Question

Tax Savings and Costing (The Case of Transfer Pricing)

Please prepare a report answering the listed questions. You may Excel to create spreadsheets and copy the answers to this document.

Hansen, Kotter, and Zales is a law firm that contains one service department (Research & Document) and two production departments (Litigation and Consulting). The firm employs a job-order costing system to accumulate costs chargeable to each client. The firm uses actual costing to assign overhead. General overhead costs can be allocated based on either direct attorney hours or the number of employees, depending on managers’ choice. At the end of the year, the records revealed the actual general overhead costs are $720,000. At the end of the year, the records revealed the following costs and operating data for all cases handled during the year:

		Research & Document			Litigation		Consulting
# of Employees		10			8		6
Direct Attorney Hours(# of hrs)		3,000			8,000		5,000
Direct Attorney Costs ($)		$150,000			$400,000		$250,000
Direct Material Costs ($)		$16,000			$15,500		$13,500

*** 50% of Research & Department's service is provided to litigation department and the other 50% to consulting department.

Part I Cost Allocation

1. (1.5 point) Compute the overhead allocation rates for general overhead based on different cost drivers. What are the overhead costs assigned to each department, using different cost drivers?

Overhead allocation based on direct attorney hours

                             Research and development |      Litigation      |       Consulting       | Total

Direct attorney hours                     3,000                              8,000                        5,000                 16,000

Percentage of total                        18.75%                           50%                        31.25%

Allocated overhead cost                 $135,000                   $360,000                  $225,000

Overhead allocation based on number of employees

                             Research and development |      Litigation      |       Consulting       | Total

Number of employees                       10                                    8                               6                        24

Percentage of total                        41.67%*                        33.33%                     25%

Allocated overhead cost                 $300,000                   $240,000                  $180,000

*rounded answer but to calculate allocated overhead cost I used (10/24)*720,000 so I would get an exact answer, I just rounded 299,999.999999 to 300,000

2. (1.5 point) Compare the total costs of each production department after departmental cost allocation, using attorney hours and the number of employees as cost driver, respectively. Does the choice of cost driver affect the total costs of each production department?

Overhead cost of production departments using different cost drivers

Based on attorney hours

                                                Litigation                     |            Consulting

Allocated costs                            $360,000                                   $225,000

Research & Development              +67,500                                     +67,500

Total Overhead Costs                     $427,500                                   $292,500

Based on number of employees

                                                Litigation                     |            Consulting

Allocated costs                            $240,000                                   $180,000

Research & Development             +150,000                                  +150,000

Total Overhead Costs                     $390,000                                   $330,000

To answer your question simply: yes, choice of cost driver does affect the costs of each production department.

• Litigation has a total overhead cost of $427,500 when allocating based on attorney hours and has a total overhead cost of $390,000 when allocating based on number of employees.
• Consulting has a total overhead cost of $292,500 when allocating based on attorney hours and has a total overhead cost of $330,000 when allocating base on number of employees.

Assume that the company uses attorney hours to allocate general overhead costs. For litigation department, the costs charged to each case are made up of four elements:

• Direct attorney costs (charged at $50 per hour)
• Direct materials and supplies used
• General overheads are applied by direct attorney hours
• Costs allocated from the service department is assigned to cases by direct attorney hours incurred within the department

The information on one of its cases during this period is given as follows:                                                              

                                                                        Case 618

Direct attorney-hours                                    150           

Direct Materials and supplies                   $5000           

c. (1.5 point) What are the total costs accumulated for Case 618? The company charged the client $30,000 for the service, what is the profit the company earned?

d. (0.5 point) Suppose the firm’s annual revenue is 2 million dollars. The corporate tax rate is 35%. How much taxes shall the company pay? Does the choice of cost driver affect the total taxes due?

Answer 1

Answers to a & b perfectly correct

c. Costs for Case 18
Direct attorney costs (150* $ 50/hr.)	7500
Direct materials & supplies	5000
General Ohs(72000/16000=45*150=	6750
Total cost	19250
Amt. charged by the co.	30000
So,profit earned (30000-19250)	10750

d.Annual revenue				2000000
Less: expenses:	Litigation	Consulting	Total
Direct Attorney Costs	400000	250000	650000
Direct Material Costs	15500	13,500	29000
Allocated OH costs(based on attorney hrs.	427500	292500	720000
Total expenses				1399000
Before tax revenues				601000
Tax at 35%(601000*35%)				210350
After-tax income				390650

So, tax amount the co.will pay = 210350
As the total OH is in any case $ 720000 , the choice of cost driver , will not affect the total taxes due.
The choice of cost driver will only affect the amt. to be allocated between different departments.

c….	Litigation	Consulting
1.Total GOH allocated as per direct attorney hrs.	427500	292500
2.Direct attorney hrs.	8000	5000
3.GOH/hr.(1/2)	53	59
4.150 hrs. split bet. 2 depts.	150*8/13=	150*5/13=
	92	58
5.Total GOH for the Job(3*4)	4933	3375
Total	8308
c. Costs for Case 618
Direct attorney costs (150* $ 50/hr.)	7500
Direct materials & supplies	5000
General Ohs (as per above wkgs.)	8308
Total cost	20808
Amt. charged by the co.	30000
So,profit earned (30000-20808)	9192