Question

Cost allocation downward demand spiral Deli One operates a chain of 10 hospitals in the Los Angeles area. Its central food-catering facility, Deliman, prepares and delivers meals to the hospitals. It has the capacity to deliver up to 1,460,000 meals a year. In 2009, based on estimates from each hospital controller, Deliman budgeted for 1,022,000 meals a year. Budgeted fixed costs in 2009 were $1,533,000. Each hospital was charged $6.00 per meal—$4.50 variable costs plus $1 .50 allocated budgeted fixed cost. Recently, the hospitals have been complaining about the quality of Deliman’s meals and their rising costs. In mid-2009, Deli One’s president announces that all Deli One hospitals and support facilities will be run as profit centers. Hospitals will be free to purchase quality-certified services from outside the system. Ron Smith, Deliman’s controller, is preparing the 2010 budget. He hears that three hospitals have decided to use outside suppliers for their meals; this will reduce the 2010 estimated demand to 876,000 meals. No change in variable cost per meal or total fixed costs is expected in 2010.

1. How did Smith calculate the budgeted fixed cost per meal of$1.50 in 2009?

2. Using the same approach to calculating budgeted fixed cost per meal and pricing as in 2009, how much would hospitals be charged for each Deliman meal in 2010? What would their reaction be?

3. Suggest an alternative cost-based price per meal that Smith might propose and that might be more acceptable to the hospitals. What can Deliman and Smith do to make this price profitable in the long run?

Answer 1

Cost allocation downward demand spiral.

Solution Exhibit 9-39

 

1.         

The 2009 budgeted fixed costs are $1,533,000. Deliman budgets for 1,022,000 meals in 2009, and this is used as the denominator level to calculate the fixed cost per meal. $1,533,000 ÷ 1,022,000 = $1.50 fixed cost per meal. (see column (1) in Solution Exhibit 9-39).

 

2.         

In 2010, 3 hospitals have dropped out of the purchasing group and the master budget is 876,000 meals. If this is used as the denominator level, fixed cost per meal = $1,533,000 ÷ 876,000 = $1.75 per meal, and the total budgeted cost per meal would be $6.25 (see column (3) in Solution Exhibit 9-39). If the hospitals have already been complaining about quality and cost and are allowed to purchase from outside, they will not accept this higher price. More hospitals may begin to purchase meals from outside the system, leading to a downward demand spiral, possibly putting Deliman out of business.

 

3.         

The basic problem is that Deliman has excess capacity and the associated excess fixed costs. If Smith uses the practical capacity of 1,460,000 meals as the denominator level, the fixed cost per meal will be $1.05 (see column (2) in Solution Exhibit 9-39), and the total budgeted cost per meal would be $5.55, probably a more acceptable price to the customers (it may even draw back the three hospitals that have chosen to buy outside). This denominator level will also isolate the cost of unused capacity and not allocate it to the meals produced. To make the $5.55 price per meal profitable in the long run, Smith will have to find ways to either use the extra capacity or reduce Deliman’s practical capacity and the related fixed costs. 

The basic problem is that Deliman has excess capacity and the associated excess fixed costs. If Smith uses the practical capacity of 1,460,000 meals as the denominator level, the fixed cost per meal will be $1.05 (see column (2) in Solution Exhibit 9-39), and the total budgeted cost per meal would be $5.55, probably a more acceptable price to the customers