Question

Case: TechPhone (Cost Allocation)

TechPhone is a medium-size manufacturer of telephone sets and switching equipment. Its primary business is government contracts, especially defense contracts, which are very profitable. The company has two plants: Southern and Westbury. The larger plant, Southern, is running at capacity while producing a phone system for a new missile installation. Existing government contracts will require Southern to operate at capacity for the next nine months. The missile contract is a firm, fixed-price contract. Part of the contract specifies that 3,000 phones will be produced to meet government specifications. The price paid per phone is $300.

                -Southern: 3,000 at $300 per phone (new government contract)

The second TechPhone plant, Westbury, is a small, old facility

-acquired two years ago to produce residential phone systems.

TechPhone feared that defense work was cyclical, so to stabilize earnings, a line of residential systems was developed at the Westbury plant. In the event that defense work deteriorated,

-the excess capacity at Southern could be used to produce residential systems.

However, just the opposite has happened. The current recession has temporarily depressed the residential business.

--Although Westbury is losing money ($10,000 per month), top management considers this an investment.

Westbury has developed a line of systems that are reasonably well received. Part of its workforce has already been laid off. It has a very good workforce remaining, with many specialized and competent supervisors, engineers, and skilled craftspeople.

-Another 20 percent of Westbury’s workforce could be cut without affecting output. Current operations are meeting the reduced demand. If demand does not increase in the next three months, this 20 percent will have to be cut.

The plant manager at Westbury has tried to convince top management

-to shift the 3,000 missile contract phones over to his plant. Even though his total cost to manufacture the phones is higher than at Southern, he argues that this will free up some excess capacity at Southern to add more government work. The unit cost data for the 3,000 phones are as follows:

	Southern	Westbury
Direct labor cost	$  70	$  95
Direct materials cost	40	55
Variable factory overhead(a)	35	45
Fixed factory overhead(a)	40	80
General burden(b)	10	20
Total unit cost	$195	$295

(a) – variable and fixed factory overhead cost are applied base on direct labor.

(b) – general burden represents a share of overhead costs allocated from corporate and is typically fixed in nature.

Westbury cannot do other government work, because it does not have the required security clearances, but can do the work involving the 3,000 phones and

-can complete this project in three months.

“Besides,” Westbury’s manager argues, “my labor costs are not going to be $95 per phone. We are committed to maintaining employment at Westbury at least for the next three months. I can utilize most of my existing people who have slack. I will have to hire back about 20 production workers I laid off. For the three months, we are talking about $120,000 of additional direct labor.”

TechPhone is considering another defense contract with an expected price of $1.1 million and an expected profit of $85,000. The work would have to be completed over the next three months, but Southern does not have the capacity to do the work and Westbury does not have the security clearances or capital equipment required by the contract.

Southern’s manager says it isn’t fair to make him carry Westbury. He points out that Westbury’s variable cost, ignoring labor, is 33 percent greater than Southern’s variable costs. Southern’s manager also argues, “Adding another government contract will not replace the profit that we will be forgoing if Westbury does the telephone manufacturing. See my schedule.”

Profits from Southern ($300 − $195) x 3,000		$   315,000
Less: Profits from Westbury ($300 − $295) x 3,000		(15,000)
Forgone profits		$   300,000
Profit in the next best government contract:
Expected price		$1,100,000
Less:
Direct labor	260,000
Direct material	435,000
Variable overhead	130,000
Fixed factory overhead	150,000
General burden	40,000	1,015,000
Expected profit		$    85,000

Required:

Top management has reviewed the Southern manager’s data and believes his cost estimates on the new contract to be accurate. Should TechPhone shift the 3,000 phones to Westbury and take the new contract or not? Clearly state the reason for your conclusion and provide supporting analysis.

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Answer 1