Question

Freeman Company has five divisions, and you are the division manager of one of these divisions. Assume that the Administrative Costs for Freeman Company represent corporate-sustaining fixed costs that are allocated to each division based on the division’s total assets. These costs represent long term commitments that cannot be changed within the next two years. Freeman Company decides to shut-down on of the other divisions (not your division) and dispose of the shut-down division’s assets.

A. (6 points) How would this decision affect your division’s profits? Make sure you explain your logic. Since of five divisions shut down, the fixed cost burden, which was allocated to five accounts easlier in the ratio of their assets will now get allocated between four active divisions. This results in your division’s fixed cost burden, which will go up in any scenario of a revised asset ratio for the active departments. If the fixed costs go up, the margins will come down with equal quantum if sales can’t be improved or other costs can’t be reduced. This fixed cost burden related to the 5th department will be borne by all active divisions in new a new ration of available assets.

B. (6 points) Describe how your answer to Part A relates to the interdependency problem of motivating performance.

C. (6 points) Describe how your answer to Part A relates to the death spiral phenomenon.

Answer 1

A. Affect on our division's profits will be from increased allocation of fixed costs. Earlier administrative costs i.e., fixed costs were borne by five divisions of the company whereas this costs are now borne by four divisions of the company. The result will be that per division fixed cost will increased due to this new allocation. Example, company has five divisions and total fixed cost of $1,000, this fixed was allocated equally between all five divsions which resulted in $ 200 fixed cost of each division. Whereas now one division has been shut down, the new allocation will result in $ 250 allocated to each division. Now, profits of each division will decrease by $ 50 due to this allocation. Similarly, our divisions profits will also be reduced by this new allocation.

B.  Interdependency problem of motivating performance in costing elaborates that when there are fixed costs of company which are to be allocated to various divisions of the company, based on some measures then profits of divisions are dependent on performance of other divisions. If divisions are performing well then other divisions will not have to bear any extra burden of fixed costs of other divisions due to loss in that divisions. On the contrary, if other divisions performance are not good then they have to bear losses due to other divisions under performance.

C. The death spiral is a cost accounting phenomenon that occurs when a company repeatedly eliminates products or services without reducing fixed costs. The concept refers to situations in which a company falls into a spiral of increased fixed costs and lower production volumes. In our case we can see that due to shutdown of one division, other divisons have to bear fixed allocation costs in there assets ratio. Which will lead to reduced profits of remaining divisions and increasing fixed costs. This effect is death spiral phenomenon in our case.