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Allocating Costs

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CHAPTER 6 Cost Analysis

CHAPTER 6 Cost Analysis

Delete each element of capability until system capability is totally gone

and 30 percent of the cost will still remain.

NORMANAUGUSTINE, AUGUSTINE’SLAW S

A sporting goods firm recently experimented with producing a new line of shoes: cross-training

shoes for boys 10 to 16 years old. The boys’ shoe is very similar to the firm’s main product, a best-

selling women’s athletic shoe. (The sizes are virtually the same; only the colors and logos differ.)

Thus, the new line of shoes is easy and inexpensive to produce; indeed, there is excess production-

line capacity to do so. Production of the women’s shoe runs about 8,000 pairs per week, and the

company recently began producing 2,400 pairs of boys’ shoes per week. The firm’s production

managers estimate that the factory overhead cost shared between the two shoe lines comes to about

$90,000 per week. (Overhead costs include shared factory space, machines, electricity, and some

sales and support staff.) The company’s policy is to allocate these shared fixed costs in proportion

to the numbers of pairs of each line of shoes.

Currently the company charges an average price of $36 per pair for the boys’ shoe. However,

the total revenues generated at that price fail to cover the shoe’s total costs: its direct cost (prima-

rily materials and labor) and the allocated overhead cost just mentioned. Faced with this apparent

loss, top management is considering various options to achieve profitability.

• The firm’s chief accountant suggests raising the price on the new line (say, to $40 per pair) to
  improve margins and better cover production costs.


• The marketing manager agrees this might be reasonable but cautions that sales are bound to drop.


• The head of production adds that unit costs will vary with volume as well. He advocates produc-
  ing at an output level at which direct costs per unit will be minimized.

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