Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 32

Departmental Cost Allocation; Outsourcing; Outside Price

McKeoun Enterprises is a large machine tool company now experiencing alarming increases in maintenance expense in each of its four produc­tion departments. Maintenance costs are currently allocated to the production departments on the basis of labor-hours incurred in the production department. To provide pressure for the production depart­ments to use less maintenance, and to provide an incentive for the maintenance department to become more efficient, McKeoun has decided to investigate new methods of allocating maintenance costs. One suggestion now being evaluated is a form of outsourcing: The producing departments could purchase maintenance service from an outside supplier. That is, they could choose either to use an outside sup­plier of maintenance or to be charged an amount based on their use of labor-hours. The following table shows the labor-hours in each department, the allocation of maintenance cost based on labor-hours, and the cost to purchase the equivalent level of maintenance service from an outside maintenance provider.

Production Department	Direct Labor-Hours Allocation Base (Percent)	Direct Labor-Hours Allocation Cost	Outside Price
A	20%	$ 90,000	$115,000
B	30	135,000	92,000
C	10	45,000	69,000
D	40	180,000	184,000
Total	100%	$450,000	$460,000

Required

1. As a first step in moving to the outsourcing approach, McKeoun is considering an allocation based on the price of the outside maintenance supplier for each department. Calculate the cost allocation on this basis and compare it to the current labor-hour basis.

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2. If McKeoun follows the proposed plan, what is likely to happen to the overall use of maintenance? How will each department manager be motivated to increase or decrease the use of maintenance? What will be the overall effects of going to the new plan?

Step 1 of 4

Significance of cost allocation:

1. It motivates the management personnel to give more efforts in achieving goal of the organisation

2. Managers should me by incentivised properly for making decisions that are consistent with the goals of top management.

3. It is used to determine the rewards that should be awarded to managers for their efforts and skills in decision making.