This week\'s question focuses on cost allocation. A major manufacturer decided t

Question

This week's question focuses on cost allocation. 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?

Note the use of the word immediately above!

Explanation / Answer

A)

Management failed to allocate overheads based on actual usage of activity. This renders the division unprofitable. Overheads should be allocated based on actual level of consumption of facilities. If overheads are not properly allocated, even incorrect decision making will be made.

Since, it is a new unit after sale, it became profitable.

B)

From the facts of the case, I can say that company used traditional method of allocation of overheads. Where, a blank rate is used to allocate overheads.

I highly suggest activity based costing. Under this costing, overheads are allocated based on the actual activity consumption recorded. Not based on any single overhead rate.

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