Emma Hanks, manager of a division that produces valves and castings on a special order basis, was excited about an order received from a new customer. The customer, a personal friend of Bob Johnson, Emmaâ??s supervisor, had placed an order for 10,000 valves. The customer agreed to pay full manufacturing cost plus 25 percent. The order was timely since business was sluggish, and Emma had some concerns about her divisionsâ?? ability to meet it targeted profits. Even with the order, the division would likely fall short in meeting the target by at least $50,000. After examining the cost sheet for the order, however, Emma thought she saw a way to increase the profitability of the job. She reached for the phone to call her division controller, Lenny Cabot, CMA.
A few minutes later, Lenny met Emma in her office. Emma explained her plan to increase the profitability of the valve job. As currently written, the cost sheet reflected an allocation of maintenance costs to the Grinding Department based on maintenance hours used. In fact, sixty percent of maintenance costs were allocated to Grinding on that basis. But suppose that machine hours were used as the allocation base in stead of maintenance hours? Then the allocation ratio would increase from 60% to 80%. This change would result in an increase of $10 per unit of the job. With the 25 percent markup, the revenues on that job would jump by $12.50 per unit â?" increasing the profitability of the division by $125,000. At that point, Emma asked Lenny to change the allocation base from maintenance hours worked to machine hours.
Lenny protested briefly, pointing out that considerable time had been spent assessing the causal relationships. He and the management team found that maintenance hours reflected the consumption of maintenance cost much better than machine hours. He worried that the change would not result in a fair cost assignment. Finally, he reminded Emma that the maintenance hours had been used as the allocation base for maintenance cost for several years.
Emma brushed aside Lennyâ??s protests, saying that allocations are arbitrary anyway. She pointed out that changing the allocation base for this new job would increase the profitability and allow their division to meet targeted profit goals for the year. Their ability to get the capital they needed to expand the business depended upon meeting profit goals, as did their likelihood of receiving year-end bonuses. She also reminded him that the new customer had a prosperous business and could easily afford to pay somewhat more for this order.
Do you agree with Emma's reasoning?
What would you do if you were the controller?
Facts of the case:
The company has received the special order for 10000 valves at the price of total manufacturing cost plus 25%. Presently, the maintenance costs are allocated on the basis of maintenance hours. Emma Hanks, manager of the division which is involved in the manufacture of valves, wants to change the allocation method i.e., she wants to allocate the maintenance costs on the basis of labor hours in lieu of maintenance hours in order to increase the total costs for attaining ...
The ethics for divisions managers are examined.