A major manufacturer decided to put one of its divisions up for sale because man

Question

A major manufacturer decided to put one of its divisions up for sale because managerial information showed the components produced by this division is losing money. A group of employees in the division purchased it. Under the new ownership, the division immediately became profitable.

A. Why do you think the division was profitable immediately under the new ownership?

B. What kind of cost allocation method may have caused the sale of a profitable division, and can you suggest a better method of cost allocation? Explain why?

Explanation / Answer

A)

The Division became profitable immediately under the new ownership simply because of the re-allocation / revised assignment of costs already incurred - a better and more appropriate way of presentation to aid decision-making .

B)

Allocation of irrelevant /indirect costs -not pertinent or not directly attributable to the division might have shown a negative profit figure.Costs relevant to two or more departments, charged to a single department,will present a wrong figure. It is this non-traceability of costs to this division ,that might have caused this sale

It is not recommendable to sell or terminate a product based on a fully-loaded cost that includes an overhead allocation. if that is done it means that the same total amount of overhead will then be allocated to the remaining divisions, which increases their cost. Instead, only sell a division if its direct/traceable cost equals or exceeds its revenue, which will help in proper decision making as to sell or continue.

To be sure that a sale of a division is beneficial, run an estimated before-and-after income statement that reveals the impact of the sale. If profits do not improve, do not sell.Direct costs are the only applicable costs to use when deciding whether to sell a division or continue.

Hence it is suggested to follow relevant costing or direct costing methods --with proper written guidelines to apportion overheads to different divisions -so as to assess the profitability of continuing a division or otherwise. All the costs under a division should be traceable to that division and controllable by the people directly involved.

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