Question

ProWorks is a website design and consulting firm based in Michigan. The firm uses a job cost system in which each client is a different job. Proworks traces direct labor, software licensing costs, and travel costs directly to each job (client). It divides overhead into two cost pools, "Indirect Labor" and "Office Overhead." It allocates Indirect Labor (support staff salaries) to jobs based on software licensing costs. It allocates Office Overhead (all other overheads) to jobs based on direct labor hours. At the beginning of 2016, managing partner Mark Milici prepared the following estimates:

Direct labor hours $14,000 hours

Direct labor costs $1,400,000

Software licensing costs $50,000

Travel costs $80,000

Support staff salaries $200,000

Computer leases $50,000

Office supplies $30,000

Office rent $60,000

In January, 2016, ProWorks served three clients. Records for the clients appear here:

Dining Corp Hut Shuttle Lucidyne

Direct Labor Hours: 600 hours 50 hours 300 hours

Software licensing costs: $5,000 $500 $2,000

Travel costs: $9,000 $2,000 $0

1) Write a business memo about cost allocation issues. In your analysis, explain the reasons why ProWork managers should assign all costs to jobs. Managers also want to know the factors they should consider when setting prices. If managers want to earn profits equal to 20% of sales revenue, what price should the company charge each client?   

Answer 1

Memo:
The allocation basis for allocating overhead cost is incorrect, for the following reasons.
(i) Indirect labour is allocated on the basis of software licensing costs, which is in the nature of a fixed expense.
Rather, it would be appropriate if it is allocated on the basis of direct labour hours. As a result of this allocation,
there is over absorption of overhead, as given below;
Total budgeted indirect labour cost for the year 2016 is $200,000
Allocated in Jan16 itself is $30,000 (20000+2000+8000). At this rate, the expected absorbtion for the
whole year would be $360,000 (30000*12), which is higher compared to $2 lacs.
Moreover, for a smaller job of 50 hrs, allocation rate is higher for "Hut Shuttle customer".
(ii) On the other hand, office overhead allocation rate is lesser, which might result in under absorbption of overhead,
when considering the total estimated overheads ( Allocated office overhead is $9500, for Jan16. At this rate,
the whole year's allocation would be $114000, which is lesser than budgeted expense of $140,000.)
When setting prices for the customers, the manger would bear in mind that there should be optimal allocation
of overhead expenses, based on the size of the customer, nature of assignment and the amount of effort spent.
If there is mismatch in the prices charged with respect to the total hours spent for a particular customer, the concerned
customer would get aggrieved. This would result in loss of a valuable customer and loss of reputation.
(iii), For a target return of 20% on sales, the prices to be charged to the customers, based on the allocation method
currently followed, is given in the above working.