I. Multiple choice questions- (Give the most correct answer/s for the statement from the choices given below.)

1. Costs are allocated:
a. To provide information useful for decision making.
b. To reduce frivolous use of resources.
c. To encourage evaluation of internally provided services.
d. To calculate the ‘full cost' of products/ services for GAAP reporting.
e. All of the above are reasons to allocate costs.

2. In cost allocation process, the cost objective is:
a. The allocation base used to allocate the costs.
b. A group of individual costs whose total is allocated using one allocation base.
c. The product, service, or department that is to receive the allocation.
d. None of the above

3. The direct method of allocating costs:
a. Allocating service department cost to other service departments.
b. Allocates only direct costs.
c. Allocating service department costs to production departments only.
d. Both b and c.

4. An important concern in forming a cost pool is to:
a. Avoid placing similar costs in the same pool.
b. Limit the number of costs that make up the pool.
c. Ensure that the costs in the pool are homogeneous or similar.
d. None of the above.

5. To prevent service departments from passing on the excess cost related to inefficiencies:
a. Budgeted costs should be allocated.
b. Actual costs should be allocated.
c. No costs should be allocated.
d. None of the above.

(1 x 5 = 5 marks)

II. Problem solving question-
World Airlines has 3 Service departments: 1. Ticketing, 2. Baggage Handling, and 3. Engine Maintenance. The Service department costs are estimated for separate cost pools formed by department and are allocated to two revenue producing departments: 1. Domestic Flights, and 2. International Flights. World does not differentiate between fixed and variable costs in making allocations. The following data relate to the allocations:

Budgeted data
Costs Air Miles
Ticketing $ 4,000,000
Baggage Handling $ 2,000,000
Engine Maintenance $ 6,000,000
Domestic Flights 5,000,000
International Flights 20,000,000

Required:
a. Allocate the service department costs to the revenue-producing departments using air miles as the allocation base.
b. Evaluate the cause and effect relationship resulting from the use of air miles as the allocation base. In which of the cost pools do you think the cause-and-effect relationship is the strongest? Suggest alternative allocation bases for the two remaining cost pools with the weakest cause-and-effect relationship.

(5 marks)

III. Case Study
Wilton International is large conglomerate with divisions that produce chemicals, tires, specialty metals and pharmaceuticals. Two years ago , the CFO noted that the company paid consultants more than $ 3 million per year to help solve problems related to manufacturing efficiency, employee motivation, investment decisions and a variety of other matters. The $ 3 million in charges reflect average fees of approximately $ 120 per hour. The CFO decided that substantial funds could be saved by setting up an internal consulting group. Accordingly, 5 senior consultants from a respected firm were hired to run an internal consulting group at an average salary of $150,000 per year. These new managers hired 15 additional employees at an average salary of $ 50,000 per year. Thus, the company had 20 full time internal consultants at a yearly cost of only $ 1,500,000. The 20 individuals can work approximately 38,000 hours per year in total.

In the first year of the consulting group, the CFO sent out a notice to all divisions that they would no longer be allowed to hire outside consultants for work that could be performed by the internal group. Further, each division was to be charged a flat annual fee for use of the consultants based on their relative size (measured in sales dollars) over the last four years. With is approach the allocation was as follows:

Chemicals $ 150,000
Tires $ 300,000
Specialty Metals $ 450,000
Pharmaceuticals $ 600,000

With this allocation, the division managers made frequent demands for the services of the consultants. Indeed, because of the demand for the services of the internal consultants, there were frequent delays, often exceeding one month.

The following year, the CFO changed the method of allocation to a charge for hours worked. Since costs were $ 1,500,000 and 38,000 hours were available, the charge was $ 39.50 per hour. With this charge, demand for consulting services declined drastically. In fact, the average consultant was only charging 70% of available hours. Further, all requests for services were easily answered within a day or two.

Required:

a. Explain the difference in demand under the two allocation schemes.

b. Since the demand is declining the CFO is considering closing the internal consultancy department. Based on the information provided what would you advise?