Issues in Cost Allocations: What Price Progress:In discussing the cost of operations, the analogy was drawn of the restaurateur who adds a rack of peanuts to the counter, intending to pick up a little additional profit in the usual course of business. His accountant-efficiency expert has some unpleasant news for him.

Expert: Joe, you said you put in these peanuts because some people ask for them, but do you realize what this rack of peanuts is costing you?

Joe: It's not going to cost! It's going to be a profit. Sure, I had to pay $100 for a fancy rack to hold the bags, but the peanuts cost 24 cents a bag and I sell 'em for 40 cents. Suppose I sell 50 bags a week to start. It'll take 12'/2 weeks to cover the cost of the rack. After that I have a clear profit of 16 cents a bag. The more I sell, the more I make.

Expert: That is an antiquated and completely unrealistic approach, Joe. Fortunately, modern accounting procedures permit a more accurate picture, which reveals the complexities involved.

Joe: Huh?

Expert: To be precise, those peanuts must be integrated into your entire operation and be allocated their appropriate share of business overhead. They must share a proportionate part of your expenditures for rent, heat, light, equipment depreciation, decorating, salaries for your waitresses, cook, .

Joe: The cook? What's he got to do with the peanuts? He doesn't even know I have them.

Expert: Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the food is what brings people in here, and the people ask to buy peanuts. That's why you must charge a portion of the cook's wages, as well as a part of your own salary, to peanut sales. This sheet contains a carefully calculated cost analysis, which indicates the peanut operation should pay exactly $2,278 per year toward these general overhead costs.

Joe: The peanuts? $2,278 a year for overhead? Nuts!

Expert: It's really a little more than that. You also spend money each week to have the windows washed, to have the place swept out in the mornings, to keep soap in the washroom, and to provide free cokes to the police. That raises the total to $3,313 per year.

Joe: [Thoughtfully] But the peanuts salesman said I'd make money—put 'em on the end of the counter, he said —and get 16 cents a bag profit.

Expert: [With a sniff] He's not an accountant. Do you actually know what the portion of the counter occupied by the peanut rack is worth to you?

Joe: Nothing. No stool there—just a dead spot at the end.

Expert: The modern cost picture permits no dead spots. Your counter contains 60 square feet, and your counter business grosses $60,000 a year. Consequently, the square foot of space occupied by the peanut rack is worth $1,000 per year. Since you have taken that area away from general counter use, you must charge the value of the space to the occupant.

Joe: You mean I have to add $1 ,000 a year more to the peanuts?

Expert: Right . That raises their share of the general operating costs to a grand total of $4,313 per year. Now then, if you sell 50 bags of peanuts per week, these allocated costs will amount to $1.65 per bag.

Joe: WHAT?

Expert: Obviously, to that must be added your purchase price of 24 cents per bag, which brings the total to $1.89 cents. So you see, by selling peanuts at 40 cents per bag, you are losing $1.49 cents on every sale.

Joe: Something's crazy!

Expert: Not at all! Here are the figures. They prove your peanut operation cannot stand on its own feet.

Joe: [Brightening] Suppose 1 sell lots of peanuts—1,000 bags a week instead of 50?

Expert: [Tolerantly] Joe, you don't understand the problem. If the volume of peanut sales increases, your operating costs will go up—you'll have to handle more bags, with more time, more depreciation, more everything. The basic principle of accounting is firm on that subject: The bigger the operation, the more general overhead costs that must be allocated. No, increasing the volume of sales won't help.

Joe: Okay. You're so smart, you tell me what I have to do!

Expert: [Condescendingly] Well—you could first reduce operating expenses.

Joe: How?

Expert: Move to a building with cheaper rent. Cut salaries. Wash the windows biweekly. Have the floor swept only on Thursday. Remove the soap from the washrooms. Decrease the square-foot value of your counter. For example, if you can cut your expenses 50 percent, that will reduce the amount allocated to peanuts from $4,313 down to $2,157 per year, reducing the cost to $1.07 per bag.

Joe: [Slowly] That's better?

Expert: Much, much better. However, even then you would lose 67 cents per bag if you charge only 40 cents. Therefore, you must also raise your selling price. If you want a net profit of 16 cents per bag, you would have to charge $1.23.

Joe: [Flabbergasted] You mean even after I cut operating costs 50 percent, I still have to charge $1.23 for a 40-cent bag of peanuts? Nobody's that nuts about nuts! Who'd buy them?

Expert: That's a secondary consideration. The point is, at $1.23 you'd be selling at a price based on a true and proper evaluation of your then-reduced costs.

Joe: [Eagerly] Look! I have a better idea. Why don't I just throw the nuts out—put them in a trash can?

Expert: Can you afford it?

Joe: Sure. All I have is about 50 bags of peanuts—cost about 12 bucks—so I lose $100 on the rack, but I'm out of this nutsy business and no more grief.

Expert: [Shaking head] Joe, it isn't quite that simple. You are in the peanut business! The minute you throw those peanuts out, you are adding $4,313 of annual overhead to the rest of your operation. Joe—be realistic can you afford to do that?

Joe: [Completely crushed] It's unbelievable! Last week I was making money. Now I'm in trouble—just because I believe 50 bags of peanuts a week is easy.

Expert: [With raised eyebrow] That is the object of modern cost studies, Joe—to dispel those false illusions.

Required: What should Joe do?