Sue Malloy works as a project manager for C3 Systems, a firm that designs sophisticated circuit boards. The firm’s boards are used in communications satellites and other civilian uses. C3’s circuit boards also form the guts of cryptography equipment used by governmental security agencies. Sue’s primary responsibility is to work on a board that potentially could open up a new civilian market for C3 systems. The firm developed the technology used in this board primarily for an application in the armed forces. Deep into the development, Sue realized the complementary civilian application. Sue is wondering how best to allocate the cost of her time as well as that of key research personnel between the government project and the civilian application. She knows that the government contract would reimburse C3 for its development expenses at cost plus a 10% markup. Both the government and C3 systems had agreed that development costs could amount to $8 to $10 million. Clearly, there is no explicit recovery of development expense in the civilian application.

Sue and her team have spent $7 million to date, and anticipate spending another $3 million if they develop both the civilian and the military application. They will spend only an extra $2 million on development if the firm abandons the civilian application. Once the product goes into production, the civilian product will have $18 million of materials cost and $12 million of labor cost. The military product will have $15 million each of materials and labor cost, for a total of $30 million. The common manufacturing overhead, for both of the products, will be $6 million. This overhead comprises $2 million in materials-related overhead and $4 million in labor-related overhead. Sue expects the civilian application to produce revenues of $40 million. The firm will negotiate a fixed price contract with the government. These fixed prices are set such that the firm obtains a 10% markup on expected product cost.

Required:

a. List two different allocations Sue could use to allocate the development cost between the military and the civilian applications. What are the comparative merits of the two schemes that you suggest?

b. Consider the cost of manufacturing the two products. What is the overhead cost that would be allocated to the military line if

(1) All overhead is allocated to products based on labor cost,

(2) All overhead is allocated to products based on materials cost, and

(3) If materials-related overhead is allocated based on materials cost and labor-related overhead is allocated based on labor cost? Which of the three mechanisms do you recommend? Why?

c. Suppose Sue decides to allocate $8.5 million of development cost (= $7 million spent already plus half of the next $3 million to be spent) to the government contract.

Do you believe this choice conforms to the norms for ethical behavior?