Question

Northwest Aircraft Industries (NAI) was founded 45 years ago by Jay Preston as a small machine shop
producing machined parts for the aircraft industry, which is prominent in the Seattle/Tacoma area of
Washington. By the end of its first decade, NAI’s annual sales had reached $15 million, almost exclusively
under government contracts. The next 30 years brought slow but steady growth as cost- reimbursement
government contracts continued to be the main source of revenue. Realizing that NAI could not depend
on government contracts for long-term growth and stability, Drew Preston, son of the founder and now
president of the company, began planning for diversified commercial growth. As a result of these efforts,
three years ago NAI had succeeded in reducing the ratio of government contract sales to 50 percent of
total sales.
Traditionally, the costs of the Material-Handling Department have been allocated to direct material
as a percentage of direct-material dollar value. This was adequate when the majority of the manufacturing
was homogeneous and related to government contracts. Recently, however, government auditors
have rejected some proposals, stating that “the amount of Material-Handling Department costs allocated
to these proposals is disproportionate to the total effort involved.”
Kara Lindley, the newly hired cost-accounting manager, was asked by the manager of the Government
Contracts Unit, Paul Anderson, to find a more equitable method of allocating Material- Handling
Department costs to the user departments. Her review has revealed the following information.
? The majority of the direct-material purchases for government contracts are high-dollar, low- volume
purchases, while commercial materials represent low-dollar, high-volume purchases.? Administrative departments such as marketing, finance and administration, human resources, and
maintenance also use the services of the Material-Handling Department on a limited basis but
have never been charged in the past for material-handling costs.
? One purchasing agent with a direct phone line is assigned exclusively to purchasing high-dollar,
low-volume material for government contracts at an annual salary of $36,000. Employee benefits are
estimated to be 20 percent of the annual salary. The annual dedicated phone line costs are $2,800.
The components of the Material-Handling Department’s budget for 20x1, as proposed by Lindley’s
predecessor, are as follows:
Payroll ................................................................................................................... $ 180,000
Employee benefits ............................................................................................... 36,000
Telephone ............................................................................................................. 38,000
Other utilities ........................................................................................................ 22,000
Materials and supplies ......................................................................................... 6,000
Depreciation ......................................................................................................... , 6,000
Total .................................................................................................................. $ 288,000
Direct-material budget:
Government contracts ..................................................................................... $2,006,000
Commercial products ...................................................................................... 874,000

Lindley has estimated the number of purchase orders to be processed in 20x1 to be as follows:
Government contracts* ........................................................................................ 80,000
Commercial products ........................................................................................... 156,000
Marketing ............................................................................................................. 1,800
Finance and administration ................................................................................. 2,700
Human resources ................................................................................................. 500
Maintenance ......................................................................................................... 1,000
Total ...................................................................................................................... 242,000
*Exclusive
Lindley recommended to Anderson that material-handling costs be allocated on a per-purchaseorder
basis. Anderson realizes and accepts that the company has been allocating to government contracts
more material-handling costs than can be justified. However, the implication of Lindley’s analysis
could be a decrease in his unit’s earnings and, consequently, a cut in his annual bonus. Anderson told
Lindley to “adjust” her numbers and modify her recommendation so that the results will be more favorable
to the Government Contracts Unit.
Being new in her position, Lindley is not sure how to proceed. She feels ambivalent about Anderson’s
instructions and suspects his motivation. To complicate matters for Lindley, Preston has asked her
to prepare a three-year forecast of the Government Contracts Unit’s results, and she believes that the
newly recommended allocation method would provide the most accurate data. However, this would put
her in direct opposition to Anderson’s directives.
Lindley has assembled the following data to project the material-handling costs.
? Total direct-material costs increase 2.5 percent per year.
? Material-handling costs remain the same percentage of direct-material costs.
? Direct government costs (payroll, employee benefits, and direct phone line) remain constant.
? The number of purchase orders increases 5 percent per year.
? The ratio of government purchase orders to total purchase orders remains at 33 percent.
? In addition, she has assumed that government material in the future will be 70 percent of total material.

Question: Calculate the change in material-handling costs applied to government contracts by NAI as a result of the new cost assignment approach.

Answer 1

Particulars		Base year		Year 1		Year 2		Year 3
Total Direct material cost		$        2,880,000		$        2,952,000		$        3,025,800		$        3,101,445
Government (70%)		$        2,016,000		$        2,066,400		$        2,118,060		$        2,171,012
Others (30%)		$            864,000		$            885,600		$            907,740		$            930,434
Note 1: The material cost is increased by 2.5 percent but the government material as % of total material remains at 70%
Total Direct material handling cost		$            288,000		$            295,200		$            302,580		$            310,145
(10% of Direct material cost)
Components of material handling costs		Amount	%	Amount	%	Amount	%	Amount	%
1.Payroll		$            180,000	63%	$            184,500	63%	$            189,113	63%	$            193,840	63%
2.Employee benefits		$              36,000	13%	$              36,900	13%	$              37,823	13%	$              38,768	13%
3.Telephone		$              38,000	13%	$              38,950	13%	$              39,924	13%	$              40,922	13%
4.Other utilities		$              22,000	8%	$              22,550	8%	$              23,114	8%	$              23,692	8%
5.Materials and supplies		$                6,000	2%	$                6,150	2%	$                6,304	2%	$                6,461	2%
6.Depreciation		$                6,000	2%	$                6,150	2%	$                6,304	2%	$                6,461	2%
		$            288,000		$            295,200		$            302,580		$            310,145
Note 2: The components of Direct material handling costs are expressed as percentage of total direct material handling costs
Costs exclusively for govt contracts
Payroll		$              36,000		$              36,000		$              36,000		$              36,000
Employee benefits (20% of payroll)		$                7,200		$                7,200		$                7,200		$                7,200
Telephone		$                2,800		$                2,800		$                2,800		$                2,800
Total exclusive costs		$              46,000		$              46,000		$              46,000		$              46,000
Note 3: Exclusive costs are constant over the three years
Common costs to be apportioned
Other utilities		$              22,000		$              22,550		$              23,114		$              23,692
Materials and supplies		$                6,000		$                6,150		$                6,304		$                6,461
Depreciation		$                6,000		$                6,150		$                6,304		$                6,461
Total common costs		$              34,000		$              34,850		$              35,721		$              36,614
Note 4: It is assumed that Payroll, Employee benefits and Telephone are not common costs
Apportioned on perpurchase order basis - New cost apportionment approach
Government contracts (33%)		$              11,220		$              11,501		$              11,788		$              12,083
Others (67%)		$              22,780		$              23,350		$              23,933		$              24,532
Note 5: New cost scheme assumes apportionment of costs on per purchase order basis
Total Material handling cost apportioned to Govt contracts
Exclusive costs		$              46,000		$              46,000		$              46,000		$              46,000
Common costs		$              11,220		$              11,501		$              11,788		$              12,083
Total		$              57,220		$              57,501		$              57,788		$              58,083
Material handling costs as per old cost assignment approach - (as a % of direct material dollar value)
Total material handling costs		$            288,000		$            295,200		$            302,580		$            310,145
Government contracts (Dollar value 70%)		$            201,600		$            206,640		$            211,806		$            217,101
Other contracts (Dollar value 30%)		$              86,400		$              88,560		$              90,774		$              93,043
Material Handling costs for Government contracts
As per Old approach		$            201,600		$            206,640		$            211,806		$            217,101
As per New approach		$              57,220		$              57,501		$              57,788		$              58,083
Difference		$            144,380		$            149,140		$            154,018		$            159,018