Wilton International is large conglomerate with divisions that produce chemicals, tires, specialty metals and pharmaceuticals. Two years ago , the CFO noted that the company paid consultants more than $ 3 million per year to help solve problems related to manufacturing efficiency, employee motivation, investment decisions and a variety of other matters. The $ 3 million in charges reflect average fees of approximately $ 120 per hour. The CFO decided that substantial funds could be saved by setting up an internal consulting group. Accordingly, 5 senior consultants from a respected firm were hired to run an internal consulting group at an average salary of $150,000 per year. These new managers hired 15 additional employees at an average salary of $ 50,000 per year. Thus, the company had 20 full time internal consultants at a yearly cost of only $ 1,500,000. The 20 individuals can work approximately 38,000 hours per year in total.

In the first year of the consulting group, the CFO sent out a notice to all divisions that they would no longer be allowed to hire outside consultants for work that could be performed by the internal group. Further, each division was to be charged a flat annual fee for use of the consultants based on their relative size (measured in sales dollars) over the last four years. With is approach the allocation was as follows:

Chemicals $ 150,000

Tires $ 300,000

Specialty Metals $ 450,000

Pharmaceuticals $ 600,000

With this allocation, the division managers made frequent demands for the services of the consultants. Indeed, because of the demand for the services of the internal consultants, there were frequent delays, often exceeding one month.

The following year, the CFO changed the method of allocation to a charge for hours worked. Since costs were $ 1,500,000 and 38,000 hours were available, the charge was $ 39.50 per hour. With this charge, demand for consulting services declined drastically. In fact, the average consultant was only charging 70% of available hours. Further, all requests for services were easily answered within a day or two.

Required:

a. Explain the difference in demand under the two allocation schemes.

b. Since the demand is declining the CFO is considering closing the internal consultancy department. Based on the information provided what would you advise?