(20 mins.) Department costing, service company

CKM is an architectural firm that designs and builds buildings. It prices each job on a cost plus 20% basis. Overhead costs in 2014 are $4,011,780. CKM's simple costing system allocates overhead costs to its jobs based on number of jobs. There were three jobs in 2014. One customer, Sanders, has complained that the cost of its building in Chicago was not competitive. As a result, the controller has initiated a detailed review of the overhead allocation to determine if overhead costs are charged to jobs in proportion to consumption of overhead resources by jobs. She gathers the following information.

Required:
1. Compute the overhead allocated to each project in 2014 using the simple costing system.
2. Compute the overhead allocated to each project in 2014 using department overhead cost rates.
3. Do you think Sanders had a valid reason for dissatisfaction with the cost? How does the allocation based on department rates change costs for each project?
4. What value, if any, would CKM get by allocating costs of each department based on the activities done in that department?

Note: The cost driver for engineering is number of engineering-hours, not number of engineers. This change does not, however, affect the solution itself.

1. Using the simple costing system, total overhead costs are equally allocated to projects. There were 3 projects in 2014, so the overhead cost per project is

= = $1,337,260 per project

2. Rates per unit cost driver.
Activity Cost Driver Rate
Design Design department hours $1,500,000 ÷ (1,000 + 5,000 + 4,000)
= $150 per design-hour

Engineering Engineering dept. hours $500,030 ÷ (2,000 + 2,000 + 2,200)
= $80.65 per engineering-hour

Construction Labor-hours $2,011,750 ÷ (20,800 + 21,500 + 19,600)
= $32.50 per labor-hour

Overhead cost allocated to each project using department overhead cost rates:
Sanders Hanley Stanley
Design: $150 × 1,000; 5,000; 4,000 $150,000 $ 750,000 $ 600,000
Engineering: $80.65 × 2,000; 2,000; 2,200 161,300 161,300 177,430
Construction: $32.50 × 20,800; 21,500; 19,600 676,000 698,750 637,000
Total overhead costs $987,300 $1,610,050 $1,414,430

3.

Sanders
Hanley
Stanley
a. Department rates
(Requirement 2)
b. Plantwide rate
(Requirement 1)
$ 987,300

$1,337,260
$1,610,050

$1,337,260
$1,414,430

$1,337,260
Ratio of (a) ÷ (b) 0.74 1.20 1.06
The overhead allocated to Sanders decreases by 26% under the department rates, the overhead allocated to Hanley increases by about 20%, and the overhead allocated to Stanley increases by about 6%.
The three projects differ sizably in the way they use the resources of the three departments.

The percentage of total driver units in each department used by the companies is:

Department Cost
Driver
Sanders
Hanley
Stanley
Design
Engineering
Construction Design-hours
Engineering-hours
Labor-hours 10%
32
33 50%
32
35 40%
36
32
The Sanders project uses only 10% of design-hours in 2014 and uses 32% of engineering-hours and 33% of construction hours. The result is that the overhead rate, based on allocating costs equally to all projects (33%), will greatly overestimate the cost of resources used on the Sanders project, which uses very few design-hours. This explains the 26% decrease in indirect costs assigned to the Sanders project when department rates are used.
In contrast, the Hanley and Stanley projects use more of design (50% and 40%, respectively). Hence, the use of department rates will report higher indirect costs for Hanley and Stanley than does a single overhead rate.
Sanders was probably complaining about the costs resulting from using the simple system because its project was being overcosted relative to its consumption of overhead resources. Hanley and Stanley, on the other hand, were having their projects undercosted and underpriced by the simple system. If the new department-based rates are used to price projects, Hanley and Stanley will be unhappy. CKM should explain to Hanley and Stanley how the calculations were done and point out their high use of design resources. CKM should discuss ways of reducing the consumption of design resources, if possible, and show willingness to partner with them to do so. CKM could even offer to phase in the new prices.

4. It would not be worthwhile to further refine the cost system into an ABC system if (1) a single activity accounts for a sizable proportion of the department's costs or (2) significant costs are incurred on different activities within a department, but each activity has the same cost driver or (3) there wasn't much variation among contracts in the consumption of activities within a department. If, for example, most activities within the design department were, in fact, driven by design-hours, then the more refined system would be more costly and no more accurate than the department-based cost system.