Solution manual cost accounting 14e by horngren chapter 14

If corporate costs allocated to a division can be reallocated to the indirect cost pools of the division on the basis of a logical cause-and-effect relationship, then it is in fact prefe

CHAPTER 14 COST ALLOCATION, CUSTOMER-PROFITABILITY ANALYSIS, AND SALES-VARIANCE ANALYSIS

14-1 Disagree Cost accounting data plays a key role in many management planning and control decisions The division president will be able to make better operating and strategy decisions by being involved in key decisions about cost pools and cost allocation bases Such an understanding, for example, can help the division president evaluate the profitability of different customers

14-2 Exhibit 14-1 outlines four purposes for allocating costs:

1 To provide information for economic decisions

2 To motivate managers and other employees

3 To justify costs or compute reimbursement amounts

4 To measure income and assets

14-3 Exhibit 14-2 lists four criteria used to guide cost allocation decisions:

1 Cause and effect

14-4 Disagree In general, companies have three choices regarding the allocation of corporate costs to divisions: allocate all corporate costs, allocate some corporate costs (those ―controllable‖

by the divisions), and allocate none of the corporate costs Which one of these is appropriate depends on several factors: the composition of corporate costs, the purpose of the costing exercise, and the time horizon, to name a few For example, one can easily justify allocating all corporate costs when they are closely related to the running of the divisions and when the purpose of costing is, say, pricing products or motivating managers to consume corporate resources judiciously

14-5 Disagree If corporate costs allocated to a division can be reallocated to the indirect cost pools of the division on the basis of a logical cause-and-effect relationship, then it is in fact preferable to do so—this will result in fewer division indirect cost pools and a more cost-effective cost allocation system This reallocation of allocated corporate costs should only be done if the allocation base used for each division indirect cost pool has the same cause-and-effect relationship with every cost in that indirect cost pool, including the reallocated corporate cost Note that we observe such a situation with corporate human resource management (CHRM) costs in the case of CAI, Inc., described in the chapter—these allocated corporate costs are included in each division’s five indirect cost pools (On the other hand, allocated corporate treasury cost pools are kept in a separate cost pool and are allocated on a different cost-allocation base than the other division cost pools.)

14-6 Customer profitability analysis highlights to managers how individual customers differentially contribute to total profitability It helps managers to see whether customers who contribute sizably to total profitability are receiving a comparable level of attention from the organization

14-7 Companies that separately record (a) the list price and (b) the discount have sufficient information to subsequently examine the level of discounting by each individual customer and

by each individual salesperson

14-8 No A customer-profitability profile highlights differences in current period's profitability

across customers Dropping customers should be the last resort An unprofitable customer in one period may be highly profitable in subsequent future periods Moreover, costs assigned to individual customers need not be purely variable with respect to short-run elimination of sales to those customers Thus, when customers are dropped, costs assigned to those customers may not disappear in the short run

14-9 Five categories in a customer cost hierarchy are identified in the chapter The examples given relate to the Spring Distribution Company used in the chapter:

Customer output-unit-level costs—costs of activities to sell each unit (case) to a customer

An example is product-handling costs of each case sold

Customer batch-level costs—costs of activities that are related to a group of units (cases)

sold to a customer Examples are costs incurred to process orders or to make deliveries

Customer-sustaining costs—costs of activities to support individual customers, regardless

of the number of units or batches of product delivered to the customer Examples are costs

of visits to customers or costs of displays at customer sites

Distribution-channel costs—costs of activities related to a particular distribution channel

rather than to each unit of product, each batch of product, or specific customers An example is the salary of the manager of Spring’s retail distribution channel

Corporate-sustaining costs—costs of activities that cannot be traced to individual

customers or distribution channels Examples are top management and general administration costs

14-10 Charting cumulative profits by customer or product type generates a whale curve This

provides information on the profitability of your customers and clearly identifies the most profitable from the least profitable

14-11 Using the levels approach introduced in Chapter 7, the sales-volume variance is a Level 2

variance By sequencing through Level 3 (sales-mix and sales-quantity variances) and then Level 4 (market-size and market-share variances), managers can gain insight into the causes of a specific sales-volume variance caused by changes in the mix and quantity of the products sold as well as changes in market size and market share

14-12 The total sales-mix variance arises from differences in the budgeted contribution margin

of the actual and budgeted sales mix The composite unit concept enables the effect of individual product changes to be summarized in a single intuitive number by using weights based on the mix of individual units in the actual and budgeted mix of products sold

14-13 A favorable sales-quantity variance arises because the actual units of all products sold

exceed the budgeted units of all products sold

14-14 The sales-quantity variance can be decomposed into (a) a market-size variance (which

arises when the actual total market size in units is different from the budgeted market size in units), and (b) a market share variance (which arises when the actual market share of a company

is different from its budgeted market share) Both variances use the budgeted average contribution margin per unit

14-15 The direct materials efficiency variance is a Level 3 variance Further insight into this

variance can be gained by moving to a Level 4 analysis where the effect of mix and yield changes are quantified The mix variance captures the effect of a change in the relative percentage use of each input relative to that budgeted The yield variance captures the effect of a change in the total number of inputs required to obtain a given output relative to that budgeted

14-16 (15-20 min.) Cost allocation in hospitals, alternative allocation criteria

Indirect costs ($11.52 – $2.40) = $9.12

Overhead rate = Error!= 380%

2 The answers here are less than clear-cut in some cases

Processing of paperwork for purchase

Supplies room management fee

Operating-room and patient-room handling costs

Administrative hospital costs

University teaching-related costs

Malpractice insurance costs

Cost of treating uninsured patients

Profit component

Cause and effect Benefits received Cause and effect Benefits received Ability to bear Ability to bear or benefits received Ability to bear

None This is not a cost

3 Assuming that Meltzer’s insurance company is responsible for paying the $4,800 bill, Meltzer probably can only express outrage at the amount of the bill The point of this question is

to note that even if Meltzer objects strongly to one or more overhead items, it is his insurance company that likely has the greater incentive to challenge the bill Individual patients have very little power in the medical arena In contrast, insurance companies have considerable power and may decide that certain costs are not reimbursable—for example, the costs of treating uninsured patients

14-17 (15 min.) Cost Allocation and Decision Making

1 Allocations based on revenues

Allocations based on direct costs

Allocations based on segment margin

Arizona Colorado Delaware Florida Total

Segment margin $2,500,000 $4,400,000 $1,900,000 $900,000 $9,700,000 Less: Headquarter costs 1,443,120 2,540,160 1,097,040 519,680 5,600,000 Division margin $1,056,880 $1,859,840 $ 802,960 $380,320 $4,100,000 Allocations based on number of employees

2 The Florida Division manager will prefer the number of employees as the allocation base

because it results in the highest operating margin for the division

3 The Arizona Division and the Delaware Division receive roughly the same percentage

allocation of headquarter costs regardless of the allocation base used (Arizona range =

25%-29%; Delaware range = 18.75%-23.5%) However, the Colorado Division and the

Florida Division vary widely (Colorado range = 22.4%-50%; Florida range = 6.25%-

25.1%) All four methods are reasonable options, but none clearly meets the

cause-and-effect criterion for selecting the allocation base If larger divisions tend to consume more

of headquarters’ resources, then using division revenues or number of employees seem to

be the best choices Without compelling reason to change, Greenbold should stay with the

division revenues as the allocation base

Another alternative is to use segment margin as the allocation base on the grounds that

this best captures the ability of different divisions to bear corporate overhead costs

4 If Greenbold elects to use direct costs as the allocation base, the Florida Division will

appear to have a $507,840 operating loss Even so, the Florida Division generates a

$900,000 segment margin before allocating the cost of the corporate headquarters As seen

in the analysis in requirement 1, different allocation bases yield different operating incomes

for the Florida Division, with the direct cost allocation base being the lowest The Florida

Division should not be closed because 1) the choice of allocation base is not based on a

cause-and-effect relation (i.e., it is arbitrary), and 2) the division earns positive segment

margin which contributes to covering the cost of the corporate headquarters The Florida

14-18 (30 min.) Cost allocation to divisions

1

Direct costs 9,819,260 3,749,172 4,248,768 17,817,200 Segment margin $ 6,605,740 $1,506,828 $ 8,091,232 16,203,800

Direct costs 9,819,260 3,749,172 4,248,768 17,817,200 Segment margin 6,605,740 1,506,828 8,091,232 16,203,800 Allocated fixed overhead costs 8,018,505 3,061,320 3,470,175 14,550,000 Segment pre-tax income $ (1,412,765) $(1,554,492) $ 4,621,057 $ 1,653,800 Segment pre-tax income % of rev -8.60% -29.58% 37.45%

B: Cost allocation based on floor space:

Allocated fixed overhead costs $ 7,275,000 $ 1,455,000 $ 5,820,000 $14,550,000 Segment pre-tax income $ (669,260) $ 51,828 $ 2,271,232 $ 1,653,800 Segment pre-tax income % of rev -4.07% 0.99% 18.41%

C: Cost allocation based on number of employees

Allocated fixed overhead costs $ 5,820,000 $ 1,455,000 $ 7,275,000 $14,550,000 Segment pre-tax income $ 785,740 $ 51,828 $ 816,232 $ 1,653,800

3 Requirement 2 shows the dramatic effect of the choice of cost allocation base on segment pre-tax income as a percentage of revenues:

Pre-tax Income Percentage

Number of employees 4.78 0.99 6.61 The decision context should guide (a) whether costs should be allocated, and (b) the preferred cost allocation base Decisions about, say, performance measurement, may be made on

a combination of financial and nonfinancial measures It may well be that Rembrandt may prefer

to exclude allocated costs from the financial measures to reduce areas of dispute

Where cost allocation is required, the cause-and-effect and benefits-received criteria are recommended in Chapter 14 The $14,550,000 is a fixed overhead cost This means that on a short-run basis, the cause-and-effect criterion is not appropriate but Rembrandt could attempt to identify the cost drivers for these costs in the long run when these costs are likely to be more variable Rembrandt should look at how the $14,550,000 cost benefits the three divisions This will help guide the choice of an allocation base in the short run

4 The analysis in requirement 2 should not guide the decision on whether to shut down any

of the divisions The overhead costs are fixed costs in the short run It is not clear how these costs would be affected in the long run if Rembrandt shut down one of the divisions Also, each division is not independent of the other two A decision to shut down, say, the restaurant, likely would negatively affect the attendance at the casino and possibly the hotel Rembrandt should examine the future revenue and future cost implications of different resource investments in the three divisions This is a future-oriented exercise, whereas the analysis in requirement 2 is an analysis of past costs

14-19 (25 min.) Cost allocation to divisions

Percentages for various allocation bases (old and new):

(1) Division margin percentages

$2,400,000; $7,100,000; $9,500,000

$19,000,000

12.63157%

37.36843% 50.0% 100.0% (2) Share of employees

Corp admin (alloc base: div admin

costs)

= (4) $4,500,000 1,285,714 1,157,143 2,057,143 4,500,000 Corp overhead allocated to each division 2,671,714 2,125,543 4,202,743 9,000,000 Operating margin with cause-and-effect

Operating margin as a percentage of

3 When corporate overhead is allocated to the divisions on the basis of division margins (requirement 1), each division is profitable (has positive operating margin) and the Paper division is the most profitable (has the highest operating margin percentage) by a slim margin, while the Pulp division is the least profitable When Bardem’s suggested bases are used to allocate the different types of corporate overhead costs (requirement 2), we see that, in fact, the Pulp division is not profitable (it has a negative operating margin) Paper continues to be the most profitable and, in fact, it is significantly more profitable than the Fibers division

If division performance is linked to operating margin percentages, Pulp will resist this new way of allocating corporate costs, which causes its operating margin of nearly 15% (in the old scheme) to be transformed into a -3.2% operating margin The new cost allocation methodology reveals that, if the allocation bases are reasonable, the Pulp division consumes a greater share of corporate resources than its share of segment margins would indicate Pulp generates 12.6% of the segment margins, but consumes almost 29.7% ($2,671,714

$9,000,000) of corporate overhead resources Paper will welcome the change—its operating margin percentage rises the most, and Fiber’s operating margin percentage remains practically the same

Note that in the old scheme, Paper was being penalized for its efficiency (smallest share of administrative costs), by being allocated a larger share of corporate overhead In the new scheme, its efficiency in terms of administrative costs, employees, and square footage is being recognized

4 The new approach is preferable because it is based on cause-and-effect relationships between costs and their respective cost drivers in the long run

Human resource management costs are allocated using the number of employees in each division because the costs for recruitment, training, etc., are mostly related to the number of employees in each division Facility costs are mostly incurred on the basis of space occupied by each division Corporate administration costs are allocated on the basis of divisional administrative costs because these costs are incurred to provide support to divisional administrations

To overcome objections from the divisions, Bardem may initially choose not to allocate corporate overhead to divisions when evaluating performance He could start by sharing the results with the divisions, and giving them—particularly the Pulp division—adequate time to figure out how to reduce their share of cost drivers He should also develop benchmarks by comparing the consumption of corporate resources to competitors and other industry standards

14-20 (30 min.) Customer profitability, customer-cost hierarchy

2

Customer Distribution Channels (all amounts in $000s)

a Cost of goods sold + Total customer-level operating costs from Requirement 1

3 If corporate costs are allocated to the channels, the retail channel will show an operating profit of

$27,735,000 ($40,735,000 – $13,000,000), and the wholesale channel will show an operating profit of

$13,165,000 ($61,165,000 – $48,000,000) The overall operating profit, of course, is still $40,900,000,

as in requirement 2 There is, however, no cause-and-effect or benefits-received relationship between

corporate costs and any allocation base, i.e., the allocation of $48,000,000 to the wholesale channel and

$13,000,000 to the retail channel is arbitrary and not useful for decision-making Therefore, the

management of Orsack Electronics should not base any performance evaluations or

investment/disinvestment decisions based on these channel-level operating income numbers They may

want to take corporate costs into account, however, when making long-run pricing decisions

14-21 (20 30 min.) Customer profitability, service company

($80 120; 210; 60; 150; 150) 9,600 16,800 4,800 12,000 12,000 Billing/Collection

($50 30; 90; 90; 60; 120) 1,500 4,500 4,500 3,000 6,000 Database maintenance

($10 150; 240; 40; 120; 180) 1,500 2,400 400 1,200 1,800 Customer-level operating income $ 54,150 $ (16,700) $ 84,300 $(10,200) $ 700

The above table and graph present the summary results (a whale curve could also be drawn using the numbers in the last column of the table) Wizard, the most profitable customer, provides 75%

of total operating income The three best customers provide 124% of IS’s operating income, and the other two, by incurring losses for IS, erode the extra 24% of operating income down to IS’s operating income

3 The options that Instant Service should consider include:

a Increase the attention paid to Wizard and Avery These are ―key customers,‖ and every effort has to be made to ensure they retain IS IS may well want to suggest a minor price reduction to signal how important it is in their view to provide a cost-effective service to these customers

b Seek ways of reducing the costs or increasing the revenues of the problem accounts—Okie and Grainger For example, are the copying machines at those customer locations outdated and in need of repair? If yes, an increased charge may be appropriate Can IS provide better on-site guidelines to users about ways to reduce breakdowns?

c As a last resort, IS may want to consider dropping particular accounts For example,

if Grainger (or Okie) will not agree to a fee increase but has machines continually breaking down, IS may well decide that it is time not to bid on any more work for that customer But care must then be taken to otherwise use or get rid of the excess fixed capacity created by ―firing‖ unprofitable customers

Customer-Level Operating Income

Wizard

14-22 (20 25 min.) Customer profitability, distribution

1 The activity-based costing for each customer is:

Charleston Pharmacy

Chapel Hill Pharmacy

Chapel Hill Pharmacy

2 Ways Figure Four could use this information include:

a Pay increased attention to the top 20% of the customers This could entail asking them for

ways to improve service Alternatively, you may want to highlight to your own personnel the importance of these customers; e.g., it could entail stressing to delivery people the importance of never missing delivery dates for these customers

b Work out ways internally at Figure Four to reduce the rate per cost driver; e.g., reduce the

cost per order by having better order placement linkages with customers This cost reduction by Figure Four will improve the profitability of all customers

c Work with customers so that their behavior reduces the total ―system-wide‖ costs At a

minimum, this approach could entail having customers make fewer orders and fewer line items This latter point is controversial with students; the rationale is that a reduction in the number of line items (diversity of products) carried by Ma and Pa stores may reduce the diversity of products Figure Four carries

There are several options here:

Simple verbal persuasion by showing customers cost drivers at Figure Four

Explicitly pricing out activities like cartons delivered and shelf-stocking so that customers pay for the costs they cause

Restricting options available to certain customers, e.g., customers with low revenues could be restricted to one free delivery per week

An even more extreme example is working with customers so that deliveries are easier to make and shelf-stocking can be done faster

d Offer salespeople bonuses based on the operating income of each customer rather than

the gross margin of each customer

Some students will argue that the bottom 40% of the customers should be dropped This action should be only a last resort after all other avenues have been explored Moreover, an unprofitable customer today may well be a profitable customer tomorrow, and it is myopic to focus on only a 1-month customer-profitability analysis to classify a customer as unprofitable

14-23 (30–40 min.) Variance analysis, multiple products

1 Sales-volume,variance =

units

in quantity

salesActual

units

in quantity

sales

per ticketmargin

oncontributiBudgeted

on contributi

averageBudgeted

=

000,10

$5)(6,000

$20)000,4(

=

10,000

$30,000000

,80

$

=

000,10

000,110

000,4

= 0.40

000,11

300,3

= 0.30

Upper-tier

000,10

000,6

= 0.60

000,11

700,7

= 0.70

Solution Exhibit 14-23 presents the sales-volume, sales-quantity, and sales-mix variances for lower-tier tickets, upper-tier tickets, and in total for Detroit Penguins in 2012

The sales-quantity variances can also be computed as:

Sales-quantity,variance = of all tickets Actual units of all ticketsBudgeted units

percentagemix-sales

Budgeted

per ticketmargincont

of

unitsActual

×

contribution marginsales-mix sales-mix

per ticketpercentage percentage

The sales-mix variances are

× Actual Sales Mix

× Budgeted

Contribution Margin per Unit

(1)

Actual Units of All Products Sold

× Budgeted Sales Mix

× Budgeted

Contribution Margin per Unit (2)

Static Budget: Budgeted Units of All Products Sold

× Budgeted Sales Mix

× Budgeted

Contribution Margin per Unit

Upper-tier (11,000 × 0.70c) × $5

7,700 × $5

(11,000 × 0.60d) × $5 6,600 × $5

F = favorable effect on operating income; U = unfavorable effect on operating income

Actual Sales Mix:

d Upper-tier = 6,000 ÷ 10,000 = 60%

f $88,000 + $33,000 = $121,000 g

$80,000 + $30,000 = $110,000

14-24 (30 min.) Variance analysis, working backward

1 and 2 Solution Exhibit 14-24 presents the sales-volume, sales-quantity, and sales-mix variances for the Plain and Chic wine glasses and in total for Jinwa Corporation in June 2011 The steps to fill in the numbers in Solution Exhibit 14-24 follow:

Step 1

Consider the static budget column (Column 3):

Budgeted contribution margin per unit of Plain $ 4

Budgeted contribution margin per unit of Chic $ 10

Suppose that the budgeted mix percentage of Plain is y Then the budgeted mix percentage of Chic is (1 – y) Therefore,

Next, consider Column 2 of Solution Exhibit 14-24

The total of Column 2 in Panel C is $8,800 (the static budget total contribution margin of

$11,000 – the total sales-quantity variance of $2,200 U which was given in the problem)

We need to find the actual units sold of all glasses, which we denote by q From Column

Step 3

Next, consider Column 1 of Solution Exhibit 14-24 We know actual units sold of all glasses (1,600 units), the actual sales-mix percentage (given in the problem information as Plain, 60%; Chic, 40%), and the budgeted unit contribution margin of each product (Plain, $4; Chic, $10)

We can therefore determine all the numbers in Column 1

Solution Exhibit 14-24 displays the following sales-quantity, sales-mix, and sales-volume variances:

3 Jinwa Corporation shows an unfavorable sales-quantity variance because it sold fewer wine glasses in total than was budgeted This unfavorable sales-quantity variance is partially offset by a favorable sales-mix variance because the actual mix of wine glasses sold has shifted

in favor of the higher contribution margin Chic wine glasses The problem illustrates how failure

to achieve the budgeted market penetration can have negative effects on operating income

SOLUTION EXHIBIT 14-24

Columnar Presentation of Sales-Volume, Sales-Quantity and Sales-Mix Variances

for Jinwa Corporation

Actual Units

of All Glasses Sold

Budgeted Sales Mix Budgeted

Contribution Margin per Unit

Static Budget: Budgeted Units

of All Glasses Sold Budgeted Sales Mix

Budgeted

Contribution Margin per Unit

(2,000 0.75) $4 1,500 $4

Sales-mix variance Sales-quantity variance

$2,160 U Sales-volume variance

F = favorable effect on operating income; U = unfavorable effect on operating income

14-25 (60 min.) Variance analysis, multiple products

Variable Contrib

Selling Cost Margin Units Sales Contribution

Budgetedcontribution marginper unit

Kola = ( 467,500 – 480,000) × $3.00 = $ 37,500 U Limor = ( 852,500 – 720,000) × $2.20 = 291,500 F Orlem = (1,430,000 – 1,200,000) × $2.00 = 460,000 F

Budgetedcontribution marginper unit

Kola = (2,750,000 – 2,400,000) × 0.20 × $3.00 = $210,000 F Limor = (2,750,000 – 2,400,000) × 0.30 × $2.20 = 231,000 F Orlem = (2,750,000 – 2,400,000) × 0.50 × $2.00 = 350,000 F

Actual units ofall productssold

Actualsales-mixpercentage

–

Budgetedsales-mixpercentage

Budgetedcontribution marginper unit

Sales-Mix and Sales-Quantity Variance Analysis of Soda King for 2011

Actual Units of Actual Units of Budgeted Units of All Products Sold All Products Sold All Products Sold

Actual Sales Mix Budgeted Sales Mix Budgeted Sales Mix

Budgeted Contribution Budgeted Contribution Budgeted Contribution

Kola 2,750,000 0.17 $3.00 = $1,402,500 2,750,000 0.2 $3.00 = $1,650,000 2,400,000 0.2 $3.00 = $1,440,000 Limor 2,750,000 0.31 $2.20 = 1,875,500 2,750,000 0.3 $2.20 = 1,815,000 2,400,000 0.3 $2.20 = 1,584,000 Orlem 2,750,000 0.52 $2.00 = 2,860,000 2,750,000 0.5 $2.00 = 2,750,000 2,400,000 0.5 $2.00 = 2,400,000

14-26 (20 min.) Market-share and market-size variances (continuation of 14-25)

Actual Budgeted

Western region 27.5 million 20 million Soda King 2.75 million 2.4 million

Average budgeted contribution margin per unit = $2.26 ($5,424,000 ÷ 2,400,000)

Solution Exhibit 14-26 presents the sales-quantity variance, size variance, and share variance for 2011

Budgetedmarketshare

Budgeted contributionmargin per compositeunit for budgeted mix

in units

–

Budgetedmarket size

in units

Budgetedmarketshare

Budgeted contributionmargin per compositeunit for budgeted mix

Despite the unfavorable market-share variance, the increase in market size was enough to result in a favorable sales-quantity variance

Sales-Quantity Variance

$791,000 F

F = favorable effect on operating income; U = unfavorable effect on operating income

a Actual market share: 2,750,000 units ÷ 27,500,000 units = 0.10, or 10%

b Budgeted average contribution margin per unit $5,424,000 ÷ 2,400,000 units = $2.26 per unit

c

Budgeted market share: 2,400,000 units ÷ 20,000,000 units = 0.12, or 12%

14-27 (40 min.) Allocation of corporate costs to divisions

1 The purposes for allocating central corporate costs to each division include the following

(students may pick and discuss any two):

a To provide information for economic decisions Allocations can signal to division

managers that decisions to expand (contract) activities will likely require increases

(decreases) in corporate costs that should be considered in the initial decision about

expansion (contraction) When top management is allocating resources to divisions,

analysis of relative division profitability should consider differential use of corporate

services by divisions Some allocation schemes can encourage the use of central services

that would otherwise be underutilized A common rationale related to this purpose is ―to

remind profit center managers that central corporate costs exist and that division earnings

must be adequate to cover some share of those costs.‖

b Motivation Allocations create incentives for division managers to control costs; for

example, by reducing the number of employees at a division, a manager will save direct

labor costs as well as central personnel and payroll costs allocated on the basis of number

of employees Allocation also creates incentives for division managers to monitor the

effectiveness and efficiency with which central corporate costs are spent

c Cost justification or reimbursement Some lines of business of Richfield Oil may be

regulated with cost data used in determining ―fair prices‖; allocations of central corporate

costs will result in higher prices being set by a regulator

d Income measurement for external parties Richfield Oil may include allocations of

central corporate costs in its external line-of-business reporting

(Dollar amounts in millions)

Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

3 First, calculate the share of each allocation base for each of the four corporate cost pools:

Copper Mining Total

Identifiable assets $14,000 $6,000 $3,000 $2,000 $25,000 (1)Percentage of total identifiable assets

corporate costs as shown below Note that the costs in Cost Pool 2 total $800 M ($150 + $110 + $200 + $140 + $200)

(Dollar amounts in millions)

Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Cost Pool 1 Allocation ((1) $2,000) 1,120.00 480.00 240.00 160.00 2,000

Cost Pool 4 Allocation ((4) $225) 67.50

90.00 45.00 22.50 225 Division Income $3,467.50 $ 1.00 $ 566.00 $ (562.50) $ 3,472

4 The table below compares the reported income of each division under the original revenue-based allocation scheme and the new 4-pool-based allocation scheme Oil & Gas Upstream seems 17% less profitable than before ($3,467.5 $4,193 = 83%), and may resist the new allocation, but each of the other divisions seem more profitable (or less loss-making) than before and they will probably welcome it In this setting, corporate costs are relatively large (about 13% of total operating costs), and division incomes are sensitive to the corporate cost allocation method

(Dollar amounts in millions)

Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

allocation of corporate costs $3,467.50 $ 1.00 $ 566.00 $(562.50) $3,472

Strengths of Rhodes’ proposal relative to existing single-cost pool method:

a Better able to capture cause-and-effect relationships Interest on debt is more likely

caused by the financing of assets than by revenues Personnel and payroll costs are more likely caused by the number of employees than by revenues

b Relatively simple No extra information need be collected beyond that already available

(Some students will list the extra costs of Rhodes' proposal as a weakness However, for a company with $30 billion in revenues, those extra costs are minimal.)

Weaknesses of Rhodes’ proposal relative to existing single-cost pool method:

a May promote dysfunctional decision making May encourage division managers to lease

or rent assets rather than to purchase assets, even where it is economical for Richfield Oil

to purchase them This off-balance sheet financing will reduce the ―identifiable assets‖

of the division and thus will reduce the interest on debt costs allocated to the division (Richfield Oil could counteract this problem by incorporating leased and rented assets in the "identifiable assets" base.)

Note: Some students criticized Rhodes’ proposal, even though agreeing that it is preferable to the

existing single-cost pool method These criticisms include:

a The proposal does not adequately capture cause-and-effect relationships for the legal and

research and development cost pools For these cost pools, specific identification of individual projects with an individual division can better capture cause-and-effect relationships

b The proposal may give rise to disputes over the definition and valuation of ―identifiable

assets.‖

c The use of actual rather than budgeted amounts in the allocation bases creates

interdependencies between divisions Moreover, use of actual amounts means that division managers do not know cost allocation consequences of their decisions until the end of each reporting period

d A separate allocation of fixed and variable costs would result in more refined cost

allocations

e It is questionable that 100% of central corporate costs should be allocated Many students

argue that public affairs should not be allocated to any division, based on the notion that division managers may not control many of the individual expenditures in this cost pool