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# Cost Allocation & Activity-Based Costing

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PROBLEM 6-5. Cost-Plus Contracts, Allocations and Ethics

Pelton Instrumentation manufactures a variety of electronic instmments that are used
in military and civilian applications. Sales to the military are generally on a cost-plus
profit basis with profit equal to 10 percent of cost. Instruments used in military
applications require more direct labor time because "fail-safe" devices must be installed.
(These devices are generally omitted in civilian applications.)

At the start of the year, Pelton estimates that the company will incur \$50,000,000
of overhead, \$5,000,000 of direct labor, and 500,000 machine hours.

Consider the Model KV10 gauge that is produced for both civilian and military uses:

Civilian Military
Direct material \$2,000 \$2,500
Direct labor \$600 \$900
Machine hours 80 80

Required
a. Calculate the cost of civilian and military versions of Model KV10 using both direct
labor dollars and machine hours as alterriative allocation bases.

b. Explain why Pelton Instmments may decide to use direct labor as an overhead allocation
base.

c. Is it ethical for Pelton to select an allocation base that tends to allocate more of
overhead costs to government contracts? Explain.

Binder Manufacturing produces small electric motors used by appliance manufacturers.
In the past year, the company has experienced severe excess capacity due to competition
from a foreign company that has entered Binder's market. The company is cunently
bidding on a potential order from Dacon Appliances for 7,000 Model 350 motors.

The estimated cost of each motor is \$55, as follows:

Direct material \$25
Directlabor 10
Total \$55

The predetermined overhead rate is \$2 per direct labor dollar. This was estimated by
dividing estimated annual overhead (\$10,000,000) by estimated annual direct labor
(\$5,000,000). The \$10,000,000 of overhead is composed of \$4,000,000 of variable costs
and \$6,000,000 of fixed costs. The largest fixed cost relates to depreciation of plant and
equipment.
Custom Metal Works received an offer from a "big box" retail company to purchase 2,000
metal outdoor tables for \$195 each. Custom Metal Works accountants determine that
the following costs apply to the tables:

Direct material \$90
Direct labor 42
Total \$197

Of the \$65 of overhead, \$10 is variable and \$55 relates to fixed costs. The \$55 of fixed
overhead is allocated as \$1.50 per direct labor dollar.

Power Electronics manufactures portable power supply units. Power has recently decided to
use an activity-based approach to cost its products. Production line setups is a major
activity at Power. Next year Power expects to perform 1,000 setups at a total cost of
\$1,500,000. Power plans to produce 750 units of product EP150, which will require
two setups.

Auburn Banking and Loans Company has six service departments:

Human Resources (hires employees and manages benefits)
Duplicating (performs copy services)
Janitorial (provides routine cleaning services)
Accounting (provides accounting services)
Graphic Design (designs forms)
Food Services (provides free breakfast and lunch to employees)

The services are used by the company's two subsidiaries (Auburn Personal Banking

Required
a. Suggest allocation bases to be used in allocating the service department costs to the
two subsidiaries.

Marvin Company has three service departments (S1, S2, and S3) and two production departments (P1 and P2). The following data relate to Marvin's allocation of service department costs:

Budgeted Costs Nbr of Employees
S1 \$3,000,000 75
S2 2,000,000 50
S3 1,000,000 25
P1 150
P2 225

#### Solution Summary

The solution explains some questions relating to cost allocation and activity based costing

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