Answer the question

AIP 8.7 Allocating Computer Costs The Independent Underwriters Insurance Co. (IUI) established a Systems Department two years ago to implement and operate its own information processing and storage systems. IUI believed that its own system would be more cost effective than the service 390 bureau that it had been using. IUI's three departments - Claims, Records, 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 demands. In addition, the system was designed to meet IUI's long-term capacity. The excess capacity designed into the system would be sold to outside users until needed by IUI. The estimated resource requirements used to design and implement the system are shown in the following schedule. Hardware and Other Capacity-Related Resources Operating Resources Records 30% 60% Claims 50 20 Finance 15 15 Expansion (outside use) Total 100% 100% IUI 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 upon actual computer time used. The actual costs for the first quarter of the current fiscal year were distributed to the user departments as follows: Department Percentage Utilization Amount Records 60% $330,000 Claims 20 110,000 Finance 15 82,500 Outside 5 27,500 Total $550,000The three user departments have complained about the cost distribution 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, as these allocated costs form the basis for the fees billed to the outside clients. Melinda Poon, IUI's controller, decided to review the distribution method by which the Systems Department's costs have been allocated for the past two years. The additional information she gathered for her review is reported in the three tables that follow (Exhibits 1 to 3). Melinda has concluded that the method of cost distribution should be changed to reflect more directly the actual benefits received by the departments. She 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 remaining costs for software development and operations would be charged to the user departments based upon actual hours used. A pre-determined hourly rate based upon the annual budget data would be used. The hourly rates that would be used for 391 the current fiscal year are shown in Exhibit 4. Exhibit 1 Systems Department Costs and Activity Levels First Quarter Annual Budget Budget Actual Hour E Hours E Hours E Hardware and other capacity-related costs $600,000 $150,000 $155,000 Software development 18,750 562,500 4,725 141,750 4,250 130,000 Operations: Computer-related 3,750 750,000 45 189,000 20 187,000 Input/output-related 30,000 300,000 7,560 75,600 7,900 78,000Exhibit 2 Historical Utilization by Users (percentage figures) Hardware and Software Operations Other Capacity Development Computer-Related Input/Output Related Needs Range Average Range Average Range Average Records 30% 0-30% 12% 55-65% 60% 10-30% 20% Claims 50 15-60 35 10-25 20 60-80 70 Finance 15 25-75 45 10-25 15 3-10 Outside 5 0-25 3-8 5 3-10 100% 100% 100% 100% Exhibit 3 Utilization of Systems Department's Services (in hours) First Quarter Operations Software Computer- Input/Output Development Related Related Records 425 552 1,580 Claims 1,700 184 5,530 Finance 1,700 138 395 Outside 425 46 395 Total 4,250 920 7,900 Exhibit 4 Function Hourly Rate ($) Software development 30 Operations Computer-related 200 Input/output-related 10 Melinda plans to use first-quarter activity and cost data to illustrate her recommendations. The recommendations will be presented to the Systems Department 392and the user departments for their comments and reactions. She then expects to present her recommendations to management for approval. a. Prepare a schedule to show how the actual first-quarter costs of the Systems Department would be charged to the users, if Melinda Poon's recommended method were adopted. b. Explain whether Melinda Poon's recommended system for charging costs to the user departments would: i. improve cost control in the Systems Department, ii. improve planning and cost control in the user departments, and iii. be a more equitable basis for charging costs to user departments