Question

In one of its divisions, an aircraft components manufacturer produces experimental navigational equipment for spacecraft and for private transportation companies. Although the products are essentially identical, they carry different product numbers. The XNS-12 model is sold to a government agency on a cost-reimbursed basis. In other words, the price charged to the government is equal to the computed cost plus a fixed fee. The JEF-3 model is sold to the private transportation companies on a competitive basis. The product development cost, common to both models, must be allocated to the two products in order to determine the cost for setting the price of the XNS-12.

Required

1. How would you recommend the product development cost be allocated between the two products?

2. What incentives do managers have to allocate product development costs? Why

Answer 1

What is product development cost :

It is the cost business incur in researching, market survey,marketing analysis, developmental engineering and customer survey. These costs are incurred before launching new product or service or expanding existing product or service. These costs are initial cost and charged to income statement as expense. These cost are also named as Research and development cost.

Further these development costs are absorbed into the product's fixed expenses and distributed into per unit cost of product. And the correct allocation of these costs will make the managers able to determine correct pricing and profitability of company.

I recommend to use Activity Based Costing (ABC) approach to allocate development cost which is common in the product XNS-12 and JEF-3.

In Activity Based Costing the indirect expenses are allocated more directly and the costs were allocated to those who actually use it. It is far better approach then allocating through traditional method.

In ABC we need to follow following steps :

1. Identify Costs : In this case it is product development cost which we need to allocate.

2.Identify secondary cost pool : These costs are incurred commonly for two or more products rather than attributable directly to one product. There may be several of these secondary cost pool. For example in development cost there are several secondary cost like research cost, Market survey cost, Testing cost, customer survey cost.

3.Identify primary cost pool : These costs are directly related to particular product and can be attributable without any method.

4.Measure activity Driver : These are data collection system used to allocate secondary cost pool into primary cost pool .For example for research cost activity driver could be Number of research hours spent on product, for Testing cost activity driver could be number of tests done for each product and so on.

5.Allocation of cost : Finally the secondary or common cost should be allocated into primary direct cost using activity driver.

For example total testing cost is $10000 and total tests done are 100. Out of 100 tests 30 done for JEF-3 and remaining 70 done for XNS-12. Here activity driver is Testing cost per test i.e., $100 per test. The cost allocation is $100*30 =$3000 for JEF-3 and $100*70=$7000 for XNS-12.

Sometime it is not possible to find cost driver and therefore we need to use the best available cost driver in that circumstances.

Management incentives in allocating Product development cost :

1. Firstly by allocating development cost management get the fair idea about profitability and the managers can decide whether to continue or shut the production of product. Also the more cost cutting methods can be adopted if needed.

2. Managers can calculate their departmental benefits and bonus to their employees correctly and precisely.

3.The non allocation of development costs in product XNS-12 will lead to wrong decision in setting cost and thus even after adding fixed fee over cost , sometime it can lead to financial loss.

4. Right allocation of development cost will lead to motivation in employees as they will be rewarded on the basis of departmental performance.