Question

An accounting professional requires at least two skill sets. The first is to be technically competent. Knowing how to capture, manage, and report information is a necessary skill. Second, the ability to assess manager and employee actions and biases for accounting analysis is another skill. For instance, knowing how a person is compensated helps anticipate information biases. Draw on these skills and write a half-page memo to the financial officer on the following practice of allocating overhead.

Background: Assume that your company sells portable housing to both general contractors and the government. It sells jobs to contractors on a bid basis. A contractor asks for three bids from different manufacturers. The combination of low bid and high quality wins the job. However, jobs sold to the government are bid on a cost-plus basis. This means price is determined by adding all costs plus a profit based on cost at a specified percent, such as 10%. You observe that the amount of overhead allocated to government jobs is higher than that allocated to contract jobs. These allocations concern you and motivate your memo.

Answer 1

To: Mr X - Head of Operations and Management

From: Mr Y

Subject- Concern regarding the allocation of overheads

I would like to bring your attention to the allocation of overheads to our portable housing with respect to general contractors and government. The amount of overhead which is allocated to government jobs (which are bid on a cost-plus basis) is higher than the cost allocated to a contract job, even though both the projects are similar in nature. This is effectively resulting in higher cost allocated to the government job and due to cost-plus pricing, resulting in a higher price. Though this may result in quicker profits, the practice is unethical and resulting in misstatements in the financial statements and cost statements. Further, upon discovery of the fact in a routine audit or on examination by the government department, this can result in withdrawal of projects by the government and possible imposing of penalty. This will not only decrease the future year's revenues but also tarnish the image of the entity in the general public, resulting in lower chances of future contracts and possible withdrawals even of general contractors in near future. Such long-term impact cannot be quantified due to their magnitude and pose a big risk to the entity. I hence request you to revise the allocation of overheads and use a more unbiased method such as Activity Based Costing to allocate overheads so the there is a fair presentation in the financial statements and cost statements and the entity is protected from the consequences of unfair allocation.

Seeking your cooperation.