Integrative Case 7-78 (Static) Predetermined Rates, Job Costing, Service Firms, Product-Line Profitability (LO 7-3)

A&R Quality Advisors is a small consulting firm offering quality audits and advising services to small and mid-sized manufacturing firms. Quality audits entail reviewing, checking, and documenting quality practices within a firm. Quality advising entails making recommendations for new or revised quality practices. Other firms in the area offer one or both of these services, although the competition for quality audit jobs is stronger than for quality advising.

In addition to senior executives, A&R employees are either staff or managers. Staff employees are usually younger with less experience. Managers, who oversee the staff on jobs, are more experienced. The average hourly wage is $60 for staff and $150 for managers. (Both staff and managers are paid an annual salary; these hourly costs are based on 2,000 average annual hours worked.) Staff are expected to spend at least 90 percent of their time on billable work. Because of administrative work associated with supervising the staff and the expectation that managers will spend a portion of their time seeking new business, managers are expected to spend about 50 percent of their time on billable work. A&R employs 10 staff and two managers.

In addition to staff and manager costs, A&R has overhead and administrative costs of $4,500,000, of which about $1,500,000 is variable with respect to billable hours. Overhead and administrative costs include the nonbillable cost of the staff and managers.

Selected information on billable hours expected for the next year follows:

	Billable Audit Hours		Billable Advising Hours		Total Billable Hours
	Staff	Manager	Staff	Manager	Staff	Manager
Client 01	150	12	200	10	350	22
Client 02	70	10	0	0	70	10
Client 03	220	30	80	15	300	45
Client 49	40	2	0	0	40	2
Client 50	300	20	200	15	500	35
Total	8,500	1,200	9,500	800	18,000	2,000

Although not all clients use A&R for both services, about 70 percent do.

A&R bills audit services based on billable hours and advising services at a fixed fee. The cost for audit services is determined by multiplying the billable hours by the quoted employee rates. Staff rates for the following year are $200 per hour, and manager rates are $500 per hour. The rates are set to meet the competition in the area.

To determine the cost (not the price) of the job, A&R uses a job costing system. To the employee costs (not the billing rates) is added an amount for overhead based on the predetermined rate and the billable hours in the job. The predetermined rate is based on expected billable hours.

Total revenue at A&R next year is expected to be $8 million.

The two founding partners of A&R are looking at these forecasts for next year and trying to decide whether to drop one of these services. We should probably become more focused, as we sometimes remind our clients.

Explanation

This problem relates overhead allocation to decision making.

Predetermined rate = (Overhead Billable hours)

$225 per hour = ($4,500,000 20,000 hours)

Client 02 Audit Billing = (Staff hours Staff billing rate) + (Manager hours Manager billing rate)

$19,000 = (70 $200) + (10 $500)

The cost is the sum of the manager time (10 hours) at the average manager hourly salary ($150) plus the cost of the staff time (70 hours) and the average staff hourly salary ($60) plus overhead applied based on total billable hours (80) multiplied by the predetermined overhead rate (225 per billable hour).

Manager cost	10	$ 150 =	$ 1,500
Staff cost	70	$ 60 =	4,200
Overhead	80	$ 225 =	18,000
Total			$ 23,700

The billing for audit services is the sum of the manager time (1,200 hours) at the manager hourly billing rate ($500) plus the staff time (8,500 hours) at the staff billing rate ($200).

Manager billings	1,200	$ 500 =	$ 600,000
Staff cost	8,500	$ 200 =	1,700,000
Total			$ 2,300,000

The cost is the sum of the manager time (1,200 hours) at the average manager hourly salary ($150) plus the cost of the staff time (8,500 hours) and the average staff hourly salary ($60) plus overhead applied based on total billable hours (9,700) multiplied by the predetermined overhead rate (225 percent).

Manager cost	1,200	$ 150 =	$ 180,000
Staff cost	8,500	$ 60 =	510,000
Overhead	9,700	$ 225 =	2,182,500
Total			$ 2,872,500

The cost is the sum of the manager time (800 hours) at the average manager hourly salary ($150) plus the cost of the staff time (9,500 hours) and the average staff hourly salary ($60) plus overhead applied based on total billable hours (10,300) multiplied by the predetermined overhead rate (225 per billable hour).

Manager cost	800	$ 150 =	$ 120,000
Staff cost	9,500	$ 60 =	570,000
Overhead	10,300	$ 225 =	2,317,500
Total			$ 3,007,500

The profit from audit services is the difference between the amount billed ($2,300,000 from requirement d) and the cost ($2,872,500 from requirement e).

This is a loss of $572,500 (= $2,300,000 $2,872,500).

The profit from advising services is the difference between the revenue for advising services less the cost ($3,007,500 from requirement f). Advising services are billed at a fixed fee and are not (directly) based on billable hours. The revenue from advising services is expected to be the total revenue A&R expects next year ($8,000,000) minus the revenue from audit services ($2,300,000 from requirement d).

Therefore revenue from advising services will be $5,700,000 (= $8,000,000 $2,300,000).

Profit will be $2,692,500 (= $5,700,000 $3,007,500).