91Ó°ÊÓ

Sportz, Inc., manufactures athletic shoes and athletic clothing for both amateur and professional athletes. The company has two product lines (clothing and shoes), which are produced in separate manufacturing facilities; however, both manufacturing facilities share the same support services for information technology and human resources. The following shows costs (in thousands) for each manufacturing facility and for each support department. The total costs of the support departments (IT and HR) are allocated to the production departments (clothing and shoes) using a single rate based on the following: Data on the bases, by department, are given as follows: 1\. What are the total costs of the production departments (clothing and shoes) after the support-department costs of information technology and human resources have been allocated using (a) the direct method, (b) the step-down method (allocate information technology first), (c) the step-down method (allocate human resources first), and (d) the reciprocal method? 2\. Assume that all of the work of the IT department could be outsourced to an independent company for \(\$ 97.50\) per hour. If Sportz no longer operated its own IT department, \(30 \%\) of the fixed costs of the IT department could be eliminated. Should Sportz outsource its IT services?

Step by step solution

01

Calculate the Support Department Costs per Unit

Begin by determining the total costs for Information Technology (IT) and Human 91Ó°ÊÓ (HR). Let \(IT_1\) be the cost per IT hour, \(IT_2\) be the IT labor, \(IT_3\) be the total IT labor hours. Let \(HR_1\) be the cost per HR employee, \(HR_2\) be the total HR employees, \(HR_3\) be the total cost assigned. For IT department: \(IT_1 = \$97.50\) \(IT_2 = 50\) \(IT_3 = \$97.50 \cdot 50 = \$4875\) For HR department: \(HR_1 = \$20,000\) \(HR_2 = 6\) \(HR_3 = \$20,000 \cdot 6 = \$120,000\)

02

Direct Method

In the direct method, we allocate all costs of the support departments directly to the production departments. The percentage of department's base for each production department will be the percentage of cost assigned. For Clothing department: Assigned IT costs: \(IT_3 \cdot 45\% = \$2193.75\) Assigned HR costs: \(HR_3 \cdot 60\% = \$72,000\) Total costs for Clothing: \(25,000 + \$2193.75 + \$72,000 = \$99,193.75\) For Shoes department: Assigned IT costs: \(IT_3 \cdot 55\% = \$2681.25\) Assigned HR costs: \(HR_3 \cdot 40\% = \$48,000\) Total costs for Shoes: \(30,000 + \$2681.25 + \$48,000 = \$80,681.25\)

03

Step-Down Method: IT First

In this method, we allocate the IT costs first and then the remaining HR costs to the production departments. Assigned IT costs to Clothing: \(IT_3 \cdot 45\% = \$2193.75\) Assigned IT costs to Shoes: \(IT_3 \cdot 55\% = \$2681.25\) Assigned HR costs to Clothing: \(HR_3 \cdot \frac{60\%}{1 - 10\%} = \$80,000\) Assigned HR costs to Shoes: \(HR_3 \cdot \frac{40\%}{1 - 10\%} = \$53,333.33\) Total costs for Clothing: \(25,000 + \$2193.75 + \$80,000 = \$107,193.75\) Total costs for Shoes: \(30,000 + \$2681.25 + \$53,333.33 = \$86,014.58\)

04

Step-Down Method: HR First

In this method, we allocate the HR costs first and then the remaining IT costs to the production departments. Assigned HR costs to Clothing: \(HR_3 \cdot 60\% = \$72,000\) Assigned HR costs to Shoes: \(HR_3 \cdot 40\% = \$48,000\) Assigned IT costs to Clothing: \(IT_3 \cdot \frac{45\%}{1 - 10\%} = \$2437.50\) Assigned IT costs to Shoes: \(IT_3 \cdot \frac{55\%}{1 - 10\%} = \$2981.94\) Total costs for Clothing: \(25,000 + \$2437.50 + \$72,000 = \$99,437.50\) Total costs for Shoes: \(30,000 + \$2981.94 + \$48,000 = \$80,981.94\)

05

Reciprocal Method

In the reciprocal method, we set up linear equations to account for the interdependencies between the support departments and solve for the costs. Let \(x\) be the cost allocated to Clothing from IT, and \(y\) be the cost allocated to Clothing from HR. We have these two linear equations based on the problem given: \(x = IT_3 + 0.1y\) \(y = HR_3 + 0.1x\) Solve for x and y: \(x = \$4875 + 0.1 (\$120,000 + 0.1x)\) \(y = \$120,000 + 0.1(\$4875 + 0.1y)\) By solving these linear equations, we get \(x = \$ 2388.39\) and \(y = \$ 74,046.03\). Total costs for Clothing: \(25,000 + \$2388.39 + \$74,046.03 = \$101,434.42\) Total costs for Shoes: \(IT_3 - x + HR_3 - y = \$4875 - \$2388.39 + \$120,000 - \$74,046.03 = \$78,440.58\)

06

Outsourcing Analysis

We need to determine if outsourcing the IT department is a better financial decision for Sportz, Inc. If the company outsources IT, it will have to pay 97.50 per IT hour, and it can eliminate 30% of the fixed costs. Cost of outsourcing: \(50 \cdot \$97.50 = \$4875\) Remaining IT fixed costs: \(0.7 \cdot IT_3 = \$3412.50\) A further analysis would require a comparison of the total costs versus the outsourcing costs and which option results in the lowest overall costs for the company.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Direct Method

The direct method is the simplest way to allocate support department costs to production departments. This approach involves the direct allocation of costs from each support department to the production departments without considering any interactions between the support departments themselves. Here’s how it works:

• Identify the total costs associated with each support department. In Sportz, Inc.'s case, this includes Information Technology (IT) and Human 91Ó°ÊÓ (HR).
• Allocate these costs to the production departments, Clothing and Shoes, based on predefined bases (e.g., percentage of usage).
• The percentage of each department's base (such as hours used or number of employees) is applied directly to allocate costs to production departments.

The main advantage of the direct method is its simplicity and ease of application. However, it does not consider any interdependencies between support departments, potentially leading to less precise cost allocations.

Step-Down Method

The step-down method allows for a partial consideration of the interactions between support departments when allocating costs. Unlike the direct method, it sequences the costing process by first allocating the costs from one support department, before moving on to the next. Here are the key points:

• Begin by choosing which support department to allocate first (e.g., Information Technology).
• Allocate the chosen department's costs to all other departments, including other support departments and production departments.
• Proceed to allocate the next support department's costs, which have now been diminished by the already allocated costs.

One of the significant benefits of the step-down method is that it recognizes partial interactions between the support departments, thus providing a slightly more accurate cost distribution compared to the direct method. However, because it follows a linear path, the order in which you allocate support department costs can influence the final allocations.

Reciprocal Method

The reciprocal method of cost allocation is the most comprehensive as it fully accounts for mutual services between support departments. It involves setting up a system of simultaneous linear equations to reflect these interactions:

• Each support department’s costs are expressed as being affected by other support departments.
• Create mathematical equations to model these relationships, using variables to allocate costs between departments.
• Solve the equations to find the exact allocation of costs between all departments, including the support departments themselves.

Although the reciprocal method is complex and requires a higher level of mathematical computation, it provides the most accurate representation of costs by recognizing full interdependencies. This detail can lead to better decision-making regarding pricing, budgeting, and outsourcing.

Outsourcing Decision

Outsourcing is an important strategic decision, especially when it involves support departments like IT or HR. The key question is whether it is more cost-effective to perform tasks in-house or to outsource them:

• Calculate the total cost of running the department internally, including variable and fixed costs.
• Consider how much these costs would decrease if part of the fixed costs could be eliminated when outsourcing (e.g., 30% elimination of fixed IT costs at Sportz, Inc.).
• Compare these total in-house costs to the potential cost of outsourcing, which is typically charged per unit of service (e.g., per hour of IT service).

In the case of Sportz, Inc., the calculations would show whether outsourcing IT at $97.50 per hour would be less than the adjusted cost of having an internal IT department. This decision can impact overall cost savings, resource allocation, and focus on core business activities. Efficient outsourcing can also lead to accessing specialized expertise and technology.