Independent Outside Underwriters Co. (IOU) established a Systems Department two years ago to implement and operate its own data processing systems. IOU believed that its own system would be more cost-effective than the service bureau it had been using.

IOU’s three departments—Records, Claims, and Finance—have different requirements with respect to hardware and other capacity related resources and operating resources. The system was designed to recognize these differing needs. In addition, the system was designed to meet IOU’s long-term capacity needs. The excess capacity designed into the system would be sold to outside users until needed by IOU. The estimated resource requirements used to design and implement the system are shown in the following schedule. 

IOU currently sells the equivalent of its expansion capacity to a few outside clients. At the time the system became operational, management decided to redistribute total expenses of the Systems Department to the user departments based on actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows:

The three user departments have complained about the cost distribution method since the Systems Department was established. The Records Department’s monthly costs have been as much as three times the costs experienced with the service bureau. The Finance Department is concerned about the costs distributed to the outside-user category because these allocated costs form the basis for the fees billed to the outside clients.

Jerry Owens, IOU’s controller, decided to review the cost-allocation method. The additional information he gathered for his review is reported in Exhibits 5A-1, 5A-2, and 5A-3.

Owens has concluded that the method of cost allocation should be changed. He believes that the hardware and capacity-related costs should be allocated to the user departments in proportion to the planned long-term needs. Any difference between actual and budgeted hardware costs would not be allocated to the departments but remain with the Systems Department.

The costs for software development and operations would be charged to the user departments based on actual hours used. A predetermined hourly rate based on the annual budget data would be used. The hourly rates that would be used for the current fiscal year are as follows:

Function                                                 Hourly Rate
Software development .............................$ 30
Operations:
Computer-related ......................................200
Input/output-related ....................................10

Exhibits 5A-1

Exhibits 5A-2

Exhibits 5A-3

Required

1. Calculate the amount of data-processing costs that would be included in the Claims Department’s first-quarter budget according to the method Jerry Owens has recommended.

2. Prepare a schedule to show how the actual first-quarter costs of the Systems Department would be charged to the users if Owens’ recommended method were adopted.

3. Explain whether Owens’ recommended system for charging costs to the user departments will

a. improve cost control in the Systems Department, or

b. improve planning and cost control in the user departments.

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Hardware and Other Capacity- Operating Related Resources Resources Records 60% 25% Claims 15 Finance 20 20 Expansion (outside use) 5 Total 100% 100% Department Percentage Utilization Amount Records 60% $330,000 Claims 15 82,500 Finance 20 110,000 Outside 27,500 Total 100% $550,000