Cost Allocations: Theory and Applications Solutions

CHAPTER 9
Cost Allocations: Theory and Applications

Solutions
REVIEW QUESTIONS
9.1 Profit margin.
9.2 Contribution margin equals revenues less variable costs, and profit margin equals
contribution margin less allocated capacity costs.
9.3 Direct estimation, and cost allocations.
9.4 The direct estimation approach involves systematically examining each cost account to
evaluate whether (and how much) a decision would change a capacity cost. An advantage
of this approach is that it can be very accurate. However, it is tedious and time-
consuming, and is subject to the biases and incentives of the decision maker.
9.5 To calculate income in accordance with GAAP, and to influence behavior.
9.6 Absorption costing.
9.7 All product costs – direct materials, direct labor, as well as variable and fixed
manufacturing overhead.
9.8 Sales volume does not affect the fixed manufacturing overhead expensed on the income
statement. Under variable costing, the entire amount of fixed overhead is expensed,
regardless of sales volume.
9.9 As sales volume increases, the amount of fixed manufacturing overhead expensed on the
income statement also increases (and vice-versa). This occurs because, under absorption
costing, fixed manufacturing overhead “travels” with the units produced and sold.
9.10 When inventory levels do not change – that is, when sales = production.
They might do this when there is uncertainty about the final cost – e.g., it allows the
government and the supplier to share the risk of cost overruns.
9.11 To protect its suppliers from the risk of cost over-runs, so that they make the necessary
investments and supply DoD’s requirements.
9.12 To increase profits, as the Ryan Supply Systems example illustrates.
9.13 Allocations can act like a tax – for example, organizations might allocate costs based on
labor hours to encourage divisions to automate.
Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

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9.14 Controllability and incentives.
9.15 Income reported under absorption costing = income reported under variable costing +
fixed manufacturing costs in ending inventory – fixed manufacturing costs in beginning
inventory.
DISCUSSION QUESTIONS
9.16 In such production facilities, all costs that are traceable directly to each product line need
not be allocated among products. In other words, many indirect costs become direct costs,
and costing a product become simpler and more accurate. The disadvantage is that when
a production line is idle because of temporary lull in demand, it cannot be used to make
other products. That is, dedicating production lines can often lead inefficient utilization of
capacity.
9.17 Supplying a product with a negative profit margin product may be necessary to keep a
large customer of the profitable products from going elsewhere. Making a negative profit
margin product may also be good for business if it brings good reputation in the market
place. For example, a restaurant can establish reputation in a community by catering to
large not-for-profit charity events at or below cost so as to develop a clientele.
9.18 Eight to ten years for the automobile industry, two to three years for the toy industry,
three to five years for the computer industry, and ten to fifteen years for the computer
industry would be reasonable estimates.
9.19 To validate this assumption, the company would have to keep track of the consumption of
the capacity resource and the activity volume as measured in units of the cost driver for a
number of periods (say, a week or a month), and then use the High-Low or regression
techniques that we learned in Chapter 4 to evaluate the association.
9.20 There are costs and benefits. As a shareholder, you can get a better idea of a firm’s cost
structure and its operating leverage if GAAP allows variable costing for financial
reporting. On the other hand, firms may not choose to follow variable costing because
they may lose a competitive edge by revealing their cost structure to the competition
(from this perspective it is not in the shareholders’ best interests as well).
9.21 Research and development expenditures are typically not unit level costs. They are either
firm-level costs or product-level costs. Moreover, benefits from research and
development are uncertain both in terms of timing and magnitude. Finally, research and
development costs are not readily identifiable with current production, just as material
and labor costs are. So it does not make sense to “inventory” these costs.
9.22 Yes. The cost pool is the original cost of the machine less salvage value. The cost object
is either the product(s) or the division(s) whose profitability is being measured. The cost
driver is the useful life of the asset being depreciated. The denominator volume is the
expected number of years of useful life.

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9.23 Yes. Reported income under absorption costing will exceed the income under variable
costing if the amount of manufacturing overhead contained in inventory increases over
the year. In multi-product firms, it is possible that the gross value of inventory increases
but the amount of overhead decreases. This seeming anomaly can occur because the
percent of overhead costs can vary across products.
9.24 If cost uncertainty is high and there is no assurance of cost recovery through cost
reimbursement contracts, the risk has to be borne by the producer or the service provider.
In this case, it will be difficult to induce the producer or the service provider to undertake
the necessary investment. On the other hand, once there is assurance of cost
reimbursement there is a natural incentive to overstate the costs. This is a “necessary
evil” that must be tolerated to ensure socially desirable projects (such as key defense
initiatives) are undertaken.
9.25 The charity might wish to choose procedure that would allocate more costs against non-
charity related taxable revenues so as to save on taxes, and use these tax savings for other
presumably charitable causes.
9.26 Not really. Strictly speaking, in competitive markets the prices are set by the market
forces. It is the firm’s overall profitability that matters. As long as the two products are
earning positive contribution margins and more capacity is allocated to the product that
makes the more profitable use of capacity, allocation of capacity costs is not necessary.
9.27 In many firms (especially service and IT firms), people are the most valuable resource.
Getting rid of good talent and people with valuable firm-specific experience just because
of incentives arising from a cost allocation procedure can hurt the company in the long
run. Should the need arise in the future for similar work force in the future it is a lot more
costly to recruit and train new people to the level where they become as efficient as those
who occupied their jobs previously.
9.28 To avoid being allocated overhead costs based on labor consumption, the product line
manager’s natural incentive would be to “outsource” labor intensive activities, even if
outsourcing may be costlier from the firm’s perspective. For example, the manager might
prefer outsourcing parts with high labor content. Outsourcing reduces labor costs as well
as the overhead that is allocated based on labor costs, but it might increase “material”
costs because of the higher prices to be paid for the parts. However, the net result on the
line profit may be positive.
9.29 Yes. From a performance evaluation perspective, the allocated costs will be treated by the
manager as if they are variable costs. By finding ways in which to reduce the costs
allocated to his/her unit, the manager can paint a better picture of his/her performance.
Thus, in making short-term decisions, the manager’s natural incentive would be to not
treat allocated costs as fixed costs even if they are truly fixed.
9.30 Most governments permit some form of accelerated depreciation of long-term assets to
allow higher tax deductions in the initial years of the assets’ lives to induce investment
and growth in their economies. As we know, depreciation is, in essence, allocation of an

9-4
assets cost over its useful life. Some governments levy taxes on imported foreign goods
to protect local industries from foreign competition. This is much like taxing labor via
cost allocation to promote automation. Even arbitrary allocations can induced desired
behavior so long as these allocations are not used for planning and decision making.
EXERCISES
9.31
a. The rate per labor hour is $2,000,000/100,000 hours = $20 per labor hour.
b. If AJ increases its operations to 150,000 labor hours, it might reasonably expect

its overhead costs to be 150,000 hours × $20 per hour = $3 million.
9.32
Molly’s estimated capacity costs for the next year are as follows:
Estimate of overhead
Item Overhead rate Expected volume Expected
(current year) (next year) overhead cost
Machine related $10 per machine hour 132,000 = 120,000 * 1.1 $1,320,000
costs
Labor related $6 per labor hour 86,250 = 75,000 * 1.15 $517,500
costs
Selling expenses 10% per sales $ $1,792,000 = $1,600,000 * 179,200
1.12
Total estimated $2,016,700
cost
9.33
a. The following table provides the required income statements.
Contribution Margin Statement

Item Amount Amount
(current year) (next year)
Revenue $1,500,000 $1,700,000
Cost of Goods sold (25% of sales) 375,000 425,000
Contribution $1,125,000 $1,275,000
Fixed costs 900,000 900,000
Profit before taxes $ 225,000 $ 375,000
Notice that fixed costs remain at $900,000 even though the volume of operations has
increased. This is a reasonable assumption – while fixed costs might increase some, they

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are not likely to increase dramatically because of a modest increase in sales. Further, the
recent hire implies that David has just crossed a step.
b. The following table provides the required statement.
Contribution Margin Statement

Item Amount Amount
(current year) (next year)
Revenue $1,500,000 $2,800,000
Cost of Goods sold (25% of sales) 375,000 700,000
Contribution $1,125,000 $2,100,000
Fixed costs 900,000 1,600,000
Profit before taxes $ 225,000 $ 500,000
Our view of “fixed” costs changes based on the volume of operation. David seems to have
a normal range of operations of about $1.5 million. His fixed costs of $900,000 support
operations at this level. However, the capacity provided by this expenditure is unlikely to
support a much higher volume of sales. For instance, David might need to make more trips,
spend more on stocking and tracking inventory, hire additional sales persons, open a branch
outlet, and so on. All of these actions contribute to higher fixed costs.
This problem reinforces that “fixed” costs are fixed only for a given volume of operations
and for a given time frame. These costs do become controllable if we significantly change
the volume of operations or consider a long time frame. In David’s case, estimating the
higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60%
of sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David
would estimate fixed costs at $1,680,000.
Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference
underscores that using an allocation to project capacity costs assumes that the underlying
relation would be the same. In David’s case, it is likely that, because of scale economies,
fixed costs do not increase proportionately with sales volume. Methods such as direct
estimation are better equipped to deal with such effects, but require more effort and
expertise.
9.34
a.
Let us begin by calculating the current overhead rate. To do so, we first calculate the total
number of labor hours used as 140,000 = 20,000 small * 4 hours per small + 10,000 large *
6 hours per large. Dividing this volume into the total cost of $2,100,000 yields a rate of $15
per labor hour.
With the changed product mix, the number of labor hours needed increases to 150,000 =
15,000 small * 4 hours per small + 15,000 large * 6 hours per large. Thus, we expect the
overhead cost to be $15 per hour * 150,000 hours = $2,250,000.

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b.
We expect no change in overhead costs if we use units as the cost driver to allocate costs
and to estimate changes. The current rate is $70 per unit = $2.1million / 30,000 units. The
expected cost is also 30,000 units * $70 per unit = $2.1 million. There is no change
because the allocation models cost as being proportional to the total volume of units,
without considering any change in the mix of units.
9.35
a.
Let us begin by constructing the income statement. The allocation rate is

$1,400,000/300,000 units = $4.67 per unit. We have (rounding numbers to the nearest $):
Standard Deluxe Total

Number of units 250,000 50,000 300,000
Revenue $3,500,000 $900,000 $4,400,000

($14 × 250,000; $18 × 50,000)
Variable costs 2,000,000 450,000 2,450,000
($8 × 250,000; $9 × 50,000)
Contribution margin $1,500,000 $450,000 1,950,000
Common fixed costs 1,167,500 233,500 1,401,000
($4.67 per unit)
Profit before taxes $ 332,500 $ 216,500 $549,000
Let us repeat the exercise with the new product mix. Notice that the common cost for each
segment now is the new product volume × the allocation rate of $4.67 per unit. We have:

Number of units 150,000 150,000 300,000
Revenue $2,100,000 $2,700,000 $4,800,000

Variable costs 1,200,000 1,350,000 2,550,000
Contribution margin $900,000 $1,350,000 2,250,000
Common fixed costs* 700,000 700,000 1,400,000
* The new product mix consists of 50% Standard and 50% Deluxe. To avoid rounding
errors, we can simply allocate 50% of the common fixed costs to each product (50%
× $1,400,000 = $700,000)
b.
Let us repeat the exercise with the new product mix. We have to compute the allocation
rate for labor hours though. Using the data for the current year, we have total cost =
$1,400,000 and total labor hours = (2 hrs × 250,000 units) + (50,000 units × 4 hours per
unit) = 700,000. Thus, the rate is $2 per labor hour ($1,400,000/700,000). With this rate,

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the following table provides the projected income statement. Notice that the common cost
for each segment now is the new product volume × number of labor hours per product ×
the allocation rate of $2 per labor hour.

Number of units 150,000 150,000 300,000
Revenue $2,100,000 $2,700,000 $4,800,000

Variable costs 1,200,000 1,350,000 2,550,000
Common fixed costs 600,000 1,200,000 1,800,000
($2 × 2 × 150,000; $2 × 4 ×
150,000)
c.
We believe that the pessimistic estimate in part (b) is likely more accurate than the
optimistic estimate in part (a). This is because the allocation in part (a) assumes that each
product, whether it is standard or deluxe, consumes the same amount of capacity resource.
This is not likely a good assumption because the deluxe product takes twice the amount of
labor taken to make a standard product. While some costs surely vary by units, other costs
(perhaps the majority of costs) bear a closer relation to labor hours. Thus, neither the
estimate in part (a) nor the estimate in part (b) is likely to be accurate. However, the
estimate in part b (using labor hours as the basis) is likely more accurate. Based on
this analysis, Bradshaw might rethink its decision to alter its product mix.
9.36
a.
Each additional member from Acme pays $60 but would lead to additional variable costs of
$35 per month. Thus, each “Acme” member would generate a contribution of $60 -$35 =
$25 per month. The 200 additional members therefore increase Hercules’ contribution
margin by 200 members × $25 per member per month = $5,000 per month.
b.
No, the answer in (a) is not a preferred way for Tom and Lynda to evaluate the
proposal. The method would be correct if the costs and benefits associated with the
proposal would be realized in the short-term. That is, accepting or denying the proposal
would not change the magnitude of ‘capacity’ or fixed costs. However, accepting the
proposal will almost surely change “fixed” costs. The proposal would increase membership
by 20% (1,000 to 1,200 members) which means considerably more usage of the facilities.
For example, cardio and strength training equipment would see more wear and tear, and
more yoga classes might need to be scheduled. This means that costs associated with
machine repair and replacement, as well as instructor salaries (fixed costs) would increase.
Tom and Lynda must consider this change to make an effective decision.

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In this context, allocating the fixed costs over members might provide a better estimate
of the long-term cost per member. The allocation is $40,000/1,000 = $40 per member per
month. Added to the $35 in variable costs, the “total cost” of servicing is $75 per member
per month. This estimate is a better approximation of the long-run cost of a member. With
this estimate, Hercules would actually lose $15 per “Acme” member, of $3,000 per month
if it accepts the proposal.
Note: The $75 is just an estimate. It is likely that not all costs (e.g., rental for building)
would increase proportionately with membership, even in the long run. Such factors (which
loosely correspond to scale economies) would lower the actual cost below $75 per member.
However, research shows that operating close to capacity increases both fixed and variable
costs more than proportionately when facilities operate close to capacity. Thus, the “true”
cost might well exceed $75 per member per month. Tom and Lynda would do well to make
the decision as if the cost were “about $75 per month” but could be lower (maybe $70) or
higher (maybe $80). Note that the decision does not change within this qualitatively
estimated range.
9.37
a.
Under variable costing, inventoriable costs only include variable manufacturing costs. In
particular, the value does not contain any allocation for fixed manufacturing overhead.
Thus, the inventoriable cost is $200 + $350 = $550 per unit. Notice that selling expenses
are not included because they only pertain to units sold.
b.
Under absorption costing, inventoriable costs includes variable manufacturing costs PLUS
any allocation for fixed manufacturing overhead. Thus, the inventoriable cost is $200 +
$350 + $500 = $1,050 per unit.
c.
The ending inventory of 50 units contains $25,000 = 50 units * $500 per unit in fixed
manufacturing cost. Because Tip-top began with zero inventories, this amount is also the
change in the fixed overhead contained in the inventory. Thus, absorption costing income
will be higher by $25,000 relative to variable costing income.
9.38
a.
As reported in the following table, the value of Charlie’s ending inventory equals the sum
of the materials cost, the labor cost, and the allocated overhead cost.
Materials cost Given $5,000

Labor cost Given 7,500

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Overhead cost 100% of labor cost 7,500

Total cost of ending inventory $20,000
b.
The change in the allocation basis will lead to a change in the amount of overhead cost
allocated to the inventory account. However, to determine the revised inventory value, we
first need to figure out Charlie’s overhead rate using materials $.
The overhead cost is given. If this value is not provided, we can compute the value
because the rate = total overhead cost/total material $. We can use the fact that the labor $
based overhead rate is 100% of labor cost and the fact that labor cost is $30,000 to
determine that Charlie’s overhead cost is $30,000. Using this estimate, we can compute:
Step 1: Overhead rate per materials $ = $30,000/$24,000 = $1.25 per materials $.
Step 2: In turn, we can use this rate to compute the value of Charlie’s ending inventory.
Materials cost Given $5,000

Labor cost Given 7,500
Overhead cost 125% of materials cost 6,250
Total cost of ending inventory $18,750
c.
Charlie will report $1,250 more in income if he uses labor $ as the allocation basis.
To see why, notice that the allocation serves to partition the total overhead cost of
$30,000 between inventory and the cost of goods sold. Changing the allocation basis
from labor $ to materials $ reduces the portion allocated to inventory from $7,500 to
$6,250. Thus, the change must increase the portion allocated to the cost of goods sold
from $22,500 (= $30,000 - $2,500) to $23,750 (= $30,000 - $6,250). Because the change
does not affect any other item in the income statement, using materials $ as the allocation
basis reduces Charlie’s reported income by $1,250.
9.39
a.
Under GAAP, inventoriable cost comprises variable manufacturing costs (e.g., materials
and labor) plus an allocation for fixed manufacturing costs. Inventoriable cost does not
include any selling or administrative costs – these costs are treated as period expenses.
Precision allocates fixed manufacturing costs to products using units produced as the
allocation basis. Thus, we have:
Step 1: We first calculate the allocation rate by dividing the costs in the cost pool by the
denominator volume. Plugging in the numbers from the problem:
$11,750,000/5,875,000 units = $2.00 per unit.

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Step 2: With this rate in hand, we can determine inventoriable cost for each kind of
bearing:
Model Model Model

6203 6210 30207
Materials cost $1.00 $1.75 $3.00
Labor cost 3.00 4.00 7.00
Allocated overhead 2.00 2.00 2.00
Inventoriable cost $6.00 $7.75 $12.00
Again, we emphasize that selling and administrative costs are not included in
inventoriable costs.
b.
This change in the allocation basis will change the overhead rate that we use to allocate
fixed manufacturing costs.
Step 1: Compute the allocation rate

Plugging in the numbers from the problem,
$11,750,000/$23,500,000 = $0.50 per labor $.
Step 2: Allocate costs

With this rate in hand, we can determine inventoriable cost of each bearing:
Model Model Model

6203 6210 30207
Materials cost $1.00 $1.75 $3.00
Labor cost 3.00 4.00 7.00
Allocated overhead 1.50 2.00 3.501
Inventoriable cost $5.50 $7.75 $13.50
1
$1.50 = $3.00 × $0.50/ labor $; $2.00 = $4.00 × $0.50/ labor $; $3.50 = $7.00 × $0.50/ labor $.
In each case, we compute the allocated overhead as the labor cost of each bearing × rate
per labor $. Notice again that we do not allocate fixed SG&A costs to determine
inventoriable costs.
c.
We find that the inventoriable cost for 6203 has decreased, the cost for 30207 has
increased, and there is no change in the cost for 6210. To understand the difference,
notice that when Precision allocates fixed manufacturing costs using units, each bearing
gets an equal share of overhead. However, when Precision allocates by labor cost,
allocated overhead is proportional to each bearings’ labor cost.

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The “average bearing” consumes $4 of labor (= $23,500,000/5,875,000 bearings). There

will be no change due to the change in the allocation basis only if each kind of bearing
actually did consume $4 per bearing in labor costs. However, this equivalence is not true.
Thus, bearings with lower than average labor cost (e.g., 6203) will experience a
reduction in reported cost if Precision changes it allocation basis from units to labor cost.
Conversely, bearings with higher than average labor cost (e.g., 30207) will experience
an increase in reported cost.
Note: While the inventoriable cost of each individual bearing changes depending on the
allocation basis chosen, the total fixed manufacturing costs allocated to all bearings will
be $11,750,000 regardless of the allocation basis chosen.
9.40
a.
Horizon would report the following income and inventory numbers under variable
costing:
Revenue 1,600 × $50 $80,000

Variable costs
Manufacturing 1,600 × $16/unit $25,600
Selling and administrative 1,600 × $6/unit 9,600
Contribution Margin $44,800
Fixed Costs
Manufacturing Given $24,000
Selling and administrative Given 10,000
Profit before taxes $10,800
Cost of Ending Inventory = $6,400

(400 units (=2,000-1,600) × $16 variable manufacturing cost per unit)
b.
Horizon would report the following income and inventory numbers under absorption
costing:
Revenue 1,600 × $50 $80,000

Cost of Goods Sold
Variable manufacturing 1,600 × $16 $25,600
Fixed manufacturing 1,600 × $121 19,200
Gross Margin $35,200
Period Costs
Variable selling and administrative 1,600 × $6 9,600
Fixed selling and administrative Given 10,000
Profit before Taxes $15,600
Cost of Ending Inventory = $11,200

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(400 units × ($16 variable manufacturing cost per unit + $12 allocated fixed
manufacturing cost per unit)).
1
: $12 = $24,000 total fixed costs/2,000 units produced.
c.
We reconcile the income reported under the two formats as follows:
Income reported under variable costing $10,800

+ fixed overhead in ending inventory 400 units × $12 allocated fixed 4,800
manufacturing cost per unit
- fixed overhead in opening inventory Given 0
= Income reported under absorption costing $15,600
Notice that the difference in income under the two approaches corresponds to the
difference in ending inventory ($4,800 = $11,200 – $6,400).
9.41
a.
The following table provides Creative Tiles’ contribution margin statement and ending
inventory value under variable costing:
Creative Tiles
Contribution Margin Statement & Ending Inventory Value
Revenue/Cost
per unit
Sales volume (in units) 13,500
Production volume (in units) 15,000
Revenue $450 $6,075,000

Variable costs
Direct materials $70 $945,000
Direct labor $140 1,890,000
Marketing & sales $50 675,000
Contribution Margin $190 $2,565,000
Fixed costs
Manufacturing $1,500,000
Marketing & sales 625,000
Profit before taxes $440,000
Inventory:
Units in ending inventory 1,500
Value per unit $70 + $140 $210
Value of ending inventory $315,000
b.

9-13
Under absorption costing, we must allocate fixed manufacturing costs. Creative uses
batches as the allocation basis to perform this allocation. Given total fixed manufacturing
costs of $1,500,000 and 15,000 batches produced, we have the overhead rate as:
$1,500,000/15,000 batches = $100 per batch.
Creative Tiles
Gross Margin Statement & Ending Inventory Value
Revenue/Cost
per unit
Revenue $450 $6,075,000
Cost of Goods Sold
Direct materials $70 $945,000
Direct labor $140 1,890,000
Allocated fixed manufacturing costs $100 1,350,000
Total Cost of Goods Sold $310 $4,185,000
Gross Margin $140 $1,890,000
Period Costs
Variable marketing and sales $50 $675,000
Fixed marketing and sales 625,000
Units in ending inventory 1,500
Inventoriable cost per unit $70+$140+$100 $310
Value of Ending Inventory $465,000
c.
As detailed in the text, the income reported under the two formats differs because of their
differing treatment of fixed manufacturing costs. We expense these costs under variable
costing, whereas we allocate them under absorption costing. Moreover, under absorption
costing, fixed overhead travels with the units produced, first passing through inventory
and then to cost of goods sold. If any units stay in inventory, the associated overhead cost
also stays in inventory, temporarily boosting reported income.
We can reconcile the income reported under the two formats as follows:
Item Calculation Amount

+ fixed overhead in ending inventory 1,500 units × $100 per unit $150,000
- fixed overhead in opening inventory 0 units × $100 per unit 0

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9.42
a.
Under GAAP, inventoriable costs include both variable and fixed manufacturing costs,
but exclude variable and fixed selling and administrative costs. While we have
information about the variable manufacturing costs per unit, we need to allocate fixed
manufacturing costs.
Step 1: First, let us compute the overhead rates in the two departments.
Fabrication = $66,000 / 12,000 machine hours = $5.50 per machine hour.

Assembly = $39,000 / 6,000 labor hours = $6.50 per labor hour.
Step 2: With the information from step 1, we can compute the cost of the product:
Materials cost $50.00 given

Labor cost 42.00 given
Fabrication Overhead 5.50 1 machine hour × $5.50 / machine hour
Assembly Overhead 13.00 2 labor hours × $6.50 / labor hour
Inventoriable cost $110.50
Again, we note that the SG&A costs, whether variable or fixed, are not included in
inventoriable costs. In addition, observe that we could perform the allocation even though
we only have data pertaining to one product.
b.
The inventoriable cost computed under absorption costing will understate the true
long-term cost of a product as it ignores SG&A costs. To determine the long-term
profitability of a product, we need to include all controllable costs. For the product in
question, this means that we should probably add $11 ($5 of variable selling costs + $6 of
fixed selling costs), as both the variable and fixed selling and administrative expenses are
controllable over an extended horizon. For example, if Boston drops the product in
question, it will no longer incur the shipping costs, sales commissions, and advertising
costs associated with selling and marketing the product.
9.43
a.
As per GAAP, Atsuko should value her inventory as the total of materials cost, labor cost,
and allocated manufacturing overhead. Selling and administrative expenses are treated as
period costs and, thus, are not included in the value of ending inventory.
We determine the allocated overhead in two steps;
1. Calculate the overhead rate. For Atsuko, dividing total manufacturing overhead of
$525,000 by total labor cost of $1,050,000 means that her overhead rate is $0.50
per labor dollar.

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2. Determine the portion allocated to inventory. Atsuko’s inventory has $62,500 of

labor content. Multiplying this amount by $0.50 per labor dollar, she will allocate
$31,250 to the inventory.
Thus, combining $50,000 materials + $62,500 labor + $31,250 allocated overhead,

Atsuko will value her inventory at $143,750.
b.
The following table computes Atsuko’s reported income.
Revenue 3,300 pairs  $750 per pair $2,475,000

- Materials ($700,000 - $50,000) 650,000
- Labor cost ($1,050,000 - $62,500) 987,500
- Overhead cost ($525,000 - $31,250) 493,750
= Gross Margin $343,750
- Selling and administrative costs Given 250,000
= Profit before taxes $93,750
Notice that the total cost of materials and labor is split between cost of goods sold (in the
income statement) and the inventory account (in the balance sheet). The manufacturing
overhead cost is split in a like fashion.
c.
The key to answering this question lies in recognizing that the manufacturing overhead
has a large fixed component, which does not change in response to volume. However,
the cost will be split between inventory (a balance sheet account) and cost of goods sold
(an income statement account) in proportion to the number of units. (For simplicity, we
use units as the allocation basis – the argument holds for other allocation bases as well).
Thus, if Atsuko increases her production, she will have more units in inventory. In turn,
the greater number of units in inventory will attract a greater share of the fixed
overhead cost. By arithmetic, the amount recorded in the cost of goods sold for
overhead expenses will decrease, causing reported income to increase. Thus, Atsuko
can increase reported income by increasing production. More generally, including
allocated manufacturing overhead when valuing inventory provides an incentive to
over-produce because such over production temporarily boosts reported income.
9.44
a.
Contribution margin is price less all variable costs. For Xenon, variable costs include
materials, labor, and variable overhead. We know the cost of materials and labor but need
allocations to determine the cost of variable overhead.
Total variable overhead costs = 1/3 of total overhead = 1/3 × $1,500,000 = $500,000.
Dividing through by the total labor cost, we have:

9-16
Variable overhead per labor $ = $500,000/$1,000,000 = $0.50/labor $.
Because the pump has $30 of labor cost, Xenon will allocate $30 × $0.50 = $15 toward
variable overhead.
Collecting this information, we have:
Sales Price $90.00 per unit

Given
Less: Materials 12.00
Given
Labor 30.00
Given
Variable overhead 15.00
$30.00 × $0.50 / labor $
Equals: Contribution margin 33.00 per unit
b.
Gross Margin is price less all manufacturing related costs, including variable and fixed
overhead. We know the cost of materials and labor but need allocations to determine the
cost of variable and fixed overhead.
From part [a], we know that variable overhead rate is $0.50 per labor $.
Additionally, total fixed overhead costs = 2/3 of total overhead = 2/3 × $1,500,000 =
$1,000,000.
Dividing through by the total labor cost, we have:
Fixed overhead per labor $ = $1,000,000/$1,000,000 = $1.00/labor $.
Because the pump has $30 of labor cost, Xenon will allocate $30 × $1.00 = $30 per pump
toward fixed overhead.
Collecting this information, we have:

Per Pump
Sales Price $90.00 Given
Less: Materials 12.00 Given
Labor 30.00 Given
Variable overhead 15.00 $30.00 × $0.50/labor $
Fixed overhead 30.00 $30.00 × $1.00/labor $
= Inventoriable cost 87.00
Equals: Gross Margin $3.00
Note: While the gross margin on Xenon’s pump is lower than its contribution margin, this
is not always the case. For example, the gross margin could exceed the contribution
margin if allocated fixed manufacturing costs are less than variable selling costs.

9-17
c.
Now, Xenon has to compute two separate fixed overhead rates, corresponding to the two
cost pools. We have:
Costs Denominator Rate
Volume
Materials related pool $240,000 $600,000 $0.40 / materials $
Labor related pool $760,000 $1,000,000 $0.76 / labor $
Using these rates, we compute:

Per Pump
Sales Price $90.00 Given
Less: Materials & components 12.00 Given
Labor 30.00 Given
Variable overhead 15.00 $30.00 × $0.50 / labor $
Fixed overhead (materials) 4.80 $12.00 × $0.40 / material $
Fixed overhead (labor) 22.80 $30.00 × $0.76 / labor $
= Inventoriable cost 84.60
Equals: Gross Margin $5.40
We can understand the difference in gross margins (inventoriable costs) by appealing to the
property that the allocated cost is proportional to the driver volume in a cost object. When
Xenon allocates cost using labor $, the overhead allocated to the pump is a multiple of the
labor $ in the pump. The percent of overhead allocated to the pump equals the percent labor
contained in the pump.
Globally, materials cost is 60% of labor cost (60% = $600,000/$1,000,000), meaning that
an average product has $0.60 of materials cost for each $1 of labor cost. However, the
pumps only have $12 of materials for $30 of labor, meaning that pumps use
proportionately less materials than the average product ($12/$30 = 40%). The ratio of
the pumps’ materials cost to total materials cost is therefore smaller than the ratio of
the pumps’ labor cost to total labor cost. Thus, when Xenon breaks out some overhead
(in this case $240,000) and allocates this amount using materials $, the amount allocated
to the pumps will decrease. Naturally, inventoriable cost also decreases, thereby
increasing gross margin.
9.45
Putting units into inventory instead of selling them has two effects. First, we would lose the
revenue and second, we would avoid the associated COGS and variable selling expenses.
Thus, if a product has a negative profit margin (or equivalently, if the allocated fixed
overhead cost > contribution margin), then inventorying the unit will increase profit.

9-18
9.46
Let’s compute the taxes paid if Shah uses garments as the allocation basis:
Cost per garment = $660,000 / (20,000 + 20,000) = $16.50 per garment.
Costs allocated to Europe = 20,000 garments × $16.50 / garment = $330,000.

Costs allocated to India = 20,000 garments × $16.50 / garment = $330,000.
We cannot compute the tax directly as we do not have data relating to income. However,
we can calculate the tax savings as the overhead cost is an allowable deduction to
income.
Thus, the allocation scheme will result in a tax shield of ($330,000 × 40%) + ($330,000 ×
30%) = $231,000.
Next, let us compute the tax shield if Shah were to allocate overhead cost using labor
hours as the allocation basis.
Denominator volume = (20,000 garments × 7 hours) + (20,000 garments × 4 hours)

= 220,000 hours.
Cost rate per hour = $660,000 / 220,000 hours = $3 per hour.
Costs allocated to Europe = 20,000 garments × 7 hours / garment × $3 / hour = $420,000.
Costs allocated to India = 20,000 garments × 4 hours / garment × $3 / hour = $240,000.
Thus, the allocation scheme will result in a tax shield of ($420,000 × 40%) + ($240,000 ×
30%) = $240,000.
Changing the allocation basis from garments to labor hours would therefore save Shah
Company, $240,000 - $231,000 = $9,000 in taxes paid.
9.47
a.
If David outsources the product, the firm will pay $90,000 but save $60,000 in materials
and labor costs. There is no change in capacity costs (as stated in the problem). Thus, the
firm’s profit would decline by $30,000 if David were to outsource this product.
b.
From David’s perspective, the cost of outsourcing the product is still $90,000. But, he will
avoid (in his profit and loss statement), the allocation for labor costs. The cost of the

9-19
component is now part of materials costs, which does not attract a overhead charge. How
much will David save in allocated overhead? We know that materials plus labor is $60,000
and that labor is usually twice the cost of materials for the average product. Thus, labor
cost is $40,000. We also know that overhead is allocated at 100% of labor cost. Thus, the
current internal cost (from David’s perspective) is $100,000 = $20,000 (materials) +
$40,000 (labor) +$40,000 (allocated overhead). Thus, the profit of his product line will
increase by $10,000 if he outsources the product.
c.
This problem illustrates the classic tension between the firm wide and the local
perspective. For the firm, capacity costs are fixed relative to this decision. If the costs were
not allocated to David, they would be allocated elsewhere. However, the allocation
process makes the fixed cost appear to be a variable cost – David’s allocation reduces
by $1 for each dollar reduction in labor costs. This change in the perception of cost
behavior is why divisions might (often unknowingly) make decisions that are not
beneficial to the entire firm.
9.48
a.
Let us consider the problem from the firm’s perspective.
Item Product A Product B

Cost to buy (outsource) $60,000 $45,000
Cost to make internally:
Materials $20,000 $40,000
Labor costs $30,000 $10,000
Total cost (internal) $50,000 $50.000
Outsource? NO YES
Profit from outsourcing ($10,000) $5,000
b.
Let us consider the problem from Samantha’s perspective.
Item Product A Product B

Cost to buy (outsource) $60,000 $45,000
Cost to make internally:
Materials $20,000 $40,000
Labor costs $30,000 $10,000
Allocated overhead $45,000 $20,000
Total cost (internal) $95,000 $70.000
Outsource? YES YES

Profit from outsourcing $35,000 $25,000

9-20
Samantha would prefer to outsource product A rather than product B as his income
increases more.
c.
This problem illustrates the classic tension between the firm wide and the local
perspective. For the firm, capacity costs are fixed relative to this decision. If the costs were
not allocated to Tim, they would be allocated elsewhere. However, the allocation process
makes the fixed cost appear to be a variable cost – Tim’s allocation reduces by $1.50 for
each dollar reduction in labor costs. This change in the perception of cost behavior is why
divisions might (often unknowingly) make decisions that are not beneficial to the entire
firm.
9.49 This problem demonstrates the arbitrary nature of allocations for some common costs. In
this case, the demand for the allocation is driven by a reimbursement consideration. There
is no underlying economics of the production process that can help guide the decision, nor
is there is a control role. Thus, because the sole objective is to split the cost between two
cost objects, Shibin must subjectively choose the allocation basis.
The following schemes come to mind:
1. Equal split of cost because both schools derive the same benefit. Under this scheme,
Shibin will seek a reimbursement for $250 from each of the two schools.
2. Allocate $400 to State University and $100 to Prestige, arguing that State
University would have paid $400, if Prestige had not invited Shibin for an
interview. Prestige is only responsible for the incremental cost.
3. Split the cost as per perceived ability to pay. Arguably, as a private Ivy League
school, Prestige has greater financial resources relative to State University, a state-
supported school. Thus, Shibin may submit expenses of, for example, $350 to
Prestige and $150 to State University.
Overall, there is no clear winner among the candidate mechanisms. The choice
depends on perceptions of fairness, equity, and ability to bear.

9-21
9.50
a.
The following table provides the required computations.
Allocation Allocation Using Allocation

Using Pam’s Sales Using
Budgeted Client’s Sales
hours
Step 1: Determine the allocation rate
Total cost in cost pool $6,000 $6,000 $6,000

Denominator volume 80 hours $125,000 $250 million
(40+40) (100,000+25,000) (50m + 200m)
Rate per unit of cost driver $75 per $0.048/$ of Pam‘s $24/million of
hour sales to client client sales
Step 2: Determine the cost allocated to each client

Apollo $3,000 $4,800 $1,200
Troy $3,000 $1,200 $4,800
Total allocated $6,000 $6,000 $6,000
Notice that the cost allocated to each client differs markedly depending on the allocation
basis chosen.
b.
Pam faces a sticky problem, with no obvious solution. The one thing that is clear is that
she cannot double-bill her clients. That is, it would be unethical for Pam to charge both
clients for the entire $6,000 cost of the common work. She must allocate this cost among
the two clients.
However, there is no obvious allocation basis. All else being the same, Pam prefers to
allocate more to Apollo as the choice increases her reimbursement. Pam’s likely goal of
increasing her wealth and building a longer client list also push her in this direction.
However, this action penalizes an existing client for a new one.
The “ability to bear” criterion suggests a greater allocation to Troy. Ultimately, Pam has
to make a subjective decision about the choice for an allocation basis. An equal split
seems as good as any other choice. Moreover, such a split is easy to explain and is a
defensible action, should a client challenge the cost.

9-22
PROBLEMS
9.51
a.
We can understand the rationale for Brian’s actions. As we learned in Module II, firms
cannot control capacity costs in the short-term. That is, these costs are not relevant for
short-term decisions. Moreover, Brian’s firm is a setting of excess capacity, meaning that
capacity has zero opportunity cost. With these facts, contribution margin is the right
measure to maximize profit in the short-term. However, the italicized “short-term” is
crucial, as we will see next.
b.
We also can understand the rationale for the VP’s actions. The VP might be considering
longer-term effects in nixing the deal. For instance, reducing the price now might make it
much harder to raise prices once demand picks up. Likewise, knowledge of a price cut for
this customer might lead other customers to demand similar concession, leading to lower
profitability. Finally, perhaps the VP knows that capacity is likely to become more fully
utilized in the near future (i.e., she knows the deals in works by ALL sales persons, unlike
Brian, who only knows the deals he is working on), meaning that she might have a finer
estimate of the opportunity cost of capacity. Thus, we can justify the VP’s actions if we
adopt a long-term view.
Note: This problem links back to the big-picture presented in the part opener.
9.52
a.
Let us begin by calculating the total number of machine hours that Catlow uses. We have:
(2,900 units × 2 hours / unit) + (1,400 units × 3 hours / unit) = 10,000 hours.
Given the overhead rates:
Expected variable costs for the year = 10,000 hours × $20 / hour = $200,000
Expected fixed costs for the year = 10,000 hours × $30 per hour = $300,000
Thus, during the current year, total expected overhead = $500,000.
We can also use the rates to project capacity costs (overhead) for the new product mix.
Under this mix, we have:
(3,400 Alpha units × 2 hours /unit) + (2000 Beta units × 3 hours/unit) = 12,800 hours

9-23
The expected overhead is (12,800 hours × $20 / hour) - $256,000 for variable overhead,
and $384,000 (= 30 × 12,800) for fixed overhead, or $640,000 in total.
b.
The estimate in part (a) is likely understated. This is because we need 12,800 hours and
each machine could only provide 2,000 hours. Thus, we need to expand capacity from 5 to
7 machines. This change would not affect the variable overhead (which is only proportional
to actual machine hours consumed). However, the purchase of 2 additional machines would
substantially increase fixed overhead costs. Currently, each machine costs 2,000 hours ×
$30 per hour = $60,000 in fixed overhead. With 7 machines, we will have $420,000 of
overhead. Thus, total overhead is more likely to be $256,000 + $420,000 = $676,000.
Why does expected overhead increase? We will need to buy 7 machines or 14,000 hours of
capacity even though we only need 12,800 hours. The additional purchase occurs because
we can only buy capacity in increments of 2,000 hours. The fixed overhead relates to the
cost of capacity supplied in the form of machine hours. The machine cost would not
decrease because we do not plan to fully use the machine.
Such fine-tuning of capacity cost estimation is possible only if we perform direct

estimation. In this case, we analyzed the individual nature of the machines to determine the
increase in costs. While refining the analysis this way leads to greater accuracy, doing so is
costly. In particular, we need to collect data on more drivers and perform more analysis to
assign costs to drivers. This is a difficult and subjective exercise. We trade off accuracy in
estimation with the ease in obtaining the estimate.
9.53
a.
Let us begin by calculating unit contribution and profit margins.
Item Standard Custom

Price $130 $175
Unit Contribution margin $65 $105
Unit profit margin $25 $65
Variable cost = (1- CMR) * price $65 $70
Allocated fixed cost = Contribution $40 $40
margin – profit margin
Comparing the allocated fixed cost for the Standard and the Custom products, it seems that
Sunder employs the number of units as the allocation basis. This is the mechanism that
would lead to an identical allocated amount for each product. (If Sunder used machine
hours instead, the custom product should receive twice the allocation received by the
standard product.)
Also notice that Sunder’s total profit is (75,000 × $25) + (25,000 × $65) = $3,500,000.

9-24
b.
We now need to calculate the rate per machine hour. For this calculation, we need the total
overhead cost and the total number of machine hours.
We can use the allocated rate per unit (in part a) to back out total overhead. The rate is $40
per unit and there are 100,000 units (= 75,000+25,000). Thus, the overhead cost must be
100,000 × $40 = $4,000,000. We compute total machine hours as (75,000 standard × 2
hours /unit) + (25,000 deluxe × 4 hours /unit) = 250,000 hours. Combining the two
estimates, we have the rate per machine hour as $16 per machine hour. Thus, we have:

Price $130 $175
Variable cost $ 65 $ 70
Unit Contribution margin $ 65 $105
Allocated fixed cost $ 32 $ 64
(2 hours × $16 ; 4 hours × $16)
Unit profit margin $ 33 $ 41
Notice that the profit margin for the standard product has increased from $25 to $33 while
that for the custom product has decreased from $65 to $41. However, Sunder’s total profit
is still (75,000 * $33) + (25,000 * $41) = $3,500,000. This equivalence emphasizes that the
allocation only divides the cost. The total is unaltered.
c.
The following table provides the required information. Notice that we treat capacity costs
as controllable for this decision. As the number of units changes, the capacity costs change
proportionately because the rate per unit stays the same.

New Units 50,000 50,000
Profit Margin per unit $ 25 $ 65
Total profit $1,250,000 3,250,000
Thus, Sunder expects to make $4,500,000 in profit with the new product mix. Also, notice
that total capacity costs stay at $4,000,000 although we changed the mix. We get this result
because the total number of units did not change even though the mix changed. Further, our
allocation scheme is as if each unit consumes the same amount of capacity resources,
regardless of the type of product.
Based on this projection, changing the product mix appears to be a good idea as it increases
expected profit.

9-25
d.
The following table provides the required information. Notice that we treat capacity costs
as controllable for this decision. As the number of units made changes, the capacity costs
change proportionately because the rate per unit stays the same.

New Units 50,000 50,000
Profit Margin per unit $ 33 $ 41
Total profit $1,650,000 2,050,000
Thus, Sunder expects to make $3,700,000 in profit with the new product mix. Also notice
that total capacity costs increases to $4,800,000. Total machine hours are (50,000 × 2) +
(50,000 × 4) = 300,000 hours, and the rate is $16 per machine hour.
Even though the total number of units did not change, the change in mix increased the
number of machine hours, increasing the total expected capacity cost.
While switching product mix still increases profit, the idea is not so compelling now. The
change in results underscores the importance of picking the right driver to estimate the
change in capacity costs. In this instance, machine hours probably are better suited as
deluxe products seem to require more work than standard products do.
9.54
:a.
Residential Commercial Total
Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue* $320,000 $3,600,000 $3,920,000
Variable costs* 56,000 720,000 776,000
Traceable fixed costs 150,000 225,000 375,000
Segment margin $114,000 $2,655,000 $2,769,000
Common fixed costs NA NA 1,100,000
Profit before taxes $1,669,000
* Residential Revenue = 200 × ($800,000/500 customers)
Commercial Revenue = 300 × ($1,200,000/100 customers)
* Residential Variable costs = 200 × ($140,000/500 customers)
Commercial Variable costs = 300 × ($240,000/100 customers)
b.
Let us first construct the allocation rates. We have $1.1 million in common fixed costs and
$2 million in total revenue. Thus, the allocation rate (for charging to segments) is $1.1/$2.0
= 55% of revenue. With this rate, we have the current income statement as:

9-26

Number of pickups per week 500 500 1,000
Revenue $800,000 $1,200,000 $2,000,000
Variable costs $140,000 $240,000 $380,000
Contribution margin $660,000 $960,000 1,620,000
Segment margin $510,000 $735,000 $1,245,000
Common fixed costs 440,000 660,000 1,100,000
($800,000×.55;$1,200,000×.55)
Profit before taxes $70,000 $75,000 $ 145,000
Now, let us re-do the income statement, except let us assume that both segment and
common fixed costs vary in proportion to sales revenue. That is, sales revenue is the driver
for fixed costs. Then, as we calculated above, the rate for common fixed costs is 55% of
revenue. With respect to traceable fixed costs, the rates are $150,000/$800,000 = 18.75%
for residential customers and $225/$1,200 = 18.75% for commercial customers.
With these rates, we have:

Number of pickups per week 200 300 ×5 = 1,700
1,500
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
($320,000×.1875;$3,600,000×.1875)
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs 176,000 1,980,000 2,156,000
($320,000×.55;$3,600,000×.55)
Profit before taxes $ 28,000 225,000 $253,000
While profit increases relative to current levels, it is substantially lower than the estimate in
part (a). The key difference, of course, is framing the problem as a long-run instead of a
short-term problem. This change means that fixed costs are potentially controllable, and we
estimate the new level using sales revenue as the cost driver.
c.
Now, let us re-do the income statement, except let us assume that both segment and
common fixed cost vary in proportion to the number of pickups. That is, pickups are the
driver for fixed costs. Then, the rate for common fixed costs is $1,100,000/1,000 = $1,100
per weekly pick up. With respect to traceable fixed costs, the rates are $150,000/500 =
$300 per weekly residential pickup and $450 per weekly commercial pickup.

9-27
With these rates, we have:

Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
Traceable fixed costs* 60,000 675,000 735,000
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs* 220,000 1,650,000 1,870,000
Profit before taxes $ (16,000) $ 555,000 $539,000
d.
The estimate in part (a), $1,669,000, is not reliable. The estimate assumes that capacity
costs would not change either in response to the change in the product mix or the change in
sales volume. This assumption seems odd because it is likely that commercial and
residential customers differ in terms of their resource demands. For example, commercial
clients need five times as many pickups as residential clients.
The estimates in parts (b) and (c) compute the expected change in capacity costs by using
allocations. However, they differ in terms of the driver used. It is difficult to uniquely
identify the single best driver – some costs might be driven by sales volume while others
might more closely relate to the number of pickup. Thus, neither measure is completely
accurate although we expect that the number of pickups is a better estimate than sales
revenue.
N&N’s management could be quite confident that the change in the nature of the business
would increase their profit. The best estimate might be a weighted average of the
estimates in parts (b) and (c), where the weights correspond to management’s belief that
the underlying activity (pickups or revenue) is the true driver of capacity costs.
9.55
Allocations of capacity costs to products and a mandate to recover full cost in prices are
among the most contentious of issues in firms. At some level, Paul has a valid point. On an
incremental basis, it is likely that the firm’s capacity costs would not change because of this
product. As Paul argues, the accounting department’s cost would not change.
However, such an incremental methodology is most appropriate for short-term decisions
only. Over the long-term, capacity costs are controllable. For instance, adding 10 such
products would change the cost in accounting. The allocation is a way, albeit a crude
way, of measuring the change in the firm’s capacity costs. The mandate to recover full
costs is then pricing from a long-term perspective, which is suitable for product planning
and portfolio decisions. For such decisions, we should consider capacity costs as being
controllable, and the allocations in the product cost sheet are a rough estimate of how these
costs would change if the firm were to add the new product.

9-28
9.56
a.
The total capacity cost for Waymire is $13,500,000 and the firm has 135,000 labor hours.
Thus, the current rate for allocating capacity costs is $100 per labor hour
(=$13,500,000/135,000).
With the change in product mix, Waymire only expects 121,500 labor hours. Thus, if it uses
labor hours as the sole driver, its expected capacity cost would be 121,500 labor hours ×
$100 per labor hour = $12,150,000.
b.
The total capacity cost for Waymire is $13,500,000. It appears that $3,540,000 of the cost
relates to marketing and the remainder of $9,960,000 pertains to manufacturing. Given that
that the firm has 81,000 machine hours. Thus, the current rate for allocating capacity costs
is $122.962 per machine hour (=$9,960,000/81,000). Similarly, the rate per sales $ is
$3,540,000 / $162,000,000 = 2.185%.
With the change in product mix, Waymire expects only 132,300 machine hours and sales of
$175,000,000. . Thus, if it uses machine hours as the sole driver, its expected capacity cost
would be 132,300 machine hours × $122.962 per machine hour = $16,267,872.
With the change in product mix, Waymire expects revenue of $175,000,000. Thus, its
expected capacity cost would be $175 million × 2.185% = $3,823,750.
Total overhead is therefore estimated at $20,091,622 = $16,267,872 + $3,821,750.
c.
It seems reasonable to use different drivers for different types of costs. The following is one
possible grouping (using the four available drivers only):
Item Driver
Materials handling and inventory Materials $
Supervision Labor hour
Payroll Labor hour
Factory administration Labor hour
Machine depreciation Machine hours
Machine operations Machine hours
Sales offices Revenue
Travel and other customer development Revenue
Selling administration Revenue
With this grouping, we have the following rates.

9-29
Item Amount Driver units Rate / driver unit

Materials related costs $2,400,000 $48,000,000 $0.05 per material $
Labor related costs $2,700,000 135,000 $20 per labor hour
Machine related costs $4,860,000 81,000 $60 per machine hour
SG&A costs $3,540,000 $162 million 2.185% of revenue
Total $13,500,000 NA NA
With the new rates, we have the estimated capacity costs as:
Rate / driver unit Projected Driver Projected amount

Item units
Materials related costs $0.05 per material $ $52,000,000 $2,600,000
Labor related costs $20 per labor hour 121,500 hours 2,430,000
Machine related costs $60 per machine hour 132,300 hours 7,938,000
SG&A costs 2.185% of revenue $175,000,000 3,823,750
Total NA NA $16,791,750
d.
The analyses in parts (a) and (b) use allocations to approximate the change in capacity
costs. The analysis in part (c) refines the allocation by considering the nature of the costs
being allocated and picking an appropriate driver. In this way, the analysis moves closer to
direct estimation, where we consider individual accounts. For example, it is possible that
the item payroll is not related to the number of labor hours but to the number of people
employed. Likewise, the cost of the item, “factory administration” might be better
estimated if we use both labor and machine hours as the drivers.
While refining the analysis this way brings us closer to direct estimation and potentially
greater accuracy, doing so is costly. In particular, we need to collect data on more drivers
and perform more analysis to assign costs to drivers. This is a difficult and subjective
exercise. Thus, we trade off accuracy in estimation with the ease in obtaining the estimate.
9.57
a.
We compute LuAnne’s margin as:
Revenue $400,000 Given

Manufacturing costs 320,000 @80% of sales revenue
Marketing costs 54,000 @13.5% of sales revenue
Margin $26,000
We compute the Betty’s margin at $22,750 = 6.5% × $350,000, where 6.5% is the
margin (= 100% - 80% - 13.50%).
Thus, LuAnne has the higher margin under the old system.

9-30
b.
Under the revised allocation system, marketing cost is allocated based on orders. Hence,
we need to compute the cost per order and determine the margins.
Step 1: Determine the rate.

Marketing cost per order = Total cost / Total number of orders
We need to calculate both figures as neither is provided to us.
Total marketing cost = 13.50% of total revenue = 0.1350 × $60 million = $8,100,000.
Total orders = Total revenue/Average order size = $60 million/$8,000 = 7,500 orders.
Thus, we have:
Marketing cost per order = $8,100,000/7,500 = $1,080 per order.
Step 2: Use the rate to determine allocated costs.
We can compute the margins as:
Other
Item LuAnne salesperson Detail
Revenue $400,000 $350,000 Given
Manufacturing costs 320,000 280,000 @80% of revenue
Marketing costs (this is 60 orders × $1,080 per order;
step 2 of the allocation) 64,800 37,800 35 orders × $1,080 per order
Margin $15,200 $32,200
Observe that LuAnne now generates less than half the margin generated by Betty.
c.
It is difficult to answer the question with the data provided as the answer depends on the
nature and composition of marketing costs. The old system assumes that marketing costs
are proportional to revenue. This assumption is probably true for many marketing
expenses such as after-sales service or shipping. However, the assumption is probably not
true for other expenses such as invoicing and sales calls. The revised system makes the
opposite assumption that all marketing costs are related to the number of orders and not
sales volume. Thus, both systems are probably inaccurate.
Ideally, we would like to partition marketing costs into two pools – costs that relate to
revenue and costs that relate to order processing. We can then use sales revenue as the
cost driver for the first pool and orders as the driver for the other pool. This kind of a
refined allocation, with two cost pools, is likely to generate a more “accurate”
estimate.

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We hasten to note, however, that there is a limit to such refinements. We are still dealing
with large pools (in $ terms) when we go from one to two pools. Once we go past a few
pools (the exact number depends on the nature of the problem such the magnitude of the
costs, the number of cost objects, and correlations among cost drivers), we increase the
chance for measurement error. Thus, it is possible that any further increase in the number
of cost pools might decrease accuracy in reported costs.
d.
The manager can use this information to focus her sales person’s efforts on the right mix
of sales and activities. For instance, LuAnne’s ranking drops because her average order
size ($6,667 = $400,000/ 60 orders) is smaller than the average of $8,000. LuAnne
therefore imposes higher demands on organizational resources for the same sales volume.
The allocation is one way of sensitizing LuAnne to the financial implications of her
choices. Allocating some (or all) of the cost using orders as the allocation basis will
motivate LuAnne to consider order volume as well when dealing with customers. For
instance, under the accountant’s scheme, LuAnne incurs a “fixed” cost of $1,080 per
order and generates a contribution margin of 20% over manufacturing costs. Thus,
LuAnne should refuse to take any order less than $5,400 (= $1,080 / 0.2) as this is the
breakeven order size. Carefully crafted allocations, when coupled with incentive
compensation, can help encourage desired activities and penalize undesired actions.
9.58
In this setting, the objective is to set prices proportional to the damage inflicted on the
road due to use. Logic tells us that vehicle weight and distance traveled are two important
criteria in determining damage done. Thus, we can view the pricing scheme as an
“allocation” of the road cost to vehicles.
Viewed in this light, a flat charge per vehicle assumes equal damage from all vehicles and
is easy to implement. We only need to install booths at entrances to the toll way and
automating the toll-collection is relatively simple.
Adjusting the flat rate by vehicle category adjusts for weight. The scheme does not
discriminate among empty and loaded trucks. Implementing the scheme is still relatively
straightforward but may require a person to collect the differing toll amounts.
The third allocation basis, using actual weight, is yet more sophisticated. As a continuous
metric, we would term it a duration driver. There are likely significant measurement costs
as the toll authority must have a mechanism to weigh each vehicle using the toll way.
The final scheme is perhaps best at estimating the cost inflicted on the toll way. However,
the scheme is also the most difficult from an implementation perspective. For instance,
we need to monitor where a vehicle enters and exits a toll way.

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This problem highlights some of the tradeoffs involved in choosing an allocation basis.
Simple drivers such as the number of vehicles (which count and are sometimes termed
count drivers) are easy to implement but are inaccurate. More complex drivers which
account for weight (called duration drivers as they account for characteristics) are often
more accurate measures of resources consumed. However, measuring duration drivers
may impose higher costs and have greater measurement error. Overall, the choice is
judgmental, as evidenced by the many observed schemes for collecting tolls.
9.59
a.
An equal assessment implicitly assumes that each household derives equal benefit from
the improvement. The use of linear feet of road front ties the cost to the work done. The
idea here is that the cost is proportional to the linear feet of pipe laid and that
homeowners “own” the pipe that runs through their property. The use of property value is
based on the assumed “ability to pay.” The notion is that persons owning more expensive
homes have greater ability to pay for the upgrade and should be charged accordingly.
All of the metrics are somewhat arbitrary. All of them are easy to implement and have
some reasonable justification. Ultimately, cities make the choice based on political
considerations, with ability to pay often being the dominant criterion.
b.
It is more common to assess sidewalks based on linear feet of road front. Unlike sewer
lines, it is possible to partition sidewalks into discrete pieces that belong to the
homeowner. Indeed, in many cities, the homeowner is responsible for maintaining the
sidewalk (e.g., shoveling snow). The key distinction between sewer lines and sidewalks
appears to be in the ability to trace the cost to the individual homeowner. As sidewalks
can be installed in pieces, there is ample justification to attach the cost of the sidewalk for
a given home to that home. In contrast, sewer lines are a “public good” and the entire
system needs to be completed before benefits are realized.
9.60
Payroll Processing. There appear to be two types of costs in this category. The first
relates to payroll processing and the second relates to employee hiring and firing. Both
expenses are part of operating the business and therefore should be allocated to individual
branches for the purpose of evaluating branch profitability.
The answer is less clear for managerial performance evaluation. The cost of payroll
processing is not controllable by the manager except via his or her influence on the
payroll. Thus, the allocation makes sense if Maggie wants the managers to pay attention
to payroll costs. However, there are likely more direct mechanisms, such as boundary
controls that specify wages and staffing strength, for controlling payroll expense. In a like
fashion, we can argue for allocating some payroll costs based on the number of new
employee hires. While more direct controls are also available (e.g., Maggie speaking with
the branch to reduce turnover), this allocation sensitizes the branch managers to the cost
of turnover.

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Advertising. The cost of corporate advertising can be allocated to branches using sales $
as the basis. The problem text indicates a direct sales effect. Because sales are recorded at
the branch level, it seems reasonable to allocate the associated costs as well for
evaluating branch performance.
The logic is less compelling if the purpose is to evaluate managers. The branch managers
have little control over the cost and, thus, would see the allocation as being arbitrary.
Moreover, it is unclear what performance-evaluation purpose the allocation would serve.
Purchasing and Inventory Handling. This cost resembles the cost of payroll in terms of
its controllability by branch managers. Thus, a similar logic applies. The cost must be
allocated to branches for profitability assessments. Allocating at least a portion of the cost
based on the number of deliveries and using it for managerial performance evaluation
sensitizes managers to the cost of poor forecasting. However, as with payroll, more direct
mechanisms (e.g., all extra deliveries must be approved by Maggie) may suffice to
provide the required control.
This problem highlights three issues.

 The reason for the allocation determines if it makes sense for the firm to allocate
the cost. Taking advertising as an example, the allocation is justifiable for
assessing branch performance but not managerial performance.
 Allocations can modify behavior. If Maggie allocates personnel costs by the
number of hires and fires, and uses the cost in managerial performance evaluation,
branch managers have an incentive to be more careful in their hiring and firing.
However, please note that mere allocation is not enough. The allocated cost must
also influence managerial compensation for the allocation to provide the correct
incentives.
 Allocations are but one tool in the portfolio of controls available to management.
Given Yin-Yang’s size, direct mechanisms may work better and be more cost
effective than cost allocations to modify managerial behavior. It is easier to
conceive of a role for such “control-related” allocations in larger firms.
9.61
a.
There are at least two salient reasons that lead to the demand for a cost allocation in this
setting.
1. Inventory Valuation. The problem indicates that a typical project spans many
years. Great Lakes needs to value the inventory of parcels in its possession at year
end to determine the income reported for a given year. The overall cost (purchase
plus development) must be allocated to individual parcels for this financial
accounting purpose.
2. Cost Justification. For political purposes, it is likely that Great Lakes will wish to
sell the parcel for the school at “cost.” Indeed, Great Lakes might even wish to

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choose a basis that allows it to show a “loss” from the sale to the school board.
Similarly, Great Lakes probably deals with the same set of builders when selling its
many properties. The allocated cost may be shared with the builders to help build
the case for the price charged.
b.
Great Lakes could use many allocation bases (or cost drivers) to determine the cost
allocated to each parcel. The following is a representative list.
1. Area
2. Desirability (Qualitative)
3. Frontage (i.e., the linear feet of road abutting a property)
4. Estimated sales price.
In addition, Great Lakes may choose to sub-divide the $1.4 million of development cost
into smaller cost pools. It could then employ a separate driver for each cost pool.
c.
Great Lakes has competing motives in its choice of allocation bases. The following
criteria seem important:
1. Postpone realizing the gain from sale. For instance, suppose the project has three
stages to be sold in turn. Then, the firm can allocate in a way that leads to least
cost charged to Stage III, that would only become available after substantial
portions in stages I and II have been sold. This mechanism reduces the present
value of the taxes paid by postponing the recognition of income to later periods.
2. Increasing the cost allocated to the schools to maximize political benefit.
3. Increase the cost allocated to homebuilders and retail space to justify higher
prices.
4. Defensibility in public. The allocation scheme must make “sense” if there is a
possibility that the scheme might be subject to public scrutiny.
9.62
a.
During April, Quick Test produced 1,250 units, selling 750 of these units. These 750 units
plus the 750 units in opening inventory comprise the total of 1,500 units sold.
Under variable costing, the 500 units in ending inventory (=1,250 – 750) would be valued
at the variable manufacturing costs. Thus, the value of the ending inventory under
variable costing = $25,000 = $50 × 500 units.
b.
The table below provides the required computation:
Total COGS $105,000 This comprises mfg. costs only

Less: Cost of units from BI 45,000 Given

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= Cost of units from this month $60,000

Cost per unit $80 $60,000/750
Less: Unit variable cost (mfg) 50
Equals Allocated fixed cost/unit $30
× Units made in April 1,250
Fixed costs in April $37,500 1,250 units × $30/unit
c.
The following table provides the required statement.
Quick Test Enterprises
Contribution Margin Statement – April
Revenue $100 × 1,500 $150,000

Variable Costs
Manufacturing costs $33,750* + (750 × $50/unit) 71,250
SGA costs $18,000 (total) - $12,000 (fixed) 6,000
Contribution Margin $72,750
Fixed Costs
Manufacturing From part [c] $37,500
Marketing & sales Given 12,000
* $45,000 total costs - $11,250 in allocated fixed costs
d.
We reconcile the income reported under the two formats as follows:

+ fixed overhead in ending inventory 500 units × $30 per unit 15,000
- fixed overhead in opening inventory $11,250 (given) 11,250
9.63
Understanding the purpose for this allocation helps us define the costs and benefits of
such mechanisms. The purpose is to convey to faculty the opportunity cost of using staff
time for special projects. The absence of allocations conveys the message that the
resource has no cost.
The benefit of allocating $50 per hour is sensitizing faculty to the resource’s cost. While
the project is supposed to be done only when time becomes available, it is easy to
conceive of faculty applying pressure to get their project done, the Center’s staff feeling
personal responsibility for meeting promised schedules, and so on. Thus, even though
there is no direct additional cost to the college, we conceive of an opportunity cost
stemming from delays in the Center’s regular work and/or degradation in the efficiency

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of their service. The arbitrary charge of $50 per hour is an attempt to measure this
opportunity cost and to convey its magnitude to the faculty seeking to use the staff for
special projects.
The cost of charging faculty $50 per hour is that faculty may not use the resource as
much. When the Center’s workload is low, meaning excess capacity is available, the
opportunity cost of available time is zero. The $50 charge therefore over-estimates
opportunity cost, and thus promotes inefficient resource usage.
Students may reasonably wonder about the feasibility of implementing a charge only
when the staff is busy and/or sticking to the norm of doing the projects only when time
becomes available. Both modifications aim to better measure the opportunity cost of staff
time. However, we anticipate practical difficulties in implementing either modification.
Whether the staff is busy is subjective, and few persons would admit to having substantial
slack time. Similarly, it may be difficult to adhere to the norm of doing projects only
when slack time becomes available.
Overall, we support the Director’s request to charge faculty for the center. The actual
charge per hour must necessarily be subjectively determined.
9.64
a.
The purpose appears to be to elicit the true benefits (only known by the divisions) to
acquiring the software. If such an allocation did not take place, each division would claim
considerable benefits and the firm might wind up acquiring software whose costs exceed
the real benefits derived by the divisions. The allocation sensitizes the managers to the
cost of the purchase, thereby modifying their behavior and estimates regarding realized
benefits.
b.
This is a difficult problem, with no obvious solution. The difficulty arises because there is
uncertainty about the number of cost objects (divisions) that should be charged.
Additionally, the allocation scheme would influence the division managers’ estimates of
benefits. For instance, an allocation scheme based on estimated benefits gives incentives
to reduce the estimate. If all managers lowball, it is possible that total estimates are too
low for the software to be acquired even though it would have been desirable absent these
agency conflicts and strategic effects.
The following four allocation schemes come to mind:
1. Equal allocation to all four product divisions. This method has the benefit of being
transparent and easy to implement. However, the allocation is quite arbitrary and has little
correlation with the true benefits realized by each division. Thus, the decision to acquire
must be made prior to obtaining the data about benefits.

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2. Allocate in proportion to benefits received. This scheme has the benefit that we could
condition the decision to acquire the software on the estimated demands. However, the
scheme also provides manages with incentives to lowball because such action shifts the
costs from their division onto other divisions. As argued earlier, such strategic behavior
could lead to the firm foregoing profitable opportunities.
3. Allocate by division size. This gets at the fact that different divisions might realize
different benefits (here the assumptions is that benefits are proportional to, for example,
revenue or assets in place). However, this method has the same faults as the equal
allocation method in terms of eliciting demand information.
4. Allocate only to divisions A and B. Charge Divisions C & D only if they subsequently
use the system, giving appropriate credit to A and B. This scheme is more complex than
the earlier schemes but begins to get at the timing issue. Again, there are incentives for C
& D to lowball their estimates (after all, the software has already been bought).
Additional problems like the one illustrated below in Part [c] also arise.
c.
The division manager has a point. However, if this becomes common practice, none of
the divisions would then become the “first user,” severely accentuating the under-
investment problem. Overall, we do not know of any easily implemented solution to this
problem. Indeed, this situation is the subject of ongoing academic research.
9.65
The following table identifies the costs and benefits of each allocation basis. Notice
that we have to apportion the common cost in some way among the users of The
Peninsula. The problem is that the parks, ponds, trails, and landscaping are public goods,
with the benefits being shared by all.
Basis Advantages Disadvantages

Property This “ability to bear” criterion imposes The retail stores might get
value costs on those most able to bear it. The affected the most as their
assumption is that persons living in value is often quite large. The
more expensive homes would be able to scheme may wind up ‘taxing’
afford more. these stores in favor of
homeowners.
Head This method attempts to measure usage. Retail stores benefit from this
count The method is fair if all parties derive method as their head count is
similar benefits from the common zero. Nevertheless, they too
facilities. derive benefits because of
increased volume and because
their customers and employees
would also use the common
facilities.

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Equal This method is simple and easy to The implicit assumption is

division implement. It assumes that each faulty. The method is also
household / store gets similar benefits regressive in that a condo and
from the park, regardless of its size. a large store would be treated
on equal footing, ignoring
differences in usage and the
ability to pay.
Fee-based This is perhaps the most equitable Some costs (e.g., landscaping)
to the method because it allows the consumer still need to be allocated. All fees
extent to pay only for facilities used. do is to reduce the magnitude of
possible. the problem. Further, there may
be significant administrative
costs associated with designing
and administering a fee-based
scheme.
9.66
In all three instances, there is a business related and a non-business related cost and
benefit. The total cost, however, is common, requiring Jean-Pierre to allocate the cost
among the two purposes.
For situation [a], we believe the Jean-Pierre should seek reimbursement for $5,000,
the business class fare. The travel afforded him an opportunity to increase his personal
enjoyment as well. This is akin to someone getting frequent flyer miles for traveling on
business, and using the miles to take a vacation or obtain an upgrade. (We note that some
firms have policies that appropriate the miles.) The firm did not incur incremental costs
due to Jean-Pierre’s actions. If anything, there is an incremental benefit because Jean-
Pierre might have been in a better state of mind when traveling with his spouse.
The situation in [b] is somewhat similar to that in [a], except that Jean-Pierre could claim
an extra $650 of reimbursement. We believe that Jean-Pierre should not seek
reimbursement for the additional $350. This expense stems purely from private
considerations, and the cost is accordingly not reimbursable.
Reimbursable amounts in situation [c] range from a low of the coach fare ($1,800) to the
entire amount ($5,000). Arguments for charging $5,000 include the idea that the firm is
willing to spend that amount on Jean-Pierre, and it is really up to him as to how he spends
it. For example, many would claim the entire per-diem allowance for meals even if their
actual expense were lower. On the other hand, the firm pays for business-class travel
because of the conveniences it provides. Jean-Pierre would be better able to transact
business if he traveled in business class. One can argue that charging $5,000 in this case
is akin to taking the shuttle bus from the airport to the hotel but charging for a taxi fare.
Overall, we believe that Jean-Pierre should have discussed his choice with his boss and/or

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with the Human Resources Department before acting. He should certainly disclose the
benefit ex post and act per his firm’s directions. In any case, it is clear that Jean-Pierre
should not charge for the extra day of hotel and meal expenses. These expenses stem
solely from private concerns.
9.67
a.
The following table lists the kinds of actions that you could take in response to the
allocation so as to reduce the amount allocated to you.
Item Actions
1 Division managers can reduce head-count by removing people from the firm’s
payroll and hiring them back as consultants. This action reduces the units of cost
drivers in the division, reducing the corporate expense allocated to it.
The action might actually increase total costs rather than reduce them. As a free-
lancer, a consultant would typically charge more than the firm would pay for an
employee. Further, there are additional coordination costs incurred for dealing with
external persons (e.g., security and confidentiality issues, dealing with invoices and
payments, etc.).
2 We can reduce the reported cost for the board by using components that perform
multiple functions in place of individual, function-specific components. For
example, think of an integrated stereo system rather than a system with a separate
amp, CD player, tuner, and speakers. This action reduces the number of components,
reducing reported cost.
The cost-benefit tradeoff is unclear. On the one hand, individual components might
increase product functionality and allow for better design. This might, in turn,
increase the product’s demand/price, thereby increasing product profitability.
However, dealing with many components could increase overhead costs (more
suppliers, more deliveries and so on).
3 We can reduce the reported cost for the board by using components common to this
and other products rather than components unique to this product. This action
reduces the number of unique components, reducing reporting cost.
The cost-benefit tradeoff is unclear as it is similar to that in situation [b]. On the

one hand, unique components might increase product functionality and allow for
better design. This might, in turn, increase the product’s demand/price, thereby
increasing product profitability. However, dealing with many more components could
increase overhead costs. Each unique component might trigger substantial costs such
as developing and certifying a vendor and setting up a part number.

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4 We can reduce the reported cost for our product by making the components
ourselves. This action substitutes labor cost for materials cost, thereby reducing the
amount of overhead allocated to our product.
This action likely increases total costs. The action requires more work to be done
at the plant, and will increase demand for labor hours. In turn, overhead costs might
also increase. Ideally make-or-buy decisions should consider all relevant costs and
benefits. The product manager will over-estimate materials costs, thereby increasing
the chances of an erroneous decision.
5 We can reduce the reported cost for our product by outsourcing components rather
than making them ourselves. This action substitutes materials cost for labor cost,
thereby reducing the amount of overhead allocated to our product.
This action likely increases total costs, as in situation [d]. Ideally make-or-buy
decisions should consider all relevant costs and benefits. The firm’s allocation system
might cause the product manager to over-estimate labor costs, thereby increasing the
chances of an erroneous decision.
b.
Item Actions
1 A firm incurs many costs associated with keeping an employee on the payroll,
particularly if the payroll is centrally administered. Allocating corporate expenses to
divisions based on head count is one way to sensitize division managers to the
hidden costs associated with head count. Unfortunately, unless the allocation is done
carefully, the charge likely over-estimates the true cost of adding employees, thereby
encouraging dysfunctional behavior.
2 Increasing the number of components increases manufacturing costs as each

component must be inserted into the board. Further, the firm has to maintain more
items. The allocation sensitizes design engineers to downstream manufacturing
costs. However, as argued earlier, the effort can backfire as the new design might
compromise product functionality.
3 Dealing with many more components increases overhead costs. Each unique
component might lead to substantial costs such as developing and certifying a vendor,
setting up a part number, and so on. The choice of the driver sensitizes design
engineers to these costs that are often “hidden” from them. The tradeoff, of course,
is that the attention to the count of unique parts might compromise product
functionality and design.
4,5 Consistent with earlier choices, this choice sensitizes product managers to the
overhead cost consequences of increasing materials cost and labor cost. Unless the
allocation is carefully done, it is easy to overestimate this cost impact. Then, because
the product managers would view the allocated cost as a variable cost, they could
easily be misled into making erroneous make-or-buy decisions.

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9.68
a.
The allocation serves to determine each person’s share of the bill. The cost is a joint cost
(visualize the wine being shared), leading to the need for an allocation. We implicitly
allocate costs every time we share a meal, in a restaurant, with friends and family.
(Sometimes, the allocation is all the cost to one person, the host, and none to the guests.)
There are several considerations. Equity in payment seems important, and is the source
of Julie’s frustration. Ease of computation is another consideration. Particularly with
“family style” meals, it may be impossible to determine consumption or other “equitable”
allocation bases. Ability to bear may be a third. Particularly if the friends had differing
economic abilities, we might expect the well-off friend to contribute more. Of these
considerations, only the first two would seem to apply in the situation described in the
problem.
b.
The following schemes come to mind.
1. Julie and/or Becky could be given an “ad hoc” adjustment because of the lower cost
associated with their food and drink choices.
2. Split out the cost of the liquor and the food. Divide each pool equally among the
friends who consumed liquor and food, respectively.
3. Track the cost of the entrée for each person. Subjectively add estimates for the
amount of liquor and other food (e.g., dessert) consumed.
4. Approximate split. That is, every one looks at the bill, estimates their share and adds a
percentage (say 20%) to cover tax and tip. If there’s slight over-contribution, it
usually goes to the waiter. If there’s an under-contribution, then often everyone chips
in a small amount. And if there’s significant under-contribution, then the problem gets
addressed rather than fall unfairly on someone’s shoulders.
The first scheme makes a move toward a more “equitable” split among the friends.
However, the scheme is not perfect. For instance, consider a friend who skipped dessert
because of a diet, or another who did not consume the main course because s/he was
watching his protein intake. Both of these persons could also claim an adjustment, with
each adjustment making the scheme more complex and ad hoc. The second scheme is a
modification that tries to capture the cost differences between liquor and food. The third
scheme takes the second scheme to a logical extreme. However, it is computationally
difficult and involves much subjectivity. Such a scheme defeats the purpose of having a
shared meal and can ruin the evening. Scheme 4, which is a compromise, often works
well in casual settings
Overall, something like scheme 1 may be the best compromise between equity and
ease of computation.

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c.
In this particular instance, we would be surprised if the front-end agreement
influenced the bill in any way. After all, the friends are on their way to becoming well
paid professionals and probably would not skimp on a celebratory dinner. Nevertheless,
allocation methods can influence behavior. The tendency is to order more liberally when
the cost is being split equally (that is, when you bear only a part of the cost of your
actions) compared to when you will bear the entire cost of your actions. This tendency is
exacerbated in groups where one person is perceived as consuming more than his or her
fair share.
MINI-CASES
9.69 a.
This is a classic short-term decision of the sort that we considered in Chapters 5 and 6.
Accepting or not-accepting the job will not substantively affect CG’s capacity costs.
Thus, these costs are not relevant for this decision.
CG is also in a situation of excess supply of capacity with respect to this decision. The
machines would be idle during weekdays, and there is no opportunity cost to using them
for this job.
The only clearly relevant cost for CG is the variable cost of $0.02 per page. One could
argue that we should consider the machine cost as well. Over its life, the cost per machine
hour is:
Total cost of machine $4,000,000

Total hours available 12,000
Cost per hour $333.33 per hour
Cost per page $0.0167 per page ($333.33/20,000 pages per hour)
Because 20 hours is such a small fraction of the machine’s 12,000 hour useful life, we
would not consider the machine cost to be relevant for this decision. Moreover, CG’s
overall machine costs are unlikely to change substantively because of this decision.
Thus, $0.02 is the controllable cost and is therefore the minimum price that can be
charged without lowering profitability. Of course, this does not mean that $0.02 is the
right bid. The marketing manager should charge what the market will bear, also taking
into account long-term strategic issues. For example, this might be a good opportunity to
get CG’s foot in the door with respect to the catalog business.
b.
We disagree with the marketing manager’s logic because we view this decision as
spanning the medium term. That is, the firm is entering a new market and will have to
adjust capacity resources to account for the additional demand. Consequently, the pricing

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decision for the catalogs must consider the cost of capacity resources consumed by
catalogs. These costs include variable costs, the costs for the machine, and the costs of
support staff.
c.
We agree with the accountant’s argument. We can compute the cost of the capacity
resources as:
Machine cost
$4,000,000/12,000 hours = $333.33 / hour,
= $0.0167 / page
($333.33/ hour/20,000 pages per hour)
Support cost
$2,250,000/4,000 hours = $562.50 / hour
= $0.0281 / page
= ($562.50/ hour/20,000 pages per hour)
Total overhead cost = $0.0448 / page
Adding the variable cost of $0.02 per page gives a total cost of $0.0648 per page, which
yields a price of $0.071 per page (= $0.0648 × 1.10), and is comparable to the current
market price of $0.07 per page.
Two points warrant discussion. First, notice that we computed the cost per machine hour
using the cost over the life of the machine. An alternate method is to employ the annual
cost of $1,000,000 (= $4,000,000/expected life of 4 years), then divide it into the
expected use of 4,000 hours per year to obtain a rate of $250 per hour or $0.0125 per
page. We believe that this alternate method is faulty because the machine’s useful life will
decrease if we use it for an additional 1,000 hours each year. That is, the useful life only
be 3 years (= 12,000 hours total life/4,000 hours each year) rather than four years as
projected with existing production.
Second, notice that we use the total cost of the support staff when computing the
overhead rate for this cost pool. An alternate method is to employ the $250,000
incremental cost only to compute the rate as $250,000/1,000 hours or $1,000 per hour (=
$0.0125 per page). We do not believe this alternate method is correct because CG is
adding an additional product line – it is not “incremental,” or temporary, business. Thus,
the catalog product must cover its full share of the support costs and not just the
incremental costs.
d.
Let us examine each cost component separately to evaluate this argument.
 The variable cost per page has not decreased.

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 The cost of the machinery per page also has not decreased. Prior to introducing
catalogs, the annual cost of machinery was $1,000,000 and the annual usage was
3,000 hours. These data yield a rate of $333.33 per machine hour. With the
catalogs, the annual cost is $1,333,333 ($4,000,000 over three years) and annual
usage 4,000 hours, again yielding a rate of $333.33 per hour.
 The support cost per hour has decreased, however. Prior to catalogs, the cost was
$2 million for 3,000 hours, leading to a rate of $666.66 per hour. With catalogs,
the rate is $562.50 per hour ($2,250,000 / 4,000 hours). The reduction occurs
because the incremental production of 1,000 hours does not proportionately
increase support overhead costs. The marginal rate for the new production is
$250,000/1,000 hours = $250 per hour, which is lower than the average rate.
Such reduction in rates could occur for two reasons. First, the additional production
consumed the excess capacity present earlier (thus, not as much was needed in
incremental cost). Second, scale economies resulted in marginal cost being lower than
average cost. In either case, we would argue for a beneficial cost impact on the cost of
producing magazines. That is, we see both the magazines and the catalogs benefiting
from better utilization of excess capacity and/or scale economies. Strategic considerations
should guide whether we should support the marketing manager’s move to share the cost
reduction with customers.
9.70
a. Income Statement - March
All of the units sold in March were produced in March as there is no opening inventory in
March. Thus, knowing that fixed manufacturing costs were $750,000 and 1,500 units
were produced, we determine the fixed cost per unit as $500 per unit = $750,000/1,500
units.
The total inventoriable cost under absorption costing is therefore $200 of variable
manufacturing cost + $500 of allocated fixed manufacturing costs = $700 per unit. We
have:
Total for
Detail March
Opening inventory (units) 0 units
Units made 1,500 units
Units sold 1,000 units
Ending inventory 500 units
Revenue $1,000 per unit × 1,000 units sold $1,000,000

Cost of Goods Sold $700 per unit *× 1,000 units sold 700,000
Gross Margin $300,000
Selling and Administrative Costs $100,000 + ($25 per unit × 1,000 units sold) 125,000
Ending Inventory Value $700 per unit × 500 units in ending
inventory $350,000

9-45
* $700 = $200 variable cost + $500 fixed cost allocation, ($500 = $750,000/1,500units)
Income Statement - April

1,250 units were sold in April but we do not know how many units were produced.
However, we do know that Emily began with an inventory of 500 units (value =
$350,000, as determined in part [a]) and ended with 0 units. Thus,
Units sold 1,250

+ Units in ending inventory 0
- Units in opening inventory 500
= Units produced 750
Of the units sold in April, 500 came from opening inventory, with the remaining 750
coming from current period production. We have to add the costs of these units to
determine the cost of goods sold. Units in opening inventory were valued at $700 per
unit. Let us therefore determine the cost per unit for April’s production.
Variable manufacturing cost $200

Fixed manufacturing cost 1,000 $750,000/750 units
Total cost per unit $1,200
The total cost of goods sold for April is:
Units from opening inventory $350,000 500 units × $700 per unit
Units from current production $900,000 750 units × $1,200 per unit
April COGS $1,250,000
Total selling and administration costs for April are $100,000 + ($25 per unit × 1,250
units) = $131,250.
With this data we have:
Total for
Detail April
Opening inventory (units) 500 units
Units made 750 units
Units sold 1,250 units
Ending inventory 0 units
Revenue $1,000 per unit × 1,250 units sold $1,250,000

Cost of Goods Sold $1,250,000, as calculated above 1,250,000
Gross Margin $0
Selling and Administrative Costs $131,250, as calculated above 131,250
Profit before Taxes ($131,250)

9-46
Ending Inventory Value 0 units in inventory $0
b.
With the data provided, we have:
Detail March April
Sales volume (in units) 1,000 1,250
Production volume (in
units) 1,500 750
Revenues $1,000 × 1,000; $1,000 × 1,250 $1,000,000 $1,250,000

Variable Costs
Manufacturing costs $200 × 1,000; $200 × 1,250 200,000 250,000
Marketing costs $25 × 1,000; $25 × 1,250 25,000 31,250
Contribution Margin $775 × 1,000; $775 × 1,250 $775,000 $968,750
Fixed Costs
Manufacturing 750,000 750,000
Marketing & sales 100,000 100,000
Profit before Taxes ($75,000) $118,750
Note that the pattern of income reported under variable costing conforms to our intuition,
developed from CVP models (i.e., income increases in sales). This correspondence
always holds because, like the CVP model, the variable costing income statement
partitions costs into fixed and variable costs.
c.
We can reconcile the income reported under the two formats as follows:
Item Calculation March April

Income reported under
variable costing ($75,000) $118,750
+ Fixed overhead in ending 500 units × $500 per unit; 0
inventory $250,000 0
- Fixed overhead in opening 0; 500 units × $500 per unit
inventory $0 ($250,000
)
d.
Under both variable costing and absorption costing, Emily’s profit over the two months
equals $43,750. The difference in the income for each month arises because of the
differing treatment of fixed manufacturing costs.
Under variable costing, the entire $750,000 of monthly fixed costs is expensed in the
income statement. In contrast, the cost is allocated to units under absorption costing. This

9-47
allocation means that the cost could be part of the inventory cost. The reconciliation
adjusts for the flow of fixed overhead costs via the inventory account.
Emily began March with zero inventories and ended April with xero inventories. Thus,
the flow of costs into inventory equaled the costs out of inventory for the two month
period. That is, there is no chance for fixed manufacturing costs to stay in the inventory
account. Because the sole difference between the methods is whether fixed
manufacturing costs stay in inventory or not, the profits must coincide over this period.
9.71
a.
There are several possible schemes:
1. Allocate the $7 million already spent to the military application and split the
balance equally between the two applications.
2. Allocate $9 million (its stand alone cost comprising of $7 million already spent
plus the $2 million to be spent) to the military application and the remainder of $1
million to the civilian application.
3. Allocate the $10 million equally to the two applications because they appear to
possess similar revenue characteristics.
Choosing among these methods is difficult, as we can argue both for and against each of
the mechanisms. The first mechanism best matches up the intent of the cost flow with the
application. The initial $7 million was spent for the military application and thus it seems
fair to allocate it as such. The remaining cost benefits both systems and thus is equally
split. The downside of this method is that it seems to give the civilian application a free
ride.
The second allocation treats the civilian product as a by-product and only charges it the
incremental cost of tailoring the technology for civilian use. The benefit is that the firm
gets the maximum reimbursement for developmental expenses, but at the cost of creating
the perception of “over-charging” the military application.
The final mechanism may be perceived by many to be most “equitable” but is not as
profitable. Ultimately, strategic considerations would dictate the choice. We believe that
most managers would choose method 2 because it is well within the initial estimate
provided to the government. That is, management would view the civilian application as
“found money,” or an unexpected bonus. In addition, government contracts often
consider the possibility of such civilian applications when negotiating contracts.
b.
The following table shows the cost allocated to each of the two applications under the
three methods.

9-48
Overhead Overhead
Total of Rate per unit of allocated to allocated to
Total allocation allocation basis civilian military
overhead cost basis application application
Method 1 (Allocate based on materials cost)
$6 million (= $33 million $0.1818 for $3.27 million (= $2.73 million
$2 million + $4 (= $18 million each materials $18 million  (=$15 million 
million) + $15 million) $ (rounded) $0.1818 / dollar) $0.1818 /
dollar)
Method 2 (Allocate based on labor cost)

$6 million (= $27 million $0.2222 for $2.66 million $3.33 million
$2 million + $4 (= $15 million each labor $ (= $12 million  (= $15 million
million) + $12 million) $0.2222 / labor  $0.2222 /
dollar) labor dollar)
Method 3 (Allocate using two cost pools)

$2 million of $33 million $0.0606 for $1.091 million $909,000
materials- (= $18 million each materials (= $18 million  ( = $15 million
related + $15 million) $ (rounded) $0.0606/materials  $0.0606/
overhead $) materials $)
$4 million of $27 million $0.1482 for $1.777 million $2.222 million
labor-related (= $15 million each labor $ (= $12 million  (= $15 million
overhead + $12 million) (rounded) $0.1482 / labor  $0.1482 /
$) labor $)
Total $2.868 million $3.131 million
The choice among the mechanisms depends on the firm’s goals. From a decision making
perspective, method 3 seems to provide the best mapping between the cost of resources
consumed by, and the overhead allocated to, each product. From a reimbursement
perspective, method 2 is preferred because it allocates the maximum overhead to the
military application, thereby increasing C3’s revenue and profit.
c.
We would be hard pressed to argue that this behavior is outside the norms for ethical
behavior. In particular, the government contracted for a certain output and negotiated the
price for that output. The civilian application is an unanticipated externality. For an
example, we observe that federal funds support many research projects at universities.
Yet, the federal government lays no claim to any commercially viable inventions
produced in the research endeavor. (Note: Existing legislation such as the Bayh-Dole Act
governs the government’s claim to profits from the invention.)

9-49
9.72
a.
There are costs and benefits associated with the firm’s choice to allocate overhead based
on labor hours, even as the firm encourages automation. The cost is that labor hours
may not appropriately measure resource consumption in an automated
environment. (The man-machine ratio would have to be the same across all processes for
this allocation to be even somewhat reasonable.) Thus, the allocated cost will poorly
measure the opportunity cost of consumed resources, possibly leading to poor decisions.
The benefit stems from the induced behavior. Product managers such as Karl and
Bjorn will view the allocation as a “tax” that increases the cost of labor. Thus, they will
seek to reduce their product’s labor content, which is behavior consistent with the firm’s
strategy. Suppose the firm’s product market prevents cost-based pricing (for example,
competition is fierce, rendering market price uncontrollable by any one firm). Then, the
benefit from the induced behavior may outweigh the potential for poor pricing decisions.
b.
Karl’s strategy reduces the amount of overhead allocated to Bjorn’s product line by
reducing the number of labor hours consumed. Outsourcing a product’s components
will result in the associated costs being classified as materials costs, which do not attract
an overhead charge. Instead, if Bjorn were to make the product, he would incur both the
cost of the raw materials and the cost of labor required to convert the raw material into
the component. The latter cost would attract an overhead charge.
We see other examples of similar behavior. When overhead is allocated based on head
count (i.e., the number of employees), division managers have incentives to lay off staff
and to rehire the same persons as consultants. The change affects the count of full time
employees (consultants are not employees) and thereby reduces the amount of overhead
allocated to the division.
c.
Suppose Bjorn follows Karl’s advice and outsources some components that are currently
in-sourced. We believe that this action is not likely to change, to any measurable
degree, the firm’s overall expenditure on overhead items. All that Bjorn’s actions
would accomplish is to reduce the overhead charged to his product line. The overhead
that he avoids will now be charged to other divisions within the firm. A popular analogy
is squeezing a balloon at one end. The action reduces the amount of air at that end but
does not reduce the total volume of air in the balloon.
We also believe that Bjorn’s actions will increase the firm’s overall expenditures. By
outsourcing, the firm avoids the materials and labor cost. However, the price paid to the
supplier must cover not only the cost of materials and labor but also the supplier’s
overhead cost and its profit. Thus, the price to outsource likely exceeds the variable cost
of making the component in house, increasing the firm’s overall expense. Nevertheless,

9-50
Bjorn may be tempted to take this action because it would reduce the amount of overhead
charged to his division.
From Bjorn’s perspective, the overhead charge is a variable cost. It is very possible for
the company’s overhead charge to be large (particularly if it is based on labor hours in an
automated environment). Overhead rates of 200 or 400% of labor cost are not unknown.
Given such a charge, Bjorn may prefer to outsource because it reduces his total cost.
From the company’s perspective, the calculation may go the other way because the firm
would ignore the overhead cost as being not relevant for the comparison.
d.
We would be hard pressed to argue that Karl’s recommendation is unethical. In an
ideal setting, Bjorn’s and the firm’s goals would be perfectly aligned and employee
actions would benefit the firm as well. However, as we learned in Chapter 1, individual
and organizational goals differ. Such differences inevitably lead to “slippage” of the sort
described in this problem. (We termed this the “agency conflict.”) While firms employ
control mechanisms such as boundary controls and performance evaluations to reduce the
slippage, it may be prohibitively expensive to eliminate it altogether. Seen in this context,
Bjorn’s behavior falls within ethical norms, although it may not advance organizational
goals. From a positive perspective, one hopes that the firm’s management understands the
incentives created by their chosen allocation mechanism. The fact that they have
implemented the mechanism suggests that they consider the costs to be less than the
benefits, with one of the costs being product managers outsourcing components.

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Cost Allocations: Theory and Applications Solutions

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CHAPTER 9

Cost Allocations: Theory and Applications

9.1 Profit margin.

9.3 Direct estimation, and cost allocations.

9.5 To calculate income in accordance with GAAP, and to influence behavior.

9.6 Absorption costing.

9.12 To increase profits, as the Ryan Supply Systems example illustrates.

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

9.14 Controllability and incentives.

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

b. If AJ increases its operations to 150,000 labor hours, it might reasonably expect

Contribution Margin Statement

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

b. The following table provides the required statement.

Contribution Margin Statement

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Let us begin by constructing the income statement. The allocation rate is

Standard Deluxe Total

Revenue $3,500,000 $900,000 $4,400,000

Standard Deluxe Total

Revenue $2,100,000 $2,700,000 $4,800,000

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Standard Deluxe Total

Revenue $2,100,000 $2,700,000 $4,800,000

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Materials cost Given $5,000

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Overhead cost 100% of labor cost 7,500

Step 1: Overhead rate per materials $ = $30,000/$24,000 = $1.25 per materials $.

Materials cost Given $5,000

$11,750,000/5,875,000 units = $2.00 per unit.

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Model Model Model

Step 1: Compute the allocation rate

$11,750,000/$23,500,000 = $0.50 per labor $.

Step 2: Allocate costs

Model Model Model

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

The “average bearing” consumes $4 of labor (= $23,500,000/5,875,000 bearings). There

Revenue 1,600 × $50 $80,000

Cost of Ending Inventory = $6,400

Revenue 1,600 × $50 $80,000

Cost of Ending Inventory = $11,200

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Income reported under variable costing $10,800

Revenue $450 $6,075,000

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

$1,500,000/15,000 batches = $100 per batch.

Item Calculation Amount

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Fabrication = $66,000 / 12,000 machine hours = $5.50 per machine hour.

Materials cost $50.00 given

We determine the allocated overhead in two steps;

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

2. Determine the portion allocated to inventory. Atsuko’s inventory has $62,500 of

Thus, combining $50,000 materials + $62,500 labor + $31,250 allocated overhead,

Revenue 3,300 pairs  $750 per pair $2,475,000

Dividing through by the total labor cost, we have:

Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY

Variable overhead per labor $ = $500,000/$1,000,000 = $0.50/labor $.

Collecting this information, we have:

Sales Price $90.00 per unit