Fully Allocated Customer Profitability

Learning Objective 5 Discuss decisions faced when collecting and allocating indirect costs to customers

• determining the number of cost pools and the costs to be included in each cost pool

In this section, we focus on the first purpose of cost allocation (see Exhibit 14-1): to provide information for economic decisions, such as pricing, by measuring the full costs of delivering products to different customers based on an ABC system.

We continue with the Astel Computers example introduced earlier in this chapter and focus on the fully allocated customer-profitability calculations for the 10 wholesale customers in the Provalue Division. The Provalue Division also uses a direct sales channel to sell Provalue computers directly to business customers. Recall that Astel has another division, the Deskpoint Division, which sells high-end computers. We illustrate how costs incurred in different parts of a company can be assigned, and then reassigned, to calculate customer profitability.

We summarize the cost categories as follows:

• CORPORATE COSTS—There are two major categories of corporate costs:

1. CORPORATE ADVERTISING COSTS—advertising and promotion costs to promote the Astel brand, $1,050,000.

2. CORPORATE ADMINISTRATION COSTS—executive salaries, rent, and general administration costs, $4,400,000.

• DIVISION COSTS—The Provalue Division, which is the focus of our analysis, has three ­indirect-cost pools—one cost pool for each of the different cost drivers for allocating division costs to distribution channels: (1) cost pool 1, which comprises all division costs allocated to the wholesale and business-sales channels based on revenues of each channel (benefits received by each channel); (2) cost pool 2, which comprises R&D and design costs allocated to the distribution channels on some fair and equitable basis; and (3) cost pool 3, which consists of all division costs allocated to the wholesale and business-sales channels based on the operating incomes of each channel before such allocations, if positive (each channel’s ability to bear). The cost pools are homogeneous, that is, all costs in a cost pool have the same or similar cause-and-effect, benefits-received, fair-and-equitable, or ability-to-bear relationship with the cost-allocation base. Different cost pools need different cost-allocation bases to allocate the costs in the cost pools to distribution channels.
• CHANNEL COSTS—Each distribution channel in the Provalue Division has two indirect-cost pools: (1) a cost pool that comprises all channel costs allocated to customers based on customer revenues (benefits received by each customer) and (2) a cost pool that consist of all channel costs allocated to customers based on operating incomes of customers before such allocations, if positive (each customer’s ability to bear).

Exhibit 15-9 presents an overview diagram of the allocation of corporate, division, and ­distribution-channel indirect costs to wholesale customers of the Provalue Division. Note that the Deskpoint Division has its own indirect-cost pools used to allocate costs to its customers. These cost pools and cost-allocation bases parallel the indirect-cost pools and allocation bases for the Provalue Division.

Implementing Corporate and Division Cost Allocations

Exhibit 15-10 allocates all overhead costs to customers based on the overview diagram in Exhibit 15-9. We describe some of the allocation choices based on the criteria for allocating costs explained in Exhibit 15-8.

1. Start at the top of Exhibit 15-9 with the allocation of corporate advertising and corporate administration costs based on the demands that the Provalue Division and Deskpoint Division customers place on corporate resources. The first two columns in Exhibit 15-10 present the allocation of corporate advertising and corporate administration costs to the Provalue division.
   1. Astel allocates a total of $1,050,000 of corporate advertising costs to the two divisions on the basis of the revenues of each division (benefits received). It is plausible to assume that customers with higher revenues benefited more from corporate advertising costs than customers with lower revenues (see Exhibit 15-7 for information on revenues of each division):

b. Using the benefits-received criterion, Astel allocates corporate administration costs of $4,400,000 to each division on the basis of division administration costs because corporate administration’s main role is to support division administration. Exhibit 15-6 shows division administration costs for Provalue Division of $1,900,000. Division administration costs for Deskpoint Division are $2,100,000. The allocations are as follows:

2. Next, drop down one level in Exhibit 15-9 and focus on the allocation of costs from the division cost pools to the distribution-channel cost pools for the Provalue Division. The three columns labeled “Provalue Division Cost Pools” in Exhibit 15-10 show the allocations of the Provalue Division costs to the wholesale channel and the business-sales channel.
   1. Using the benefits-received criterion, the corporate advertising cost of $450,000 that had been allocated to the Provalue Division is now reallocated to the wholesale and business-sales channels’ revenue-based cost pools on the basis of the revenues of each channel (see Exhibit 15-6).

b. The R&D costs and design costs are aggregated into one homogeneous cost pool and allocated to channels on the basis of a study analyzing the demand for R&D and design resources by the wholesale and business-sales channels. A significant amount of the R&D and design costs arises as a result of modifications to the Provalue computer demanded by the more sophisticated business customers. Using the results of the study and the fairness criterion, the Provalue Division allocates half of the R&D and design costs to the business-sales channel (and half to the wholesale channel) even though the business-sales channel accounts for only about one-third of the total sales of the Provalue Division. Exhibit 15-10 shows that the Provalue Division allocates $\$\text{2,700,000}\hspace{0.17em}(\$\text{5,400,000}÷\mathrm{2)}$ each to the wholesale and business-sales channels’ revenue-based cost pools.

c. Each division adds the allocated corporate administration costs to the division administration cost pool. The costs in this cost pool are facility-sustaining costs and do not have a cause-and-effect relationship with any of the activities in the distribution channels. Astel, however, allocates all costs to products so that managers are aware of all costs when making pricing and other decisions. The Provalue Division allocates the total costs of $3,990,000 in the Provalue Division Administration cost pool ($2,090,000 of Corporate Administration Costs allocated to the $\text{Provalue Division}+\$\text{1,900,000}$ of Provalue Division Administration Costs) to the wholesale channel and business-sales channel based on operating incomes of the wholesale and business-sales channels, representing the ability of each channel to bear division administration costs (including allocated corporate administration costs). The lower the operating income of a channel, the lower the division costs allocated to it. As described earlier in the chapter, the rationale for the ability-to-bear criterion is that the Provalue Division will work hard to reduce the support it provides to channels with lower incomes. From Exhibit 15-10, the operating income of the wholesale channel after subtracting all costs that have been allocated to it thus far is $\$\text{11,234,850} (\$\text{15,027,500} (\text{Cell} \mathrm{R}7)-\$\text{292,650} (\text{Cell} \mathrm{G}15)-\$\text{2,700,000} (\text{Cell} \mathrm{G}16)-\$\text{800,000} (\text{Cell} \mathrm{G}17)$ while the operating income of the business-sales channel is $5,215,150 (calculations not shown).

3. Finally, focus on the bottom rows in Exhibit 15-9 and the allocation of costs from the wholesale distribution-channel cost pools of the Provalue Division to individual wholesale-channel customers. The four columns labeled “Provalue Division Distribution Channel Cost Pools” in Exhibit 15-10 show costs accumulated in the wholesale channel and the business-sales channel. Exhibit 15-10 only presents the allocation of wholesale-channel costs to wholesale customers.
   1. The wholesale-channel revenue-based cost pool is allocated to individual wholesale customers on the basis of revenues because revenues are a good measure of how individual customers benefit from these costs. The costs in this cost pool total $3,792,650 and are composed of three costs: (1) $292,650 of corporate advertising costs allocated to the wholesale channel revenue-based cost pool in Step 2a, (2) $2,700,000 of R&D and design costs allocated to the wholesale channel revenue-based cost pool in Step 2b, and (3) $800,000 of costs of the wholesale-distribution channel itself (Exhibit 15-6). In Exhibit 15-10, the costs allocated to Customer A and Customer B, for example, are shown below:

b. The second wholesale-channel cost pool is composed of $2,725,049 of the division-­administrative costs allocated to the wholesale channel operating-income-based cost pool in Step 2c. These costs are allocated to individual wholesale customers in Exhibit 15-10, row 21, on the basis of operating incomes (if positive) (see Exhibit 15-10, row 20) because operating incomes represent the ability of customers to bear these costs. In Exhibit 15-10, the sum of all the positive amounts in row 20 equals $13,195,922. The costs allocated to Customer A and Customer B, for example, are as follows: