50-50 split.

Required:

a. Prepare financial statements for Federal Systems and International illustrating the effects of the alternative ways of handling Engineering Design costs.
b. Which method of assigning Engineering Design costs do you favor? Why?

23. Analyzing Alternative Allocation Schemes for Distribution Costs

Telstar Electronics manufactures and imports a wide variety of consumer and industrial electronics, including stereos, televisions, camcorders, telephones, and VCRs. Each line of business (LOB) handles a single product group (e.g., televisions) and is organized as a profit center. The delivery of the product to the wholesaler or retailer is handled by Telstars distribution division, a cost center. Previously, Telstar was organized functionally, with manufacturing, marketing, and distribution as separate cost centers. Two years ago, it reorganized to the present arrangement.
Distribution assembles products from the various LOBs into larger shipments to the same geographic area to capture economies of scale. The division is also responsible for inbound shipments and storage of imported products. It has its own fleet of trucks, which handles about two-thirds of the shipments, and uses common carriers for the remainder. Currently, the costs of the distribution division are not allocated to the LOBs, but LOBs do pay the cost for any special rush shipment using an overnight or fast delivery service, such as Federal Express or UPS. For example, if a customer must have overnight delivery, the LOB ships directly without using Telstars distribution center and the LOB is charged for the special delivery.
The corporate controller is mulling over the issue of allocating the costs of distribution. Several allocation schemes are possible:

1. Allocate all distribution division costs based on gross sales of the LOBs.
2. Allocate all distribution division costs based on LOB profits.
3. Allocate the direct costs of each shipment (driver, fuel, truck depreciation, tolls) using the gross weight of each LOBs product in the shipment. Then allocate the other costs of the distribution division (schedulers, management, telephones, etc.) using the total direct shipping costs assigned to each LOB.
One argument against allocating is that it will distort relative profitability. The controller says, Because allocations are arbitrary, the resulting LOB profitabilities become arbitrary. Another argument is that it is not fair to charge managers for costs they cannot control. LOBs cannot control shipping costs. For example, there are savings when two small separate shipments are combined into a single large shipment. LOBs will tend to avoid opening up new sales territories when other Telstar products are not being shipped to that area.

Required:

Write a memo addressing the controllers concerns. Should Telstar begin allocating distribution costs to the LOBs? If so, which allocation scheme should it use?

24. Single vs. Dual-Rate Allocations

Bio Labs is a genetic engineering firm manufacturing a variety of gene-spliced, agricultural-based seed products. The firm has five separate laboratories producing different product lines. Each lab is treated as a profit center and all five labs are located in the same facility. The wheat seed lab and corn seed lab manufacture two of the five product lines. These two labs are located next to each other and are of roughly equal size in terms of sales. The two departments have close interaction, often sharing equipment and lab technicians. Both use very similar technology and science and usually attend the same scientific meetings.
Recent discoveries have shown how low-power lasers can be used to significantly improve product quality. The wheat seed and corn seed managers are proposing the creation of a laser testing department to employ this new technology. Leasing the equipment and hiring the personnel cost \$350,000 per year. Supplies, power, and other variable costs are \$25 per testing hour. The testing department is expected to provide 2,000 testing hours per year. The wheat seed manager expects to use 700 testing hours per year of the laser testing department and the corn seed manager expects to use 800 testing hours. The remaining 500 hours of testing capacity can be used by the other three labs if the technology applies or can be left idle for future expected growth of the two departments. Initially, only wheat and corn are expected to use laser testing.
The executive committee of Bio Labs has approved the proposal but is now grappling with how to treat the costs of the laser testing department. The committee wants to charge the costs to the wheat seed and corn seed labs but is unsure of how to proceed.
At the end of the first year of operating the laser, wheat seed used 650 testing hours, corn seed used 900 hours, and 450 hours were idle.

Required:

a. Design two alternative cost allocation systems.
b. Give numerical illustrations of the charges the corn and wheat seed labs will incur in the first year of operations under your two alternatives.
c. Discuss the advantages and disadvantages of each.

25. Cost Allocations can Change the Relative Profitability of Products

Woodley Furniture is a small boutique manufacturer of high quality contemporary wood tables. They make two models: end tables and coffee tables in a variety of different woods and finishes. Current annual production of end tables is 8,000 units that sell for \$250 and have variable cost of \$120 each. Current annual production of coffee tables is 6,000 units that sell for \$475 and have variable cost of \$285 each. Woodley has fixed costs of \$2.4 million. Woodley sells all the tables they produce each year.

Required:

a. Calculate total firm-wide profits and product-line profits for the end tables and coffee tables after allocating the fixed costs to the two product lines using sales revenues as the allocation base.
b. Which of the two products is the most profitable based on total profits (after allocating fixed costs)? Is Woodley making an adequate profit?
c. Woodley management decides to add a dining table to its product offerings. The plant currently has excess capacity, so no additional fixed costs are required to produce the dining tables. The new dining table will not affect the number of units sold or prices of the existing coffee and end tables. They expect to sell 4,000 dining tables at a price of \$620 each, and variable cost per table is \$500. Calculate total firm-wide profits and product-line profits for the end tables, coffee tables, and dining tables after allocating the fixed costs to the three product lines using sales revenues as the allocation base.
d. Analyze the profitability of the three products and firm-wide profits calculated in part (c) compared to the profitability of the two products alone and firm-wide profits in part (a).
e. Recalculate your answers to parts (a) and (c), but, instead of allocating the \$2.4 million of fixed costs using sales revenues as in parts (a) and (c), allocate the \$2.4 million of fixed costs using the total contribution margin of each product (total sales revenue less total variable cost).
f. Discuss the relative advantages and disadvantages of using total contribution margin to allocate the fixed costs in part (e) relative to using sales revenues to allocate the fixed costs, as in parts (a) and (c).

Chapter 07 Cost Allocation: Theory Answer Key

Multiple Choice Questions

1. Which is not a reason for allocating internal costs to cost objects?

A. Managers should be charged for benefits received by departments (or products) under their control

B. US GAAP requires allocation of factory overheads

C. To determine the selling price of products

D. To determine the amount to be reimbursed under a cost-reimbursement contract

E. All of the above are reasons for allocating internal costs to cost objects
In a market-driven economy, selling prices are set by supply and demand, not by an arbitrary measure of one producers inputs.

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Difficulty: 1 Easy
Topic: Cost-Based Reimbursement
Topic: Decision Making and Control
Topic: External Reporting/Taxes

2. You are going to dinner with three friends, one who likes steak, another wine, and the third is a vegetarian (which is assumed to be the least expensive). Which is true?

A. How the bill is shared has no effect on what and how much people choose to eat

B. Equal sharing of the bill ensures that people order a similar dollar amount of food

C. The wine-drinker will argue for equal shares, and will drink as fast (and/or as much) as possible

D. The vegetarian will be better off with equal shares

E. None of the above
Where there is a common resource, and billing is not proportionate to consumption or benefits received, the greedy and the first-arrivals are better off. The vegetarian is better off with individual billing. In an equal sharing of the bill, the vegetarian is subsidizing those with more expensive tastes. Billing practices for internal services must take these aspects into account.

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Difficulty: 2 Medium
Topic: Decision Making and Control

3. A sound allocation system should:

A. be cheap and easy to administer

B. provide incentives for cost control

C. charge in proportion to amount used or benefit received

D. be perceived as equitable by those who are charged

E. be all of the above
A well-designed allocation system should display all of these characteristics.

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Difficulty: 1 Easy
Topic: Cost Allocations Are a Tax System
Topic: Pervasiveness of Cost Allocations

4. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the direct materials and direct labor cost (i.e., the prime cost) per drum?

A. \$1,433.33

B. \$1,413.33

C. \$1,313.33

D. \$1,293.33

E. None of the above
The direct materials and direct labor cost per drum:

XENTRA: Unit cost sheet per drum
Qty Cost Total
Chemical Xeta, gals 15 \$25.00 \$375.00
Chemical Thenta, gals 35 \$27.50 \$962.50
Base material, lbs 20 \$1.00 \$20.00
100-lb lined drum 1 \$51.83 \$51.83
Direct labor, hr 1/6 \$24.00 \$4.00
Prime cost per drum \$1,413.33

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: External Reporting/Taxes
Topic: Manufacturing Organizations

5. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the conversion cost (direct labor and overhead) per drum?

A. \$191.67

B. \$287.40

C. \$311.67

D. \$315.67

E. None of the above
Conversion cost is the sum of direct labor and factory overheads per drum.

Conversion costs Qty Cost Total
Direct labor, hr 1/6 \$24.00 \$4.00
Variable overheads 100 \$1.20 \$120.00
Labor-based, per DLH 1/6 \$400.00 \$66.67
Machine based per MH 1 1/4 \$100.00 \$125.00
Conversion cost per drum \$315.67

OH allocation rate
*Variable Mfg OH: lbs \$1,200,000 \$1.20 per lb
lbs 1,000,000
*Fixed Mfg OH: DLH \$1,400,000 \$400.00 per DLH
DLH 3,500
*Fixed Mfg OH: MH \$2,100,000 \$100.00 per MH
MH 21,000

Some students may allocate the labor-based overheads on the basis of direct labor dollars. While the intermediate values differ, as shown below, the final answer is the same.

\$1,400,000 OH\$ / \$84,000 DL\$ = \$16.667 per DL\$.

One drum uses 10 minutes of DL costed at \$24/DLH. So \$16.667 * \$24 / 6 = \$66.67 per drum

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: External Reporting/Taxes
Topic: Manufacturing Organizations

6. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

Assuming normal production levels, what is the full cost per drum?

A. \$1,725.00

B. \$1,700.73

C. \$1,625.00

D. \$1,609.00

E. None of the above

Prime cost per drum \$1,413.33
Variable overheads, per lbs \$120.00
Direct labor-based, per DLH \$66.67
Machine-based, per MH \$125.00
Full cost per drum \$1,725.00

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: External Reporting/Taxes
Topic: Manufacturing Organizations

7. Pluton makes particular plastics for sale to the public and the government. Basic cost data for a 100-pound drum of one particular product called Xentra appears below:

Qty Cost
Chemical Xeta, gals 15 \$25.00
Chemical Thenta, gals 35 \$27.50
Base material, lbs 20 \$1.00
100-lb lined drum 1 \$51.83

Variable factory overheads are estimated to be \$1,200,000 per month, when 1,000,000 pounds of various products are produced. The plant employs 20 chemical workers who typically work 175 hours each per month and are paid \$24 per hour. Other workers are classified as indirect and are included in fixed overheads. The highly automated plant typically runs 21,000 machine hours per month. The preparation of one 100 lbs batch of Xentra needs ten minutes of direct labor and 75 minutes of machine time. Fixed manufacturing overheads total \$3,500,000 per month. Forty percent of these fixed manufacturing overheads are labor-related costs and the balance are machine-related costs.

A government agency wants to purchase 200 drums of Xentra at cost plus a flat fee. Which allocation method gives the profit-maximizing result?

A. The current method of determining cost

B. Allocating overheads per machine hour

C. Allocating overheads per direct labor hour

D. Allocating overheads per pound

E. None of the above
The profit-maximizing definition of costs is one which increases the amount of overheads eligible for reimbursement.

Current method:
Allocated overheads per drum
Variable overheads, per lb \$120.00
Direct labor-based, per DLH \$66.67
Machine-based, per MH \$125.00
\$311.67
Variable \$1,200,000
Fixed \$3,500,000
Units per drum
Total pounds 1,000,000 OH\$/lb \$4.70 100 \$470.00
Total DLH 3,500 OH\$/DLH \$1,342.86 1/6 \$223.81
Total MH 21,000 OH\$/MH \$223.81 1 1/4 \$279.76

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Difficulty: 2 Medium
Topic: External Reporting/Taxes

8. If Pluton selects the cost allocation method indicated by your answer to Q7-7, how much will profits increase on this order compared with the present system?

A. No change

B. Change by \$31,666.67

C. Change by \$17,571.43

D. Change by \$6,380.95

E. None of the above

Increase in profits
Additional overhead per drum (\$470.00 \$311.67) \$158.33
# Drums 200
Increase in reimbursed costs \$31,666.67

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: Manufacturing Organizations

9. Which of the following are true about cost allocation?

A. Cost allocation is a form of transfer pricing for indirect costs

B. Cost allocation is an internal tax on services

C. Cost allocation distorts choices that managers would make otherwise

D. Cost allocation should be imposed when marginal cost exceeds average cost of an internal resource

E. All of the above
In practice, cost allocation of centrally-incurred line items is resented by managers who are charged a share of costs for services where they have no control over that line item.

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Difficulty: 1 Easy
Topic: Cost Allocations Are a Tax System
Topic: Decision Making and Control
Topic: Insulating versus Noninsulating Cost Allocations

10. King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to \$4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh.

If KKC uses the simplest algorithm to allocate power costs, which is not true?

A. Kong will be charged \$1.6 million

B. Kang will be charged \$2.18 million

C. Kangs charge will depend on Kongs usage

D. Since the production departments consume the vast majority of the plants power costs, it is not cost-efficient to allocate power costs to the service departments

E. All are true
The simplest system allocates total plant power costs to the big consumers, based on their fraction of use. This system creates interdependence in billing, i.e., it is non-insulating.

Kong Department Kang Department Plant
Production, millions 5 4
Unit power consumption, kwh 4 6
Total million kwh used 20 24
% of total Power consumed 20 24
Total charge (\$ millions) \$1.82 \$2.18 \$4.00

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Decision Making
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: Cost Allocations Are a Tax System
Topic: Insulating versus Noninsulating Cost Allocations

11. King Khan Corporation (KKC) manufactures kongs and kangs, the production of which requires considerable energy. Power generation department costs amounted to \$4 million this month, for a total of 50 million kilowatt hours (kwh) supplied to the plant. Analysis shows that 40% of power generation costs are fixed. This month the Kang Dept. made 5 million kangs, each using 4 kwh, and the Kang Dept. made 4 million kangs, each using 6 kwh.

In the following month, the power generation department costs amounted to \$4.3 million for 51 million kwh. Kong Dept.s usage was the same, but the Kang Dept. increased output to 4.1 million kangs, each using the standard power allowance. If KKC employs an insulating cost allocation mechanism, and fixed costs are shared equally, which is true?

A. Kang will be charged \$1.93 million

B. Kong will be charged \$1.79 million

C. Kong will be charged \$2.07 million

D. Kang will be charged \$2.29 million

E. None of the above
The first step is to calculate the Power Departments fixed costs, then to share the variable costs based upon current usage. When total costs were \$4 million, 40% (\$1.6 million) was fixed. At a different but very similar level of activity (51 as opposed to 50 million kwh), the fixed costs should remain the same, unless there is clear evidence of a step-fixed cost function. Answer (b) illustrates the problems caused by a non-insulating allocation mechanism. In the simplest system, Kongs charge for power was \$1.82 million. In the second month, even though Kongs actual power draw was constant, Kongs bill falls to \$1.79 million, because Kang fraction of the total power consumption, and hence share of the bill, increased.

(all millions) Kong Department Kang Department Plant
Production 5 4.1
Unit power consumption, kwh 4 6
Total million kwh used 20 24.6
Share of fixed costs 50% \$0.80 50% \$0.80 \$1.60
Share of variable costs 20 \$1.21 24.6 \$1.49 \$2.70
44.6 44.6 \$4.30
Total allocation \$2.01 \$2.29

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: Decision Making and Control
Topic: External Reporting/Taxes

Essay Questions

12. Cost Allocation and Contingency Fees

A lawyer allocates overhead costs based on his hours working with different clients. The lawyer expects to have \$200,000 in overhead during the year and expects to work on clients cases 2,000 hours during the year. In addition, she wants to pay herself \$50 per hour for working with clients. In other words, the lawyers billing rate is the sum of her hourly fee (\$50) and a fee to recover the expected overhead spread over 2,000 hours. The lawyer, however, does not bill all of her clients based on covering overhead costs and her own salary. Some clients pay her on contingency fees. If the lawyer works with a client on a contingency fee basis, the lawyer receives half of any settlement for her client. During the year the lawyer works 1,200 hours that are billable to clients. The remaining hours are worked on a contingency basis. The lawyer wins \$300,000 in settlements for his clients of which she receives half. Actual overhead was \$210,000.

Required:

What does the lawyer earn during the year after expenses?

Overhead application rate = \$200,000/2,000 hours = \$100/hour
Billing rate = \$100/hour + \$50/hour = \$150/hour

Billing revenue (\$150/hour) (1,200 hours) \$180,000
Contingency fees (.50) (\$300,000) 150,000
Actual overhead costs (210,000)
Lawyers earnings \$120,000

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: Cost Allocations Are a Tax System
Topic: External Reporting/Taxes

13. Fixed Costs and Allocated Costs

The maintenance departments costs are allocated to other departments based on the number of hours of maintenance use by each department. The maintenance department has fixed costs of \$500,000 and variable costs of \$30 per hour of maintenance provided. The variable costs include the salaries of the maintenance workers. More maintenance workers can be added if greater maintenance is demanded by the other departments without affecting the fixed costs of the maintenance department. The maintenance department expects to provide 10,000 hours of maintenance.

Required:

a. What is the application rate for the maintenance department?
b. What is the additional cost to the maintenance department of providing another hour of maintenance?
c. What problem exists if the managers of other departments can choose how much maintenance to be performed?
d. What problem exists if the other departments are allowed to go outside the organization to buy maintenance services?

a. Total expected costs are \$500,000 + (\$30/hour) (10,000 hours) = \$800,000
The application rate is \$800,000/10,000 hours = \$80/hour
b. The additional cost to the maintenance department of providing another hour of maintenance is the variable cost of \$30/hour.
c. The other departments will under-use the maintenance department because the application rate of \$80/hour is much greater than the additional costs of providing maintenance.
d. If departments are allowed to go outside the organization to buy maintenance services, fewer in-house maintenance hours will be used. This will cause the application rate to become even higher if the fixed cost is included.

AACSB: Analytical Thinking
AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Blooms: Understand
Difficulty: 3 Hard
Topic: External Reporting/Taxes
Topic: Insulating versus Noninsulating Cost Allocations
Topic: Taxing an Externality

14. Choosing Allocation Bases for Levying Taxes

The town of Seaside has decided to construct a new sea aquarium to attract tourists. The cost of the measure is to be paid by a special tax. Although most of the townspeople believe the sea aquarium is a good idea, there is disagreement about how the tax should be levied.

Required:

Suggest three different methods of levying the tax and the advantages and disadvantages of each.

Possible methods of taxing include:

a. Sales tax on hotel rooms and restaurants: This is the most common method of taxing for the construction of a tourist site because the hotels and restaurants benefit directly from tourism. This taxing method is the same as allocating all the costs to the primary customers of the aquarium.
b. Property tax on businesses: This method allocates most of the costs of the aquarium to the businesses with the most expensive property. These businesses are most likely to be able to afford the additional tax. Not all businesses, however, will benefit from the aquarium.
c. Income tax on individuals: Once again, this method allocates costs to the individuals who are most likely to be able to afford the additional tax. But not all of these individuals will benefit from the aquarium.
d. A non-tax method of covering the cost of the aquarium is to issue a bond to pay for the aquarium and then use proceeds from ticket sales to pay the principle and interest on the bond.

AACSB: Communication
AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Difficulty: 3 Hard
Topic: Cost Allocations Are a Tax System
Topic: Insulating versus Noninsulating Cost Allocations
Topic: Taxing an Externality

15. Outsourcing and Overhead

Peluso Company, a manufacturer of snowmobiles, is operating at 70 percent of plant capacity. Pelusos plant manager is considering manufacturing headlights, which are now being purchased for \$11 each (a price that is not expected to change in the near future). The Peluso plant has the equipment and labor force required to manufacture the headlights. The design engineer estimates that each headlight requires \$4 of direct materials and \$3 of direct labor. Pelusos plant overhead rate is 200 percent of direct labor dollars, and 40 percent of the overhead is fixed cost.

Required:

If Peluso Co. manufactures the headlights, how much of a gain (loss) for each headlight will result?

Purchase price saved \$11.00
Direct labor and materials (7.00)
(200% \$3 60%)
(\$3.60)
Projected savings from making \$0.40

The \$0.40 gain from making the headlights assumes that increasing volume does not cause variable overhead per unit to rise as congestion costs increase. Also, the excess capacity consumed by manufacturing the headlights is assumed (implicitly) to have no opportunity cost.

AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Difficulty: 3 Hard
Topic: External Reporting/Taxes

16. Incentive Effects of Cost Allocations

Eastern University prides itself on providing faculty and staff a competitive compensation package. One aspect of this package is a faculty and staff child tuition benefit of \$4,000 per child per year for up to four years to offset the cost of a college education. The faculty or staff members child can attend any college or university, including Eastern University, and receive the tuition benefit. If a staff member has three children in college one year, the staff member receives a \$12,000 tuition benefit. This money is not taxed to the individual staff or faculty member.
Eastern University pays the benefit directly to the university where the staff/faculty members child is enrolled or if the student is attending Eastern, it reduces the amount of tuition owed by the faculty/staff member. The university then charges this payment to a benefits account. This benefits account is then allocated back to the various colleges and departments based on total salaries in the college or department.

Required:

Evaluate the pros and cons of the present university accounting for tuition benefits. What changes would you recommend making?

Pros: The major advantage of the tuition benefit is that it provides tax-free income to faculty and staff. This can reduce the total compensation cost to the University by the amount of the tax savings, or else the staff receives a windfall gain if their base pay is not adjusted to reflect this additional income.
The current accounting treatment via the benefits account is simple. College tuition benefits are not completely free to each college. When making hiring decisions, deans of the colleges will take into consideration the average cost of the tuition benefit. If a large number of faculty/staff in one college are drawing the benefit, their budget is not unduly burdened in this year.

Cons: The problem with the present scheme is that the individual colleges are not charged with the actual cost of the tuition benefits they generate. Deans have incentive to hire staff with college-bound children since they do not bear 100% of the cost. Salary administration is made more difficult. Since a particular dean does not pay the full cost of the tuition benefit of each individual faculty/staff in his or her college, the dean is not aware of the benefit the faculty/staff is drawing, and thus is less likely to adjust the base pay, making it more likely that the faculty/staff receives a windfall gain from the tuition benefit. The deans of each college do not take into account the full cost of hiring/retaining a staff/faculty member with several college-bound children.

Proposal: Each college should be charged for the actual tuition benefits paid for children of faculty/staff in its college.

AACSB: Communication
AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Difficulty: 2 Medium
Topic: Cost Allocations Are a Tax System
Topic: Taxing an Externality
Topic: Universities

17. Allocating Overhead versus Direct Tracing

Nixon & Ross, a law firm, is about to install a new accounting system that will allow the firm to track more of the overhead costs to individual cases. Overheads are currently allocated to individual client cases based on billable professional staff salaries. Attorneys working on client cases charge their time to billable professional staff salaries. Attorney time spent in training, law firm administrative meetings, and the like is charged to an overhead account titled unbilled staff salaries.
The following is a summary of the costs for the current year:

Billable professional staff salaries \$4,000,000
Total costs \$12,000,000

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