Frank Delaney owned and operated Delaney Motors, a General Motors automobile dealership in Ohio. Its operations consisted
Question:
Frank Delaney owned and operated Delaney Motors, a General Motors automobile dealership in Ohio. Its operations consisted of new-car sales, used-car sales, parts sales, vehicle lease and rentals, vehicle service, and automobile body repairing and repainting. The dealership was profitable, earning almost 5 percent on sales, but the reported profit on the body shop operation seemed low to Mr. Delaney. Consequently, he engaged a consultant to study the body shop operation and make recommendations. As a background for his study, the consultant took Mr. Delaney?s data for the most recent year and made certain adjustments, shown in Exhibit 1 (attached). He explained them in the following paragraphs taken from his report: Most semi-variable costs contain a significant portion of common costs. For example, the accountant performs many common services in order to maintain the corporate structure (e.g. preparing and filing the dealer?s tax returns). The attorneys and the owner also spend much of their time providing general services. Although many of the expenses would not be significantly reduced if the owner sold certain departments, each department benefits from these expenses, and thus should be allocated a portion of these costs. The body shop, for example, should pay its proportionate share of accountant?s fees relating to the preparation and filing o the dealership?s income tax returns. Telephone expenses and the fixed costs could properly be allocated to the departments if the necessary documentation were available. Since it is not, other cost allocation methods must be considered. A potentially controversial issue involves the owner?s salary. The body shop manager could claim that because he exercises no control over the owner?s salary, this cost should not be charged to his department. The owner puts his time and name in all aspects of the business, however, and his salary should be allocated accordingly. Furthermore, industry data show that owners? salaries tend to vary with sales volume. Semi-variable costs can be allocated to operating departments in several ways, thereby better appraising departmental and managerial performance. These bases include units of production, machine-hours, material costs, sales dollars, direct labor costs, and direct labor-hours. Valid cost allocation bases reliably relate semi-variable costs to the basis used for the allocation. Because the operating departments product heterogeneous products that require dissimilar materials and machines (the new-car and used-car departments probably use no machines), the first three allocation bases ? units of production, machine-hours, and material costs ? clearly are inappropriate. Sales dollars also are an invalid cost allocation basis. For example, the cost of sales ratio on a $9,000 new automobile usually exceeds the cost of sales ratio for a $1,000 body shop repair, thereby implying an unequal allocation basis. Direct labor costs do constitute a valid cost allocation basis in companies in which semi-variable costs are labor related (i.e., the operations are predominantly manual) and hourly rates among and within departments are fairly uniform. But because the dealership?s semi-variable costs are not labor related and the hourly rates are usually not uniform, direct labor costs do not constitute a competent activity basis for your company. Direct labor-hours will provide an acceptable cost allocation base. Although some semi-variable costs do not vary directly with direct labor-hours, such as legal and audit fees, in the interest of practicality and because the other methods clearly are not acceptable, allocating semi-variable costs based on direct labor-hours appears to be the most variable alternative. Your financial statements list the number of direct and indirect employees in each department but fail to disclose the number of departmental hours worked. It is assumed that all direct employees work approximately the same number of hours per week. The number of direct laborers consequently becomes the cost allocation base for semi-variable costs. As discussed later, fixed costs are allocated based on the ratio of departmental square footage to total dealer square footage, adjusted by a weighting factor. Calculations A summary of the selected data extracted from your financial statements is shown in Exhibit 1 (attached). The body shop?s and dealership?s semi-variable costs are shown in lines 7 and 11, respectively. Semi-variable cost allocations are based upon direct labor-hours, assuming that each employee works the same number of hours per week. In line 13 the number of body shop employees performing the direct labor work is divided by the total number of employees for the entire dealership. Based on this method, the increase in semi-variable costs, as seen in line 15, shows that you have under-allocated overhead to the body shop manager, whose bonus includes a portion of his department?s profit. The cost accounting system therefore should be changed to more accurately reflect each department?s use of dealership resources. Fixed costs for the body shop and the dealership are summarized in lines 16 and 17. The quotient of these two amounts appears in line 18. In line 19 the revised allocation of fixed costs is shown. Many GM dealers allocate fixed costs to the body shop based on the ratio of body shop square footage to dealer?s total square footage. This allocation base accurately allocates fixed building costs but fails to account for the various machinery, equipment, furniture, and fixtures located throughout the dealership. To allocate these fixed costs more properly, ?weights,? similar to those developed by Volkswagen, should be used. Volkswagen dealers multiply the square footage of each dealership segment by a value factor to weight the proper distribution of fixed costs. For example, used vehicles and body shop weights are 2.4 and 1.0, respectively. Assuming that these weights also apply to you, you should reduce your allocation to the body shop to 20 percent. Line 19 thus represents this 20 percent balance of the dealership?s fixed costs. Lines 21 through 25 summarize the findings. The revised cost allocations decrease the body shop?s profits from 2.94 percent of sales to 0.30 percent of sales. The consultant had collected data similar to that shown in Exhibit 1 for 11 other dealerships. Summary data for three of these are shown at the bottom of Exhibit 1. They are arranged in order of the body shop profit percentage (line 25): Dealer No. 3 had the third highest percentage, Dealer No. 6 was in the middle, and Dealer No. 9 was third from the bottom. The consultant pointed out that the body shop was even less profitable than Mr. Delaney had thought, and he suggested that Mr. Delaney consider selling it, leasing it to another party, increasing prices, or, if the body shop demand was thought to be elastic, lowering prices. He pointed out that selling or leasing the body shop would permit Mr. Delaney to devote more time to other areas of the dealership. Mr. Delaney considered this recommendation, but he was by no means sure that profitability should be the major consideration. He felt that the dealership had an obligation to provide high-quality body shop work to its customers, and that a lessee might provide below-standard service. He was not sure that prices could be raised, but asked the consultant to find out more about the prices charged by competitive dealers before making a judgment on this. Questions ? 1. Comment on the consultant?s adjustments made in Exhibit 1. Do you agree with each of them? If not, can you suggest better methods of making the adjustments for the stated purpose? 2. Assuming Mr. Delaney decides to keep the body shop, and the consultant reports that it is feasible to raise prices, should Mr. Delaney do so? If he does, what general guide can you suggest as to how much price should be increased? 3. What action should Mr. Delaney take? (**Please note Exhibit 1 is attached in excel format.) Thanks for your help :)
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