2: 1- Define activity-based costing. Explain why this approach to cost assignment is superior to the traditional method of using a plantwide overhead cost pool and overhead rate. 2- In the early 1990s, president Will Thomas, son of the founder, realized that Thomas-Britt could not depend on government contracts for long-term growth and stability. Consequently, he began planning for diversified commercial growth. By the end of 2003, Thomas-Britt had succeeded in reducing government contract sales to 50% of total sales. Traditionally, the costs of the Materials Handling Department have been allocated to other departments as a percentage of the dollar value of direct materials. Peter Anderson, manager of the government contracts unit, has been complaining about this allocation for several months. He believes that since his unit's materials costs are high and materials handling activities are low relative to the commercial unit, he is absorbing more than his fair share of this overhead. He wants to find a way to transfer some of these charges to another unit, thereby increasing the government contracts unit's profitability and his year-end performance bonus. Peter shared his views in a recent meeting with Sarah Lindley, the newly hired cost accounting manager, and Reese Mason, manager of the commercial unit. After a heated discussion, Sarah agreed to investigate the current allocation method and, if appropriate, recommend an alternative method. After doing some research, Sarah learned the following: The majority of the direct materials purchases for government contracts are high-dollar, low-volume purchases. Direct materials purchases for commercial contracts are mostly low-dollar, high-volume purchases. There are other departments that use the services of the Materials Handling Department on a limited basis, but they have never been charged for materials handling costs. One purchasing agent with a direct phone line is assigned exclusively to purchasing high-dollar, low-volume materials for government contracts, at an annual salary of $36,000. His employee benefits are estimated to amount to 20% of his annual salary. The dedicated phone line costs $2,800 a year. The Materials Handling Department's budget for 2017, as proposed by Sarah Lindley's predecessor, follows. Payroll Employee benefits Telephones Other utilities Materials and supplies Depreciation $ 180,000 36,000 38,000 22,000 6,000 6,000 Total materials handling costs $ 288,000 Direct materials budget Government contracts Commercial products $1,958,400 921,600 Total direct materials budget $2,880,000 After reviewing the situation, Lindley has recommended that allocating materials handling costs based on the number of purchase orders issued is preferable to the current allocation based on direct materials cost. She estimated the number of purchase orders to be processed in 2017 as follows: Government contracts 79,860 Commercial products Other Total 154,880 7,260 242,000 Using the 2017 estimates, she provided the following analysis to Anderson and Mason. Materials handling cost based on purchase orders issued Materials handling cost based on direct materials cost Difference in cost allocated to unit Government Contracts Unit $ 95,040 195,840 ($100,800) Commercial Unit $184,320 92,160 $92,160 When Mason saw the projected increase in the commercial unit's costs, he exploded. He was not going to lose any of his year- end performance bonus just because Lindley wanted to change the way she calculated the numbers. He marched into Lindley's office and reminded her that he had been with the company for 25 years and had "plenty of pull" with Thomas as a member of the senior management team. He then told her to "adjust" her numbers and modify her recommendation so that the results would be more favorable to the commercial unit. He added that since materials handling costs were only allocated to the government contract and commercial units, she could just hide some of the commercial unit's purchase order volume in those other units. Given her new position, Lindley is not sure how to proceed. She questions Mason's motivation. To complicate matters, Thomas has asked her to prepare a three-year forecast of the two units' results, for which she believes the new allocation method would provide the most accurate data. Using the new method would put her in direct opposition to Mason's directives, however. Lindley has assembled the following forecasted data to project the units' direct materials handling costs. 2017 2018 2019 Total materials handling costs $288,000 $ 326,785 $ 374,420 Direct materials cost Total direct materials cost Government contracts unit $1,958,400 $2,275,000 $2,576,000 Commercial unit 921,600 975,000 1,104,000 $2,880,000 $3,250,000 $3,680,000 2017 2018 2019 Purchase orders Government contracts unit Commercial unit 79,860 85,024 89,400 154,880 164,734 172,840 Other units 7,260 15,942 35.760 Total purchase orders 242,000 265,700 298,000 Required a. Using the forecasted information, calculate the materials handling costs that would be allocated to each unit under both allocation methods. Show the cumulative dollar impact over the three-year period 2017-2019. b. Why might the number of purchase orders be a better cost driver for materials handling costs than direct materials cost? Are there other factors in the allocation that Lindley should consider? C. d. In a recent meeting between Sarah Lindley and Reese Mason, Mason said that there is nothing in any accounting pronouncement that requires the use of activity-based costing. Therefore, there is no reason to make Lindley's recommended change in allocation methods. Do you agree with Mason? Why or why not