Deck 7: Cost Allocation: Theory

Question 1

Phonetex
Phonetex is a medium-size manufacturer of telephone sets and switching equipment. Its primary business is government contracts, especially defense contracts, which are very profitable. The company has two plants: Southern and Westbury. The larger plant, Southern, is running at capacity producing a phone system for a new missile installation. Existing government contracts will require Southern to operate at capacity for the next nine months. The missile contract is a firm, fixed-price contract. Part of the contract specifies that 3,000 phones will be produced to meet government specifications. The price paid per phone is $300.
The second Phonetex plant, Westbury, is a small, old facility acquired two years ago to produce residential phone systems. Phonetex feared that defense work was cyclical, so to stabilize earnings, a line of residential systems was developed at the small plant. In the event that defense work deteriorated, the excess capacity at Southern could be used to produce residential systems. However, just the opposite has happened. The current recession has temporarily depressed the residential business. Although Westbury is losing money ($10,000 per month), top management considers this an investment. Westbury has developed a line of systems that are reasonably well received. Part of its workforce has already been laid off. It has a very good workforce remaining, with many specialized and competent supervisors, engineers, and skilled craftspeople. Another 20 percent of Westbury's workforce could be cut without affecting output. Current operations are meeting the reduced demand. If demand does not increase in the next three months, this 20 percent will have to be cut.
The plant manager at Westbury has tried to convince top management to shift the missile contract phones over to his plant. Even though his total cost to manufacture the phones is higher than at Southern, he argues that this will free up some excess capacity at Southern to add more government work. The unit cost data for the 3,000 phones are as follows:

Required :
Top management has reviewed the Southern manager's data and believes his cost estimates on the new contract to be accurate. Should Phonetex shift the 3,000 phones to Westbury and take the new contract or not? Prepare an analysis supporting your conclusions.

Answer 1

Manufacturing Overheads:
These are the expenses incurred by the company or the organization during the course of manufacturing of the product. These can be direct or indirect.
Variable Costs:
These cost changes with the level of output. Variable costs are considered relevant under relevant costing.
In the present case P Company manufactures phones and owned two plants namely S and W. Plant S is also engaged in some government work and unit cost of the phone under S plant is $195 which is $295 under W plant.
In case the 3,000 phones get manufactured under plant S then its opportunity cost is $85,000. On the other hand plant, W contains some sunk cost in form of labor cost and variable overheads as these costs can't get reduced and only further labor cost is relevant for the calculation of incremental cash flows.
Prepare a schedule to compute the incremental cash flows using MS Excel, which will be shown as follows:
The result of above will be as follows:
The incremental cash flows from making of 3,000 phones under plant S will be $368,200.

Question 2

MRI
Magnetic resonance imaging (MRI) is a noninvasive medical diagnostic device that uses magnets and radio waves to produce a picture of an area under investigation inside the body. A patient is positioned in the MRI and a series of images of the area (say, the knee or abdomen) is generated. Radiologists then read the resulting image to diagnose cancers and internal injuries. The MRI at Memorial Hospital has the following projected operating data for next year.

Memorial Hospital serves two types of patients: elderly, whose hospital bills are covered by governments (state and federal reimbursement), and other patients, who are covered by private insurance (such as Blue Cross and Blue Shield). About one-third of Memorial's patients are elderly. Elderly patients using MRI services normally require more time per MRI image. The typical elderly patient requires one hour of MRI time to produce the 10 MRI images needed for the radiologist. Other patients only require about 45 minutes per patient to generate the 10 MRI images.
Governments reimburse MRI imaging based on the reported cost by the hospital. Reimbursable costs include both the fixed and variable costs of providing MRIs. Private insurers reimburse MRI imaging based on a standard fee schedule set by the insurance company. These fee schedules are independent of the hospitals' cost of providing MRI services.
Required:
a. Calculate Memorial Hospital's projected cost per MRI image.
b. Calculate Memorial Hospital's projected cost per hour of MRI time.
c. Suppose a typical elderly patient at Memorial Hospital requires 10 MRI images and takes one hour of MRI time. Calculate the cost of providing this service if Memorial Hospital calculates MRI costs based on cost per image.
d. Suppose a typical elderly patient at Memorial Hospital requires 10 MRI images and takes one hour of MRI time. Calculate the cost of providing this service if Memorial Hospital calculates MRI costs based on cost per hour of MRI time.
e. Should Memorial Hospital calculate the cost of MRI services based on the cost per image or the cost per MRI hour? Explain why.

Answer 2

Variable and Fixed Cost
There are two components to the cost of a product from the point of the manufacturer. One is the fixed cost which remains fixed at any level of sales and one is the variable cost which is directly propionate to the level of sales.
If the quantity increases variable cost increases and quantity decreases the variable cost also decreases. Variable costs are relevant cost and fixed cost are irrelevant costs.
a.In the present case, M Hospital has projected its fixed cost for $606,000, variable cost for $279,000 and number of hours for 2,800. The majority of patients of M Hospital belongs to privately insured individuals.
Compute the projected cost per image with the help of the following equation, which is as follows:
Hence, the projected cost per image is
.
b.Compute the projected cost per hour with the help of the following equation, which is as follows:
Hence, the projected cost per hour is
.
c
Compute the projected cost of 10 images in one hour on cost per image basis with the help of the following equation, which is as follows:
Hence, the projected cost of 10 images in one hour on cost per image basis is
.
d
Compute the projected cost of 10 images in one hour on cost per hour basis with the help of the following equation, which is as follows:
Hence, the projected cost of 10 images in one hour on cost per hour basis is
.
e.Since the amount of MRI images of patients is get reimbursed either by the government or by insurance company hence M hospital should go with the cost of the image on per hour basis as it will increase the collection of the hospital without affecting the pockets of patients.

Question 3

Durango Plastics
SCX is a $2 billion chemical company with a plastics plant located in Durango, Colorado. The Durango plastics plant of SCX was started 30 years ago to produce a particular plastic film for snack food packages. The Durango plant is a profit center that markets its product to film producers. It is the only SCX facility that produces this plastic.
A few years ago, worldwide excess capacity for this plastic developed as a number of new plants were opened and some food companies began shifting to a more environmentally safe plastic that cannot be produced with the Durango plant technology.
Last year, with Durango's plant utilization down to 60 percent, senior management of SCX began investigating alternative uses of the Durango plant. The Durango plant's current annual operating statement appears in the accompanying table

One alternative use of the Durango plant's excess capacity is a new high-strength plastic used by the auto industry to reduce the weight of cars. Additional equipment required to produce the automotive plastic at the Durango plant can be leased for $3 million per year. Automotive plastic revenues are projected to be $28 million and variable costs are $11 million. Additional fixed costs for marketing, distribution, and plant overhead attributable solely to auto plastics are expected to be $4 million.
All of SCX's divisions are evaluated on a before-tax basis.
Required:
a. Evaluate the auto industry plastic proposal. Compare the three alternatives: (1) close Durango, (2) produce only film plastic at Durango, and (3) produce both film and auto plastic at Durango. Which of the three do you suggest accepting? (If Durango is closed, additional one-time plant closing costs just offset the proceeds from selling the plant.)
b. Suppose the Durango plant begins manufacturing both film and auto plastic. Prepare a performance report for the two divisions for the first year, assuming that the initial projections are realized and the film division's 2016 revenue and expenses are the same as in 2015. Plant administration ($17 million) and depreciation ($5 million) are common costs to both the film and auto plastics divisions. For performance evaluation purposes, these costs are assigned to the two divisions based on sales revenue. All costs incurred for the Auto Plastics division should be charged to that division.
c. Does the performance report in part ( b ) accurately reflect the relative performance of the two divisions? Why or why not?
d. In the year 2017, the Durango plant is able to negotiate a $1 million reduction in property taxes. Property taxes are included in the "plant administration account." In addition, the Film Division is able to add $3 million in additional revenues (with $2.1 of additional variable cost) by selling film to European food packagers. Assuming that these are the only changes at the Durango plant between 2016 and 2017, how does the Auto Plastics Division's performance change between these two years? Allocate the common costs using the method described in part ( b ).
e. Write a short memo evaluating the performance of the Auto Plastics Division in light of the events in the year 2017 and describing how these events affect the reported performance of the Auto Plastics Division.

Answer 3

not answer

Question 4

Fair Allocations
Choosing among alternative cost allocation methodologies typically is based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. Discuss how the "fairness" criterion can be used in selecting a cost allocation methodology.

Question 5

Slawson
Slawson is a publicly traded Argentine company with three operating companies located in Argentina, the United States, and Germany. Slawson's corporate headquarters in Buenos Aires oversees the three operating companies. The annual cost of the corporate headquarters, including office expenses, salaries, and legal and accounting fees, is 2.4 million pesos. The following table summarizes operating details of each of the three operating companies.

Required:
a. Allocate the 2.4 million pesos corporate headquarters cost to the three operating companies using number of employees in each operating company.
b. Allocate the 2.4 million pesos corporate headquarters cost to the three operating companies using net income of each operating company as the allocation base.
c. Discuss the advantages and disadvantages of allocating corporate headquarters costs using (1) employees and (2) net income.

Question 6

The Corporate Jet
A large corporation maintains a fleet of three 30-passenger corporate jets that provide (weather permitting) daily scheduled service between Detroit and several cities that are home to its production facilities. The jets are used for business, not personal, travel. Corporate executives book reservations through a centralized transportation office. Because of the limited number of seats available, the planes almost always fly full, at least in the nonwinter months. Excess demand for seats is assigned by executive rank within the firm. The executive's budget is charged for the flight at the end of the month. The charge is based on the jet's total operating expenses during the month (including fuel, pilot's salary and fringes, maintenance, licensing fees, landing fees, and 1/12 of the annual accounting depreciation) divided by the actual passenger miles logged in the month. This rate per passenger mile is multiplied by each passenger's mileage flown in the month.
Required:
a. Describe the formula being used to calculate the cost per passenger mile flown.
b. As passenger miles flown increases, what happens to the cost per passenger mile?
c. Describe what causes the monthly charge per passenger mile flown to fluctuate.
d. What other problems are present in the current system and what improvements do you suggest making?

Question 7

Massey Electronics
Massey Electronics manufactures heat sinks. Heat sinks are small devices attached to solid-state circuit boards that dissipate the heat from the circuit board components. Made of aluminum, the devices consist of many small fins cut in the metal to increase its surface area and hence its ability to dissipate the heat. For example, Intel Pentium and Celeron processors are first mounted onto heat sinks and then attached to circuit boards. These processors generate heat that will ultimately destroy the processor and other components on the circuit board without a heat sink to disperse the heat.
Massey has two production facilities, one in Texas and the other in Mexico. Both produce a wide range of heat sinks that are sold by the three Massey lines of business: laptops and PCs, servers, and telecommunications. The three lines of business are profit centers, whereas the two plants are cost centers. Products produced by each plant are charged to the lines of business selling the heat sinks at full absorption cost, including all manufacturing overheads. Both plants supply heat sinks to each line of business.
The Texas plant produces more complicated heat sinks that require tighter engineering tolerances. The Texas workforce is more skilled, but also more expensive. The Mexico plant is larger and employs more people. Both facilities utilize a set of shared manufacturing resources: a common manufacturing IT system that schedules and controls the manufacturing process, inventory control, and cost accounting, industrial engineers, payroll processing, and quality control. These shared manufacturing overhead resources cost Massey $9.5 million annually.
Massey is considering four ways to allocate this $9.5 million manufacturing overhead cost pool: direct labor hours, direct labor dollars, direct material dollars, or square footage of the two plants. The following table summarizes the operations of the two plants:

Massey has significant tax loss carryforwards due to prior losses and hence expects no income tax liability in any tax jurisdiction where it operates for the next five years.
Required:
a. Prepare a table showing how the $9.5 million would be allocated using each of the four proposed allocation schemes (direct labor hours, direct labor dollars, direct material dollars, and square footage of the two plants).
b. Discuss the advantages and disadvantages of each of the four proposed allocation methods (direct labor hours, direct labor dollars, direct material dollars, and square footage of the two plants).

Question 8

Avid Pharmaceuticals
Avid, a small, privately held biotech pharmaceutical manufacturing firm, specializes in developing and producing a set of drugs for rare classes of cancers. Avid has two divisions that share the same manufacturing and research facility. The two divisions, while producing and selling two different classes of products to different market segments, share a common underlying science and related manufacturing processes. It is not unusual for the divisions to exchange technical know-how, personnel, and equipment. The following table summarizes their most current year's operating performance:

Avid's corporate overhead amounts to $900,000 per year. Management is debating various ways to allocate the corporate overhead to the two divisions. Allocation bases under consideration include: number of employees, plant square footage, revenues, operating expenses, and operating profits. Each division is treated as a separate profit center with each manager receiving a bonus based on his or her division's net income (operating profits less allocated corporate overhead).
Required:
a. For each of the five proposed allocation bases, compute Division A's and Division B's net income (operating income less allocated corporate overhead).
b. Recommend one of the five methods (or no allocation of corporate overhead) to allocate corporate overhead to the two divisions. Be sure to justify your recommendation.

Question 9

Wasley
Wasley has three operating divisions. Each manager of a division is evaluated on that division's total operating income. Managers are paid 10 percent of operating income as a bonus. The AB division makes products A and B. The C division makes product C. The D division makes product D. All four products use only direct labor and direct materials. However, a fixed (unavoidable) $1,784 corporate overhead is applied to each division (or product) based on direct labor dollars. In the following operating income statement for the first quarter of the year, all numbers are in 000s.

Required:
a. Allocate the corporate overhead and compute divisional operating income (after allocating corporate overhead) for each of the three divisions.
b. One day, the manager of the AB division, Shirley Chen, announces that starting in the second quarter she will be discontinuing product B (replacing it with nothing and letting the labor go, cutting all direct costs attributable to the product). She reasons that product B is losing money for her division and the company. Recompute first-quarter operating income for both division AB and the corporation without division AB's product B (as though the manager had already dropped product B).
c. Is Shirley Chen, the manager of the AB division, better off this way? Why or why not?
d. Is the corporation better off this way? Why or why not?
e. What problems do you see with the reporting/evaluation/incentive system currently in place?

Question 10

Hallsite Imaging
Hallsite Imaging produces hardware and software for imaging the structures of the human eye and the optic nerve. Hallsite systems are in most major medical centers and leading ophthalmology clinics. Hallsite has three divisions: Hardware, Software, and Marketing. All three are profit centers, and the three divisional presidents are compensated based on their division's profits. The Hardware Division produces the equipment that captures the images, which are then viewed on desktop PCs. The Software Division produces the software that runs on both Hallsite imaging equipment and the users' PCs to view, manipulate, and manage the images. Hallsite hardware only works with the Hallsite software, and the software can only be used for images captured by Hallsite hardware. The Marketing Division produces the marketing materials and has a direct sales force of 1,000 Hallsite people that sells both the hardware and software in the United States (Hallsite operates only in the United States). To assess the profits of the Hardware and Software Divisions, the costs of the Marketing Division are allocated back to the Hardware and Software Divisions based on the revenues of the two divisions. The following table summarizes the divisional sales and divisional expenses (before allocation of Marketing Division costs) for the Hardware and Software Divisions for last quarter and this quarter. (All figures are in millions of dollars.)

The Marketing Division reported divisional costs of $320 million last quarter and $370 million this quarter.
Required:
a. Allocate the Marketing Division's costs to the Hardware and Software Divisions for last quarter and this quarter.
b. Calculate the Hardware and Software Divisions' profits for this quarter and last quarter after allocating the Marketing Division's expenses to each division.
c. After receiving her division's profit report for this quarter (which included the Hardware Division's share of the Marketing Division's costs), the president of the Hardware Division called Hallsite's chief financial officer (whose office prepared the report) and said, "There must be something wrong with my division's profit report. Hardware's sales rose and our expenses were in line with what they should have been given last quarter's operating margins. But my profits tanked. Now I know that there was a major problem with Software's new version 7.0 that hurt new sales of upgrades to version 7.0 and required more Marketing resources to address our customers' concerns with this new software. But why am I getting hammered? I didn't cause the software problems. My hardware continues to sell well because version 6.8 of the software still works great. This is really very unfair."
Write a memo from Hallsite's chief financial offer to the Hardware Division president explaining that the Hardware Division's current quarter profit report (which includes the Division's share of the Marketing expenses) is in fact correct and outlining the various rationales as to why Hallsite allocates the Marketing Division's expenses to the other two divisions.

Question 11

Rowe Waste Removal (B)
Continuing the problem started in Rowe Waste Removal (A) in Chapter 2, Rowe Waste Removal hires Sue Lingle to manage the apartment complex collection service and enters the apartment refuse removal market. To provide Lingle incentives to maximize Rowe's profit, she will receive a bonus tied to the profits of her apartment waste collection business. Apartment profits are calculated based on the apartment waste collection revenues less the costs of the apartment waste service (truck lease, dumpsters, driver, fuel, oil, licensing, landfill charges, and Lingle's salary and benefits). (Note: Any bonus paid to Lingle is not included in calculating the profits of the apartment waste service.) In addition to these direct costs of the apartment refuse collection service, Lingle is charged a fee of $50 per 25-unit apartment complex to cover her share of the billing, accounting, legal costs, and general operating expenses of Rowe.
Required:
a. Assume all the costs in Rowe Waste Removal (A) in Chapter 2 remain the same and in addition to the $54,000 per month cost of the truck, driver, etc., Lingle's salary and benefits are $72,000 per year. What price-quantity combination will Lingle select to maximize her bonus?
b. Explain why the price-quantity combination Sue Lingle chooses in part (a) is the same or differs from the firm-profit maximizing price-quantity combination chosen in part (b) of Rowe Waste Removal (A) in Chapter 2.
c. In computing Sue Lingle's apartment waste collection profits for determining her bonus, should she be charged a fee of $50 per 25-unit apartment complex to cover her share of the billing, accounting, legal costs, and general operating expenses of Rowe?

Question 12

Winterton Group
The Winterton Group is an investment advisory firm specializing in high-income investors in upstate New York. Winterton has offices in Rochester, Syracuse, and Buffalo. Operating as a profit center, each office receives central services, including information technology, marketing, accounting, and payroll. Winterton has 20 investment advisors, 7 each in Syracuse and Rochester, and 6 in Buffalo. Each investment advisor is paid a fixed salary, a commission based on the revenue generated from clients, plus 2 percent of regional office profits and 1 percent of firm profits. One of the senior investment advisors in each office is designated as the office manager and is responsible for running the office. The office manager receives 8 percent of the regional office profits instead of 2 percent.
Regional office expenses include commissions paid to investment advisors. The following regional profits are calculated before the 2 percent profit sharing. Firm profits are the sum of the three regional office profits.
This table summarizes the current profits per office after allocating central service costs based on office revenues.

The manager of the Buffalo office sent the following e-mail to the other office managers, the president, and the chief financial officer:
One of the primary criteria by which all cost allocation schemes are to be judged is fairness. The costs allocated to those bearing them should view the system as fair. Our current system, which allocates central services using office revenues, fails this important test of fairness. Receiving more allocated costs penalizes those offices generating more revenues. A fairer, and hence more defensible, system would be to allocate these central services based on the number of investment advisors in each office.
Required:
a. Recalculate each office's profits before any profit sharing assuming the Buffalo manager's proposal is adopted.
b. Do you believe the Buffalo manager's proposal results in a fairer allocation scheme than the current one? Why or why not?
c. Why is the Buffalo manager concerned about fairness?

Question 13

National Training Institute
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.

In addition to its assigned space, the technical training department offers training during offhours 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 department's business manager, proposed a rental allocation plan based on each department's 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 Daniels's and Richards's proposed rent allocation plans. Make appropriate recommendations.

Question 14

Colorado BBQ
Colorado BBQ makes a unique barbecue sauce that involves slow roasting very spicy chili peppers from India, pureeing the peppers to remove the seeds, and then flash frying the roasted peppers with the other ingredients before bottling. The sauce is sold throughout the United States. Colorado BBQ is considering entering the Canadian BBQ market with a slightly different recipe and bottle design and label. In order to be able to export its Colorado BBQ sauce into Canada without paying Canadian customs duty at 7 percent of the wholesale price (U.S. $8.99), Colorado BBQ must certify that at least 90 percent of the total manufacturing cost of the Canadian BBQ sauce is from products sourced entirely within the North American Free Trade Agreement or NAFTA (Canada, Mexico, and the United States). If more than 10 percent of the total product cost is determined to be from ingredients sourced outside of NAFTA (Canada, Mexico, and United States), then the product is subject to a 7 percent Canadian import duty. Given the competitive nature of the Canadian BBQ market, Colorado BBQ is unable to pass any Canadian customs duty on to its Canadian importer.
The current breakdown of the direct costs (excluding allocated manufacturing overheads) of the U.S. and Canadian BBQ sauces is (all amounts are U.S. dollars):

The manufacturing overhead for the factory that may produce both the U.S. and Canadian Colorado BBQ sauces is $383,000 per year, and 65,000 bottles will be produced for the U.S. market and 22,000 bottles for the Canadian market. Manufacturing overhead will be allocated to the two BBQ sauces using direct labor cost. All of the manufacturing costs, ingredients, and packaging (except the Indian chilies) are sourced entirely within the NAFTA countries.
Required:
a. Calculate the manufacturing overhead allocated per bottle of the Canadian BBQ sauce.
b. Calculate what, if any, Canadian import customs duty Colorado BBQ must pay on the importation of its BBQ sauce based on NAFTA.
c. Before beginning the production of its Canadian sauce, Colorado BBQ learns of a very similar chili pepper from Mexico that can be used in the Canadian BBQ sauce without altering the sauce's flavor or consistency. The cost of the Mexican chili is $1.26 per Canadian bottle of BBQ sauce instead of the $0.76 per bottle for the Indian chili. Substituting the Mexican chilies for the Indian chilies in the Canadian sauce does not alter any of the other costs of the Canadian sauce. Should Colorado BBQ substitute the Mexican chili for the Indian chili in its Canadian BBQ sauce it plans to export to Canada? What advice would you give to the managers of Colorado BBQ regarding the production, cost certification for Canadian customs under NAFTA, and exportation of its Canadian Colorado BBQ sauce?

Question 15

Ball Brothers Purchasing Department
The purchasing department of Ball Brothers purchases raw materials and supplies for the various divisions in the firm. Most of the purchasing department's costs are labor costs. The costs of the purchasing department depend on the number of items purchased. The manager of the purchasing department estimates how her department's costs will vary with different levels of demand by the divisions. The following table provides her estimates of how the costs of purchasing vary with the aggregate number of items purchased by all divisions.

In deriving this table, the manager of purchasing projects expanding the size of the department in order to keep roughly constant the time to purchase an item and the quality of the purchasing department's services at all levels of demand placed on the department. That is, if the department is processing 750 items per week, it will provide the same quality of services given a budget of $2,600 as it would processing 250 items per week given a budget of $1,100.
Required:
a. Suppose the purchasing department is currently purchasing 610 items per week. Should the department's costs of $2,100 per week be allocated back to the divisions, making the purchases at a charge of $3.44 per item purchased ($2,100 ÷ 610)? Explain why or why not.
b. Suppose the purchasing department is currently purchasing 210 items per week. Should the department's costs of $1,100 per week be allocated back to the divisions, making the purchases at a charge of $5.23 per item purchased ($1,100 ÷ 210)? Explain why or why not.
c. Reconcile (explain) why your answers to parts (a) and (b) are either the same or different.

Question 16

Dewan Locks
Dewan Locks produces and sells a keyless bicycle lock that uses a small wireless fob to lock and unlock the lock without the need of a key. Dewan produces two models: one for the European market (EU) and one for North America (NA). Dewan started producing the North American lock at its Eastbury plant, and then introduced the EU model, which was also assembled in the Eastbury plant. When demand for both models grew and exceeded the capacity of Eastbury, Dewan leased the Westbury plant. Following the weakening global economy, Dewan saw the demand for its locks from both Europe and North America fall. This caused Dewan's total profits to plummet. The following table summarizes operations for the last fiscal quarter.

To address the current operating loss of $100,000, Dewan owners are moving the EU lock production from the Westbury plant to the Eastbury plant where it now has excess capacity due to the declining sales of the NA lock, and since the lease on the Westbury plant is expiring soon. By canceling the lease of the Westbury plant and moving the EU locks back to the Eastbury plant, the fixed manufacturing overhead of producing EU locks will fall from its current level of $630,000 to $210,000. In other words, Dewan will save the lease and occupancy cost of the Westbury plant ($630,000) but will have to incur additional fixed manufacturing cost of $210,000 in Eastbury to produce the EU locks in Eastbury. Stated differently, with both plants in operation, Dewan's total fixed manufacturing overhead is $1,140,000 ($630,000 + $510,000). Total manufacturing overhead will be $720,000 ($510,000 + $210,000) by consolidating both NA and EU lock production into the Eastbury plant.
The EU and the NA locks are separate profit centers with the managers of the two profit centers evaluated and compensated based on the operating income of their respective profit centers.
Required:
a. Dewan still expects to sell 11,000 locks in Europe and 17,000 in North America. By closing the Westbury plant and producing both the NA and the EU locks in Eastbury, what happens to Dewan's operating income?
b. After consolidating production of the NA and EU locks in the Eastbury plant, Dewan needs to allocate the $720,000 of common fixed manufacturing overhead of the Eastbury plant to the two profit centers (NA locks and EU locks). The $720,000 of Eastbury's common fixed manufacturing overhead to the two profit centers is to be allocated using total contribution margin (unit sales times the difference between selling price and variable cost per unit) as the allocation base. Using total contribution margin to allocate the manufacturing overhead to the two profit centers, prepare operating income statements for the NA locks and EU locks profit centers for last quarter as if the Westbury plant has closed and all locks are produced in Eastbury.
c. After seeing the operating income statements prepared in part b, the manager of the NA lock profit center argues, "Something must be wrong in these operating income statements. Why should the NA lock operating income change just because EU locks are now being produced in Eastbury? I haven't done anything differently, so why is NA Locks being penalized for closing Westbury plant and moving the EU locks into Eastbury? All of the benefits of closing Westbury seem to accrue to EU Locks and none to NA Locks." Write a memo to Dewan's president explaining whether the arguments by the manager of the NA Locks profit center have any merits.
d. Would you recommend using the overhead allocation scheme described in part (b), or would you propose an alternative allocation scheme? And if so, what scheme would you recommend, and why?

Question 17

Diagnostic Imaging Software
Diagnostic Imaging Software (DIS) is the leading producer of imaging software for the health sciences. DIS develops, writes, produces, and sells its software through two direct selling organizations: North America and South America. Each of these direct selling forces is evaluated and rewarded as profit centers. The remaining world sales of DIS software are handled through independent distributors in Europe, Asia, and Africa. DIS has a software development group that designs, writes, and debugs the software before turning it over to the direct sales organizations (North and South America) and the independent distributors who then sell the software. The cost of designing, writing, and debugging the software is $12 million this year.
The following table presents the income statements of the two divisions (millions of $) for this year:

Senior management of DIS wants to allocate the software costs to the two direct-selling forces in order to evaluate and reward their performance.
Required:
a. Calculate the profits of the two direct selling organizations (North and South America) after allocating the software costs of $12 million based on the relative revenues of the two organizations. (Round all decimals to three significant digits.)
b. Calculate the profits of the two direct selling organizations (North and South America) after allocating the software cost of $12 million based on the relative profits before software development cost of the two organizations. (Round all decimals to three significant digits.)
c. Calculate the profits of the two direct selling organizations (North and South America) after allocating the software cost of $12 million where 75 percent of the cost is assigned to North America and 25 percent to South America. (Round all decimals to three significant digits.)
d. Discuss the advantages and disadvantages of each of the three allocation methods used in parts (a), (b), and (c).

Question 18

Fuentes Systems
Fuentes Systems provides security software to law enforcement agencies. It has a sales force of 70 and has plans to add another 10-15 salespeople. Fuentes allocates corporate administrative costs based on the number of salespeople. The current total administrative cost of $2,184,000 comprises the costs of the human resources, payroll, accounting, and information technology departments.
You manage the western region of Fuentes Systems with 18 salespeople and you plan to add one or two more salespersons. Each salesperson you hire costs $120,000, which includes salary, benefits, and payroll taxes. If you hire one additional salesperson, you expect that person will generate $185,000 of net operating margin for your region. Net operating margin is revenues less cost of sales and less travel and entertainment expenses associated with that salesperson. Net operating margin does not include the salary, benefits, and payroll taxes of the salesperson. If you hire two salespeople, the combined additional net operating margin added to your region is expected to be $323,000. You are evaluated and rewarded as a profit center, where profits are calculated as net operating margin less the total salaries, benefits, and payroll taxes of all salespeople employed in the region, plus allocated corporate administrative costs.
Required:
a. What is the current allocated administrative cost per salesperson?
b. Assuming that your hiring of additional salespeople does not alter the allocated cost per salesperson, how many salespersons will you hire in the western region?
c. Suppose that Fuentes hires an additional 10 salespeople, and the total corporate administrative cost rises from $2,184,000 to $2,640,000. Should Fuentes continue to allocate corporate administrative costs to the regions? Explain why or why not.
d. Now suppose that Fuentes hires an additional 10 salespeople and the total corporate administrative cost rises from $2,184,000 to $2,200,000. Should Fuentes continue to allocate corporate administrative costs to the regions? Explain why or why not.

Question 19

Vorma
Vorma manufactures two proprietary all-natural fruit antioxidant food additives that are approved by the U.S. Food and Drug Administration. One is for liquid vitamins (LiqVita) and the other is used by dry cereal producers (Dry). Both of these products are sold only in the United States, and although they both share common chemistry and manufacturing, their end markets are completely separated. Both are produced in the same plant and share common manufacturing processes, such as purchasing, quality control, human resources, and so forth. These common fixed overhead costs amount to $1,500,000 per month. Each product also has its own directly traceable fixed costs, such as dedicated equipment leases used only by one of the two products, dedicated product engineers, and so forth. The following table summarizes the operations of Vorma for a typical month.

Again, the "Own fixed costs" consist of all fixed costs that can be traced directly to one of the two products (LiqVita and Dry), and these costs do not vary with the number of units produced.
Required:
a. Prepare a typical monthly income statement for LiqVita and Dry after allocating the common fixed overhead costs of $1,500,000 per month to the two product lines based on the relative proportions of total variable costs generated by each product.
b. Which of the two products in part (a) is the most profitable and which is the least profitable? (Note: You are not being asked to analyze or explain the relative profitablities of LiqVita and Dry.)
c. Vorma is planning to introduce a tablet version of its vitamin into China, with a selling price of $9 and a variable cost per unit of $7. At a price of $9, Vorma managers believe they will sell 950,000 units per month in China. Introducing the new product (called China) will require additional "Own fixed costs" (just for China) of $800,000. As in part (a), prepare monthly income statements, computing the monthly net income for the three products (LiqVita, Dry, and China). Allocate the common fixed overhead of $1,500,000 based on the relative proportions of total variable costs generated by each product.
d. As in part (b), list the order of the most profitable to least profitable products. Do not do any analysis. e. Compare the relative profitability of the two products (LiqVita and Dry) before introducing China [part (b)] and after introducing China [part (d)]. Analyze and discuss why the relative profitability of the two preexisting products (LiqVita and Dry) does or does not change with the introduction of the new product (China).

Question 20

Easton Taylor Beckett LLC
Easton Taylor Beckett, LLC (ETB), an enterprise risk management (ERM) firm, offers IT and security consulting services including network and IT security risk assessment, computer forensic services, IT audit services, regulatory compliance, and attestation services for clients in the food processing industry.
Until recently, ETB has been organized around three regional offices (Boston, Chicago, and Atlanta), each treated as a separate profit center. The corporate office manages the three regional offices (human resources, accounting, payroll, marketing, etc.), develops the specialized enterprise risk management products, and makes them available for use by the three regional offices. The following table summarizes the operations of ETB when it had only three regional offices.

Direct cost represents the cost incurred by the regional office to provide ERM services to clients, such as consulting labor, travel, etc. "Own indirect costs" represents costs incurred by the regional office (occupancy costs, training, etc.) that are not directly traceable to a particular client. In addition to the costs incurred by the regional offices (direct and indirect costs), ETB incurs corporate expenses (executive officers, occupancy costs, IT, tax compliance) of $3,780,000 to manage the entire firm and to maintain and develop the ERM tools offered to ETB clients through the regional offices.
Required:
a. Calculate the profitability of each of the three regional offices after allocating the corporate expenses to the three offices using revenues as the allocation base.
b. What is the relative profitability of the three regional offices (first, second, and third most profitable) after allocating corporate expenses?
c. At the end of last year, ETB acquired a similar ERM consulting firm in San Francisco. To support the expanded operations, ETB expects to incur an additional $500,000 of corporate expenses. The following table provides information regarding the operations of ETB as if the San Francisco office had been part of ETB for the entire year.

Calculate the profitability of each of the four regional offices after allocating the total corporate expenses ($4,280,000) to the four offices using revenues as the allocation base.
d. What is the relative profitability of the four regional offices (first, second, third, and fourth most profitable) after allocating corporate expenses?
e. Compare the relative profitability of the three original offices (Boston, Chicago, and Atlanta) before [part (b)] and after the acquisition of the San Francisco office [part (d)]. Analyze and discuss why the relative profitability of the three original offices (Boston, Chicago, and Atlanta) does or does not change with the acquisition of the San Francisco office.
f. Comment on the appropriateness or inappropriateness of ETB's current cost allocation methodology.

Question 21

World Imports
World Imports buys products from around the world for import into the United States. The firm is organized into a number of separate regional sales districts that sell the imported goods to retail stores. The eastern sales district is responsible for selling the imports in the northeastern region of the country. Sales districts are evaluated as profit centers and have authority over what products they wish to sell and the price they charge retailers. Each sales district employs a full-time direct sales force. Salespeople are paid a fixed salary plus a commission of 20 percent of revenues on what they sell to the retailers.
The eastern district sales manager, J. Krupsak, is considering selling an Australian T-shirt that the firm can import. Krupsak has prepared the following table of his estimated unit sales at various prices and costs. The cost data of the imported T-shirts were provided by World Imports's corporate offices.

The unit cost of the imported shirts rises because the Australian manufacturer has limited capacity and will have to add overtime shifts to produce higher volumes. Corporate headquarters of World Imports is considering allocating corporate expenses (advertising, legal, interest, taxes, and administrative salaries) back to the regional sales districts based on the sales commissions paid in the districts. It estimates that the corporate overhead allocation rate will be 30 percent of the commissions (for every $1 of commissions paid in the districts, $0.30 of corporate overhead will be allocated). District sales managers receive a bonus based on net profits in their district. Net profits are revenues less costs of imports sold, sales commissions, other costs of operating the districts, and corporate overhead allocations.
The corporate controller, who is proposing that headquarters costs be allocated to the sales regions and included in bonus calculations, argues that all of these costs must ultimately be covered by the profits of the sales districts. Therefore, the districts should be aware of these costs and must price their products to cover the corporate overhead.
Required:
a. Before the corporate expenses are allocated to the sales districts, what wholesale price will Krupsak pick for the Australian T-shirts and how many T-shirts will he sell? Show how you derived these numbers.
b. Does the imposition of a corporate overhead allocation affect Krupsak's pricing decision on the Australian T-shirts? If so, how? Show calculations.
c. What are the arguments for and against the controller's specific proposal for allocating corporate overhead to the sales districts?

Question 22

Painting Department
You are manager of a painting department of a large office complex. The painting department is responsible for painting the buildings' exteriors and interiors. Your performance is judged in part on minimizing your department's operating costs, which consist of paint and labor, while providing a high-quality and timely service.
The job of painting the halls of a particular building is being evaluated. Paint and labor are substitutes. To provide the quality job demanded, you can use less paint and more labor, or more paint and less labor. The accompanying table summarizes this trade-off. Paint costs $10 per gallon and labor costs $6.40 per hour.

Required:
a. How much paint and how much labor do you choose in order to minimize the total cost of the hall painting job? (Show calculations in a neatly labeled exhibit.)
b. The accounting department institutes an overhead allocation on labor. For every dollar spent on labor, $0.5625 of overhead is allocated to the paint department to cover corporate overhead items, including payroll, human resources, security, legal costs, and so forth. Now how much labor and paint do you choose to minimize the total accounting cost of the hall painting job? (Show calculations in a neatly labeled exhibit.)
c. Explain why your decisions differ between parts (a) and (b).
d. Explain why the accounting department might want to allocate corporate overhead based on direct labor to your painting department.

Question 23

Scanners Plus
Scanners Plus manufactures and sells two types of scanners for personal computers, the Home Scanner and the Pro Scanner. The Home model is a low-resolution model for small-office applications. The Pro model is a high-resolution model for professional use. The two models are manufactured in separate facilities and each model is treated as a profit center. This table summarizes the prices and costs of each model.

Both models are sold through large office supply and computer stores and through computer catalogs. The marketing department of Scanners Plus sells both models. It has a direct sales force that sells to retail stores and an advertising group that prepares and places ads in computer magazines and computer catalogs. The annual operating budget of the marketing group is $1,000,000. The marketing costs can be allocated to the two profit centers in one of two ways: either on the basis of total revenues or on the basis of 24 percent to the Home model and 76 percent to the Pro model.
At a selling price of $1,600, the Home model division projects the number of units it expects to sell next year to be either 1,000 units or 1,400 units, each equally likely. Similarly, at $8,800, either 600 or 800 units of the Pro model are equally likely to be sold. The demand for Pro scanners is independent of the demand for Home scanners. That is, one can be in high demand while the other one can be in either low or high demand.
Required:
a. Calculate total revenues under various scenarios for the Home model.
b. Calculate total revenues under various scenarios for the Pro model.
c. Suppose the marketing department costs of $1 million are allocated to Home and Pro models using the predetermined, fixed proportions of 24 percent to Home and 76 percent to Pro. Prepare a table projecting all the various total profits of Home and Pro after allocating marketing costs using these predetermined rates.
d. Calculate all the possible overhead proportions that can result from allocating the marketing department costs using the revenues in each profit center as the allocation base. (Round all overhead proportions to two significant digits, e.g., 44.67 percent rounds to 45 percent.)
e. Same as in part (c), except calculate profits for the two profit centers using the overhead rates computed in part (d).
f. Parts (c) and (e) asked you to compute divisional profits for the Home and Pro models using two different methods for allocating marketing costs. Comment on the relative advantages and disadvantages of the two methods.

Question 24

Taylor Connect
Taylor Connect operates dedicated call services for a variety of global customers in financial services, consumer products, and health sciences. Conner Beckett manages the call center in Omaha, Nebraska. This call center takes customer queries from a consumer products client. Taylor Connect employees are trained to handle calls from customers of this client in such a way that the callers believe they are talking to employees of the consumer products firm and not those of an outsourced provider of the call center (Taylor Connect). This consumer products client generates 1,200 calls a day at the Omaha call center. To handle this volume of calls, Conner requires both human operators and sophisticated technology (hardware and software). Technology allows many typical questions to be answered by prerecorded messages and by routing specific questions to agents trained to answer these queries. The following table shows how operators (also called agents) and technology can be substituted for each other in order to handle the 1,200 calls per day.

To process 1,200 calls per day, Conner can either hire eight agents and purchase 150 technology units or hire 20 agents and purchase 60 technology units (and various combinations between these two). A technology unit consists of hardware and software that can route and process calls. The various combinations of agents and technology units in the above table yield the same "quality" in the sense that callers (and the consumer products client) are indifferent among the various combinations. Agents cost $160 per day (salary, fringe benefits, taxes, etc.), and one technology unit costs $30 per day.
Conner is evaluated as a cost center and has decision rights over how many agents to hire and how many technology units to purchase. His performance is evaluated on several criteria, including the total cost of operating his call center.
Required:
a. How many agents and technology units will Conner choose to minimize the daily operating cost of the call center?
b. The chief financial officer (CFO) of Taylor Connect decides to allocate corporate overhead (human resources, legal, accounting, etc.) to the call centers to better judge the profitability of the firm's various decentralized call centers. Each call center will be charged $40 per operator (agent) per day as the mechanism to allocate this corporate overhead. Will Conner change the number of agents and technology units chosen to process the 1,200 calls per day after corporate overhead of $40 per agent per day is allocated? And if so, how many of each will he select?
c. The CFO justifies the allocation of overhead by arguing, "The corporate overheads have to be paid for by our operations. So it is natural to charge our call centers for these costs." Critically evaluate the CFO's justification for charging the call centers corporate overhead.
d. Should the call centers be charged corporate overhead? Explain.

Question 25

Economic Experts
Economic Experts (EE) provides economic consulting and litigation support in complex legal cases. One of EE's current clients, USClient, had a contract with ForeignCO to design and build a plant for ForeignCO. Before the plant was completed (and before ForeignCO made any payments to USClient), ForeignCO notified USClient that it was canceling the contract. USClient filed a lawsuit claiming that ForeignCO breached the contract and as a result of this contract breach USClient was claiming damages of $220 million. These damages consist of $170 million of out-of-pocket expenses that USClient spent designing and building the ForeignCO plant and $50 million of fixed overhead that USClient allocated to the ForeignCO project.
At the time it was building the ForeignCO plant, USClient had several other construction projects. As part of USClient's normal accounting practice, it allocates all overhead costs not incurred directly on particular projects to all projects, using total direct costs as the allocation base. Using this allocation methodology, the total overhead costs allocated to the ForeignCO project totaled $50 million.
ForeignCO hired an expert who wrote a report rejecting the $50 million of overhead as damages. Specifically, the expert for ForeignCO argued:
"Costs included as damages must be incremental to the contract in order to be damages. As such, those costs must be directly related and necessary to the activities caused by the breach and reflect expenditures that would not have been made but for the breach. Based on my review of USClient's overhead, it is my opinion that the $50 million of overhead claimed as damages by USClient are either unrelated to the ForeignCo project or are fixed in nature and needed for the general operations of USClient. The $50 million of overhead costs would have been incurred by USClient and are not incremental to the ForeignCO project. Therefore, the damages claimed by USClient of $50 million of fixed overhead should not be included as damages."
EE has been engaged by USClient to provide an expert witness to comment on ForeignCO's expert report cited above. You have been hired by EE as the expert witness to rebut ForeignCO's opinion. The legal definition of damages resulting from a breach of contract by a defendant are usually calculated under the principle that compensation awarded to the plaintiff as damages should place the plaintiff in the economical position equivalent to the plaintiff's position had the harmful event never occurred.
Required: Write a rebuttal report that critiques the ForeignCO expert witness. In other words, do you agree with ForeignCO's expert that the $50 million of fixed overhead should be excluded as damages claimed by USClient? If you disagree, explain why the ForeignCO expert's opinion is wrong. Note: For the purposes of your report, you should assume that the $50 million of overhead consists of allocated fixed indirect charges such as the salaries of the senior executives (CEO, CFO, etc.), the human resource department, accounting, information technology, depreciation on the corporate office, and so forth.

Question 26

Finsys
Finsys offers Web design and website maintenance and hosting for the mutual fund industry. Finsys clients are small mutual funds that do not have scale economies to design and maintain their own Web portals that their mutual fund investors can access to check account information, receive performance reports on their investments in the fund, and manage their accounts. Finsys uploads real-time information feeds and interfaces with their mutual fund clients' IT systems. The Finsys product line consists of various tools and software modules that enable their clients to control their data and content by automating Web content, print production, and securities regulation compliance.
Finsys has four departments: marketing, Web design, website maintenance, and website hosting. The marketing department contacts potential customers to sell Finsys services, prepares bids, and negotiates final contract details. The typical contract is for three years. (Finsys' Web design services are priced very competitively to win the initial bid.) The Web design department works with clients to design the Web client's initial website to create the client's brand (i.e., the look and feel of the client's website). The website maintenance department provides day-to-day and end-ofquarter website revisions and data feeds so the mutual fund client's customers have access to the latest information about their accounts. Finally, the website hosting department maintains the secure servers that contain the client's mutual fund's data and provides security against hackers and backup. Mutual fund clients of Finsys pay separately for Web design services, website maintenance, and website hosting.
Web design, website maintenance, and website hosting are profit centers, and the managers of these profit centers are rewarded based on their department's operating income. In addition to the four departments, Finsys has an administration department consisting of the CEO, CFO, human resources, and accounting. The following data summarize Finsys's current operating performance:

Currently, Finsys does not allocate the marketing and administration costs to the three profit centers. The CEO and CFO believe that the three profit centers' operating profits are not indicative of the real profits of these profit centers because the profit centers are not bearing any of the marketing and administration expenses. The CEO and CFO propose allocating the marketing and administration costs back to the three profit centers based on the percentage of the profit centers' revenues to Finsys's total revenue.
Required:
a. Prepare a revised set of financial statements that report each profit centers' net income after allocating the marketing and administration costs back to the three profit centers using revenues as the allocation base.
b. Briefly discuss the relative profitability of the three profit centers after allocating marketing and administration expenses using revenues as the allocation base.
c. Analyze the CEO's and CFO's proposal to allocate marketing and administration expenses using revenues as the allocation base. What, if any, changes would you suggest to their proposal of allocating marketing and administration expenses using revenues as the allocation base?

Question 27

Allied Adhesives
Allied Adhesives (AA) manufactures specialty bonding agents for very specialized applications (electronic circuit boards, aerospace, health care, etc.). AA operates a number of small plants around the world, each one specializing in particular products for its niche market. AA has a small plant in
St. Louis that manufactures aerospace epoxy resins and a larger plant in Atlanta that manufactures epoxies for electronics. Each produces somewhat similar epoxy resins that are sold to different customers. The manufacturing processes of the aerospace and electronic adhesives are quite similar, but the selling processes and the types of customers are very different across the two divisions. The St. Louis plant is being closed and moved to Atlanta to economize on duplicative selling, general, and administrative costs (SGA). Aerospace and Electronics will continue to operate as separate divisions. The following table summarizes the current operations of the two plants:

After Aerospace moves to the Atlanta facility, each division continues to operate as a separate profit center, and neither Aerospace nor Electronics is expected to have its revenues, manufacturing cost, or variable SGA affected. The only change projected from moving Aerospace to Atlanta is that the total fixed SGA will fall from $4.4 million to $3.0 million through elimination of redundant occupancy, administrative, and human resource expenses.
AA evaluates its divisional managers based on return on sales (net income divided by sales).
Required:
a. Prepare separate financial statements reporting net income and return on sales for Aerospace and Electronics after the move where the expected lower fixed SGA of $3 million is allocated to the two divisions using: (1) Revenues as the allocation base. (2) Manufacturing cost as the allocation base. (3) Manufacturing margin as the allocation base. (Round all allocations to the nearest $1,000.)
b. Discuss how moving Aerospace into Atlanta affects the relative profitability of the Aerospace and Electronics divisions.
c. Which of the three possible allocation schemes in part (a) will each division manager (Aerospace and Electronics) prefer? Why?
d. Which allocation scheme should AA adopt? Explain why.
e. Should AA be using return on sales as the performance measure for its divisional managers?

Question 28

Plastic Chairs
Plastic Chairs manufactures plastic lawn chairs using a combination of new and recycled plastic. Varying amounts of each type of plastic can be used to produce a batch of 100 chairs. The following table lists the various combinations of recycled and new plastic required to produce one batch of 100 chairs.

the chair manufacturing department receives a bonus based on minimizing the cost per batch of 100 chairs.
Required:
a. What combination of new and recycled plastic will the manager of the chair manufacturing department choose?
b. Overhead (including plant administration, utilities, property taxes, and insurance) is allocated to the chair manufacturing department based on the number of pounds of recycled plastic used in each batch. For each pound of recycled plastic used, the chair manufacturing department is charged $30 of plant overhead. What combination of new and recycled plastic will the manager of the chair manufacturing department select if the manager's bonus is based on minimizing the total cost per batch, which includes new and recycled plastic and plant overhead?
c. Why are your answers to parts (a) and (b) either the same or different?
d. Should the plastic chairs manufacturing manager's bonus be based on minimizing only the plastic costs or should it also be based on minimizing plastic costs plus allocated plant overhead?

Question 29

Law Firm Merger
The managing partners of the law firms Spencer, Spinelli, and Howe (SSH) and Gilbert and Lenz (GL) are discussing a possible merger. The two firms specialize in different areas of law, but focus on the same corporate client pool. The proposed merger offers two benefits: higher revenues and lower combined overhead costs. Higher revenues are forecast through cross selling (current SSH clients will start to use GL and vice versa). Three percent more billable hours per attorney in each firm is expected, and these additional billable hours will not require adding any more staff or other costs (such as higher lawyer salaries) because both firms have excess capacity across their professional staffs. Moreover, the billing rates of the two firms will not change following the merger. All attorneys in each firm are paid a flat annual salary and a share of any profits.
Combined overhead costs will fall 25% by merging and eliminating duplicate service functions such as accounting, IT, marketing, and so forth. The following table summarizes the pre-merger operating data for each firm.

Overhead consists of all other costs except the cost of attorneys (salary and benefits). Each firm now distributes any profits among its lawyers using formulas based on seniority and revenues generated by the attorney.
Post-merger, the new firm will be known as Spinelli and Gilbert (SG) and will consist of two profit centers: SSH and GL. All attorneys in the two pre-merged firms will remain and will be assigned to the corresponding post-merger profit center. Each profit center will distribute its profits to the lawyers in that profit center using the same pre-merger distribution formula. Post-merger, the overhead of the two firms will be pooled and allocated back to the two profit centers based on the number of billable hours generated in each profit center.
Required:
a. Prepare a table that reports the current profits of each firm before the merger and the total profits of the two firms prior to the merger.
b. Prepare a table that reports the profits of each profit center (SSH and GL) after allocating the overhead based on billable hours following the merger assuming that the cost savings and additional revenues are realized.
c. Based on the analyses in parts (a) and (b), discuss the likely outcome of the proposed merger talks. For example, will the attorneys in SSH and GL be equally enthused about the merger? Do you expect the merger to occur if put to a vote of all the lawyers in each firm?
d. What is the underlying cause for your prediction in part (c)?

Question 30

Transmation
Transmation, with sales of more than $2.2 billion, builds and markets several of the world's leading brands of construction and agricultural equipment. Transmation has three operating divisions that are decentralized investment centers. While the three divisions produce and sell different lines of equipment to different customers, they do share a common R D platform, corporate brand name, and many of the same marketing strategies, and operate in many of the same international jurisdictions. Currently, each division president is evaluated and rewarded based on the division's return on assets, defined as net income divided by total assets invested in the division. Net income is revenues generated by the division less operating expenses incurred by the division. The table below summarizes Transmation's annual operating results by division ($ millions).

Required:
a. Calculate each division's ROA.
b. Each of the three Transmation divisions utilizes substantial corporate office resources. These include legal, marketing, information technology, human resources, and research and development. In addition to these corporate level services. Transmation incurs expenses for being a publicly traded firm (accounting, taxes, and the cost of corporate officers and director). These annual corporate-level expenses amount to $270 million, and currently each division is not being charged for these corporate expenses. The divisional operating expenses in the preceding table do not include any allocation of the $270 million corporate expenses. The corporate chief financial officer (CFO) argues that because each division has roughly equal amounts of total assets, each division should be allocated onethird of the $270 million corporate expenses. Calculate each division's ROA after allocating the corporate expenses using the CFO's proposed scheme.
c. Transmation's chief executive officer (CEO) likes the CFO's idea of allocating the corporate expenses to the divisions, but argues that each division does not consume equal corporate resources. Rather, each division's consumption of the various corporate resources is more likely proportional to the division's operating expenses. The CFO and CEO rule out more elaborate metering systems whereby each corporate resource, such as HR or IT, would keep track of the time they devote to each division. The CEO and CFO are convinced that such direct metering would be costly and generate much ill will between the divisions and the corporate departments. Calculate each division's ROA after allocating the corporate expenses using the CEO's proposed scheme.
d. Briefly describe how the relative profitability of the three divisions changes across the three scenarios calculated in parts (a), (b), and (c). Do NOT discuss the pros and cons of the various scenarios. Just describe how the numbers change.
e. Now describe the pros and cons of the three allocation scenarios [including part (a), where there are no allocations].
f. Which of the three allocation schemes would you recommend, or would you propose an alternative allocation scheme?

Question 31

Symmetric Inc.
Symmetric Inc. has two profit centers (North and South) operating in different regions of the world. North and South divisions sell identical services to similar types of customers. However, because of their geographic separation, the two divisions do not share common customers. Most of the compensation of the senior management teams of North and South is tied to their division's profits, and the remainder is base salary. Annual profits in the two divisions depend heavily on the effort and skill of the senior management teams. Nonetheless, random shocks to each division's regional economy can cause its profits in any given year to add or subtract $100 million (each equally likely) from the profits the division would have earned absent the shock. For example, if the South Division would have earned $200 million absent the shock, after the shock it would have earned either $100 million or $300 million. Random economic shocks to North's profits are uncorrelated (independent) with random shocks to South's regional economy. Both divisions have the same expected profits.
The CFO of Symmetric wants to allocate $80 million of fixed corporate-level overhead costs to the two divisions, and is considering one of two possible allocation schemes: (1) allocate the $80 million based on the profits of the two profit centers, or (2) allocate the $80 million evenly; that is, $40 million to each division irrespective of the actual profits of the two profit centers.
Required: Critically analyze the two alternative overhead allocation schemes and make a recommendation to senior management based on your analysis. Your recommendation should be supported by a rigorous quantitative analysis of the situation.

Question 32

BFR Ship Building
BFR is a ship-building firm that has just won a government contract to build 10 high-speed patrol boats for the Coast Guard for drug interdiction and surveillance. Besides building ships for the government, BFR has a commercial vessel division that designs and manufactures commercial fishing
and commuting ships. The commercial division and the government division are the only two divisions of BFR, and the Coast Guard contract is the only work in the government division.
The Coast Guard contract is a cost-plus contract. BFR will be paid its costs plus 5 percent of total costs to cover profits. Total costs include all direct materials, direct labor, purchased subassemblies (engines, radars, radios, etc.), and overhead. Overhead is allocated to the Coast Guard contract based on the ratio of direct labor expense on the contract to firmwide direct labor.
BFR can either purchase the engines from an outside source or build them internally. The following table describes the costs of the commercial division and the Coast Guard contract if the engines are built by BFR versus purchased outside.

Overhead for BFR is $83.5 million and does not vary if the engines are purchased outside or manufactured inside BFR. Overhead consists of corporate-level salaries, building depreciation, property taxes, insurance, and factory administration costs.
Required:
a. How much overhead is allocated to the Coast Guard contract if (1) The engines are manufactured internally? (2) The engines are purchased outside?
b. Based on the total contract payment to BFR, will the Coast Guard prefer BFR to manufacture or purchase the engines?
c. What is the difference in net cash flows to BFR of manufacturing versus purchasing the engines?
d. Explain how cost-plus reimbursement contracts in the defense industry affect the make- buy decision for subassemblies.