Question

Bio Labs is a genetic engineering firm manufacturing a variety of gene-spliced, agricultural-based seed products. The firm has five separate laboratories producing different product lines. Each lab is treated as a profit center and all five labs are located in the same facility. The wheat seed lab and corn seed lab manufacture two of the five product lines. These two labs are located next to each other and are of roughly equal size in terms of sales. The two departments have close interaction, often sharing equipment and lab technicians. Both use very similar technology and science and usually attend the same scientific meetings. Recent discoveries have shown how low-power lasers can be used to significantly improve product quality. The wheat seed and corn seed managers are proposing the creation of a laser testing department to employ this new technology. Leasing the equipment and hiring the personnel cost $350,000 per year. Supplies, power, and other variable costs are $25 per testing hour. The testing department is expected to provide 2,000 testing hours per year. The wheat seed manager expects to use 700 testing hours per year of the laser testing department and the corn seed manager expects to use 800 testing hours. The remaining 500 hours of testing capacity can be used by the other three labs if the technology applies or can be left idle for future expected growth of the two departments. Initially, only wheat and corn are expected to use laser testing. The executive committee of Bio Labs has approved the proposal but is now grappling with how to treat the costs of the laser testing department. The committee wants to charge the costs to the wheat seed and corn seed labs but is unsure of how to proceed. At the end of the first year of operating the laser, wheat seed used 650 testing hours, corn seed used 900 hours, and 450 hours were idle.

Required:

a. Calculate costs of the two labs, based on the expected hours used by the two labs and on capacity hours.

b. What are the implications of these two alternatives?

c. Discuss advantages and disadvantages of these two cost allocation options.

d. Assess theses two cost allocation option on strategic decision perspective.

e. What are the other issues to be considered in designing cost allocation problems.

Answer 1

a. Given below are the 2 methods given for the cost allocation of the Laser Testing Equipment:

1. Expected Hours - $350,000 x 25 x 1500 / 1500 = $258.33 per hour. Here, the total acquistion cost is added up the total variable cost of the 2 labs. It is assumed that the balance hours in testing machine will be kept idle and hence the acquisition cost has been divided between the 2 labs only.

Wheat Lab cost - $258.33 x 700 = $180,831

Corn Lab cost - $258.33 x 800 = $206,669

2. Capacity Cost - $350,000 x 25 x 2000 / 2000 - $200 per testing hour. Here, the total acquisition cost has been added with the 100% capacity variable cost.

Wheat Lab cost - $200 x 650 - $130,000

Corn Lab cost - $200 x 900 - $180,000

Balance cost - $200 x 450 - $90,000 - This cost can be accounted under idle cost or can be apportioned to the remaining 3 departments if utilised for them.

b. Implications -

For Expected Hours - Using this cost as the basis for allocation, the cost are apportioned to the units for which the equipment was basically purchased. However, it restricts the use of the equipment for only these 2 labs and the other labs cannot test using this equipment if and when the need be. Hence, apportioning it via the expected hours can limit the usage of the equipment to only these 2 labs.

For Capacity Hours - Using this cost as the basis for allocation. the cost will be appropriately apportioned to cost centres on the basis of their use of the product. However, under this method the cost remaining to be apportioned will be treated as unabsorbed overheads cost which cannot be recovered from the further sale of the product it tends to recover from. It forms part of the sunk cost of the company. Hence, we should apportion cost under this method if the equipment is to be used at its 100% capacity only.

c. Advantages -

For Expected Hours - Under this method the total cost gets apportioned as the expected usage of the cost centres for which the expenses were initially incurred..

For Capacity Hours - Under this method the total cost gets divided as per the actual usage of the cost centres.

C. Disadvantages -

For Expected Hours - Units other than the basic unit won't be allowed the usage of the equipment as the cost is apportioned only for the basic division for which the expenses were initially incurred.

For Capacity Hours - Hours remaining unapportioned will be treated as sunk cost and will be recoverable from the further sale of the product.

d. Strategic decision perspective - Since these 2 divisions seems to be heavy duty departments of the company it is advisable for the company use the spend for the equipment. Cost allocation method that can be for the 1st year where the capacity is not 100% utilised it is advisable for the company to use the expected hours for the allocating the cost of the equipment and variable factors associated with the equipment. Going forward where the 100% capacity get utilised it is advisable for the company to switch to capacity hours method which will be give the company the correct overhead figure utilised for the unit for the year.