CASE STUDY III
Jim Davies is the manager of one of six large distribution warehouses for Mars & Spars, a
multinational clothing and footwear chain store. Jim’s warehouse operates as a profit centre
whereby purchasing officers based within his warehouse buy in items under appropriately
negotiated contracts and ‘sell’ them on to the company’s UK-based stores, although
occasionally the goods can be exported. These are his ‘customers’. Suppliers are both UK and
overseas companies.
Goods issued by Jim’s warehouse are charged to his ‘customers’ at the agreed contract price
plus variations for agreed factors such as inflation. Any cost outside the contract price plus
agreed variations are borne by the supplier. The charge to Jim’s customers is the cost charged
to Jim plus 5%. This is thus effectively Jim’s performance measure as at the end of the year
his warehouse must show a 5% ‘profit’ after allowing for all costs. This profit margin
determines not only Jim’s performance-related pay bonus but also that of every person who
works in the warehouse and Jim’s distribution network. It also is a factor in determining
Jim’s promotion chances.
Jim is feeling aggrieved. Every year for the past three years his operating surplus has failed to
achieve the necessary 5% target. This has resulted in little or no performance related pay and
he is under pressure from his senior managers to explain why he is failing to perform –
particularly as the other five warehouses have all achieved their targets (and more in some
cases).
Jim conjectures that the way in which the company allocates and apportions overheads to his
warehouse causes the failure to achieve targets.
At present the company uses the following definitions of overheads:

Corporate overheads – costs of board meetings, secretarial staff, board members’ salaries
and expenses, etc.

Technical support – financial, legal and personnel support, including such functions as
business planning, financial advice on budgets, equal opportunities policy advice, etc.

Buildings – costs for every building owned or occupied by the company.
All these overheads are charged to a trading account for each section – legal, finance,
personnel, IT etc. – and then charged to a frontline service such as Jim’s warehouse based on
a staff time analysis for each division. Staff in the support departments fill in an individual
timesheet every three years. They are asked to estimate the amount of time they spend on
each activity of the company and then these time sheets are analysed and used as the basis to
apportion costs in the appropriate trading account. The last time sheet analysis was completed
in 1990.
With buildings, all costs for all buildings are allocated to one central building account. These
are then apportioned to all departments and functions based on floor area occupied. For
central overhead departments, the final costs are apportioned to all frontline services such as
warehouses based on the staff time analysis.
The net result of this process is that all costs of the overhead departments are fully
apportioned to frontline departments such as warehouses.
Having read and analysed the above case:
a) Do you think the issue of overhead allocation is important to companies?
b) Why do you hold your point of view?
c) Identify what, if anything, is wrong with the above system.
d) What alternatives do you think might exist to the above?
e) Do you agree with Jim that overheads are the cause of all his problems?
f) How would you go about implementing any alternative?
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SOLUTION:
a) Do you think the issue of overhead allocation is important to companies?
Overhead Allocation:
Overhead allocation is the apportionment of indirect costs or expenses to created merchandise
(produced goods). It is required under the principles of certain accounting frameworks. In
many businesses, the amount of overhead to be allocated is substantially greater than the
direct cost of goods, so the overhead allocation technique can be of some significance.
There are two types of overhead, which are administrative overhead and manufacturing
overhead. Administrative overhead includes those costs not involved in the development or
production of goods or services while manufacturing overhead is all of the costs that a factory
incurs, other than direct costs.
Calculation:
The overhead allocation formula is:
Cost pool ÷ Total activity measure = Overhead allocation per unit
Common bases of allocation are direct labour hours charged against a product, or the amount
of machine hours used during the production of a product. The amount of allocation charged
per unit is known as the overhead rate.
Opinion:
Yes. According to me, issue of overhead allocation is important to companies for the purpose
of decision making and efficient resource usage. During the production process, the expenses
must be allocated to products so that they properly reflect the full cost of producing the good.
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b) Why do you hold your point of view?
For a company, the basic manufacturing objectives are:

Improving quality

Reducing costs

Speeding throughput

Increasing production flexibility
This helps companies compete more effectively and meet their customers’ price, quality and
delivery requirements. By using overhead allocation process, the more competitive they are
in the marketplace. Managing expenses is a key for business success, and overhead costs play
a pivotal role in realizing favourable profit margins. Almost all companies have some form of
overhead consisting of specific categories of indirect expenses.
If a company never has inventory (because each period, it sells all its production) the
allocation of manufacturing overhead could be avoided. The reason is that all the
manufacturing costs will be reported as the cost of goods sold. However, the company may
still choose to allocate the manufacturing overhead for internal pricing decisions or to comply
with a government contract.
Manufacturing overhead, which is also known as factory overhead, burden, and indirect
manufacturing costs, needs to be allocated to products for the following reasons:

Some of the goods manufactured are not sold in the same period in which they were
produced. The goods not sold must be reported at their cost in the company's asset
entitled Inventory.

Accounting principles require that each product's inventory cost include both direct and
indirect manufacturing costs. Indirect costs mean they are not directly traceable to a
product and will require an allocation.

Some companies set their products' selling prices based on their costs. In the long run, the
products' selling prices must be large enough to cover all a company's manufacturing
costs (including the indirect manufacturing costs) plus the company's selling, general and
administrative expenses and a profit for the company's owners.
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Manager, such as Jim Davies, allocate overhead costs to products for:
 Decision Making:
Setting prices for products is one example of a decision that must be made by management.
Prices are often established based on the cost of products. It is not enough to simply include
direct materials and direct labor. Overhead must be considered as well.
 Promote Efficient Use of Resources:
Several different activities are performed to produce a product, such as purchasing raw
materials. All these activities consume resources. If products are charged for the use of these
activities, managers will have an incentive to be efficient in utilizing the activities.
 Comply with Accounting Principles:
Accordingly, the standards requirement all manufacturing costs i.e. direct materials, direct
labor, and overhead must be assigned to products for inventory costing purposes. This
requires the allocation of overhead costs to products.
Therefore, the allocation of overhead is important for every business and is an issue for every
company so that they can make the economic decisions in a more systematic and structured
form.
c) Identify what, if anything is wrong with the system?
Jim’s Performance:
A growing business needs to be closely and carefully managed to ensure the success of new
investment decisions and expansion plans. However, many owner-managers find that as their
business grows, they feel more remote from its operations.
Most growing businesses ultimately target increased profits, so it's important to know how to
measure profitability. The key standard measures are:
Gross Profit
This measure accounted for Jim’s Performance Gross Profit respectively 2300, 2480 and
2500 in year 2002, 2003, and 2004 is made after direct costs of sales have been considered, or
the contribution as it is also known.
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Analysis:
We can evaluate from the results that the gross profits have been increasing from 2002-2004.
The reason that can be spotted out with the increase in sales volume there was the increase in
the cost of inventory such as the finished goods as the prices are affected by the inflation.
Due to this very reason one must see that increase in sales is not only the positive sign but
increase in cost of sales has a negative value associated to it.
Operating Profit
The operating profit lies between the gross and net measures of profitability are respectively
600, 720 and 700 in year 2002, 2003 and 2004. Overheads are considered, but interest and tax
payments are not. For this reason, it is also known as the EBIT (earnings before interest
and taxes) margin.
Analysis:
The operating profit has increased from 2002-2003 about 120000 pounds while it had
decreased in 2004 about 20000 pounds. Therefore, it has been evaluated that due to
increase in the operating costs the operating profit has decreased.
Net Profit
This is a much narrower measure of profits, as it takes all costs into account, not just direct
ones. So, all overheads, as well as interest and tax payments, are included in the profit
calculation.
Analysis:
The net profit has been decreasing constantly from 2002-2004 as the central overheads has
been deducted from the operating profit which means that there has been over allocation of
cost and these costs are referred to as not allocating the combined costs of all the
organization in one division segment that is only one warehouse which is under the
provision of Jim.
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Return on Capital Employed (ROCE)
This calculates net profit as a percentage of the total capital employed in a business are
respectively 4.3, 3.7 and 3 in year 2002, 2003 and 2004.This allows you to see how well the
money invested in your business is performing compared to other investments you could
make with it.
Analysis:
To explain further, the return on capital employed has been decreasing gradually and that is
why Jim is concerned about it, as the investors are not getting the required return which
they will be seeking for.
See the Table 1.1:
Year
2004
2003
2002
£000’s
£000’s
£000’s
10,000
9,500
9,250
Cost of Sales
7,500
7,020
6,950
Gross Profit
2,500
2,500
2,300
1,800
1,780
1,700
Operating Profit
700
720
600
Central Overheads
400
350
200
Net Profit
300
350
400
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3.7
4.3
Sale
Expenses
Operating Costs
Percentage Return
A question arises that why Jim’s performance failure did not lead to maintain 5% growth
every year. In other words, what has been identified wrong on this system?
Firstly, Jim’s wrong allocation of corporate overhead charges to warehouse overhead.
Warehouse costs charge only four categories above are described. These all overhead charge
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to directly customer incurs to cost of goods sold. Due to Jim not maintain product prices plus
inflation variation. The burden for business overhead is failure for Jim’s Performance. See
Table 1.1 Jim Activity show that’s business performance increased the operating profit yearly
but allocating other business overhead burden charge only Jim’s warehouse.
Warehouse Allocation Overhead
All companies with warehouses incur the same elements of cost, but they compile them
differently. However, a costing system can be used to compare costs of one warehouse to
another or one company to others.
In this system wrongly charge business overheads are as follows:
 Technical Support:
Financial, legal and personnel support, including such functions as business planning,
financial advice on budgets, equal opportunities policy advice isn’t part of warehouse
expense. Since it’s a complete overhead cost for the organization but not the division or
(warehouse) which is under the supervision of Jim. Thus, over allocation of costs leads to
lowering down of profits.
 Buildings Value and Costs:
That has been charged as an expense to the central overheads isn’t according to the
accounting set rules and principles so the values should be represented in the Balance Sheet
as per IAS 1(Presentation of financial Statements). So, buildings should be presented under
Non-current Assets headings at its net book value which is;
Non-Current Assets= Value of Buildings- depreciation.
 Depreciation Separate Provisions:
It should be made under the heading of operating costs which appears as an expense and it
should be shown as per IAS 1.
 Building Owned or Occupied:
The building owned or occupied by the company should be shown in balance sheet and if
lease is taken on it then again the amount should be represented in this financial statement in
long-term liability section while if rent is paid on it then it is to be represented in income
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statement. The total holdings of the assets should be shown in the consolidated statement of
financial position.
 Not Operating as a Profit Centre:
Then the case study mentions that Jim’s warehouse operates as a profit centre whereby
purchasing officers based within his warehouse buy in items under appropriately negotiated
contracts and ‘sell’ them on to the company’s UK-based stores, although occasionally the
goods can be exported. So, when comparing his actual situation and planning we can see that
he was unable to keep a distinction between cost centre and profit centre.

Cost Centre:
It is that department within the organization which is responsible for identifying and
maintaining the cost of the organization as low as possible by analysing the processes
and making necessary changes in the company whereas a Profit Centre focuses on
generating and maximizing revenue streams for the organization by identifying and
improving activities such as sales it is much more complex and has a wide area of
scope.

To explain further, cost centre helps a company identify the costs and reduce them as
much as possible. And a profit centre acts as a sub-division of a business because it
controls the most important key-factors of every business. While in case of Jim when
viewing his actual results through three years we see that his company has tried to
reduce operating costs, but they haven't focused on other areas of the business. In
other words, the overhead costs have increased throughout the years where the sales
did increase but not with a good level as costs have risen.

Jim is focusing and concerned only with his relative performance and pay where he
lacks in controlling costs, profits and revenue generation for the whole business for
which a profit centre is build.
 No Consistency in Keeping Data Records:
It is evident that the staff’s activity is measured based on time sheet analysis where timesheet
analysis was not filled after 1990 which means that the company isn’t consistent or does not
follow the accounting principle of consistency when measuring staff’s performance.
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d) What alternatives do you think might exist to the above?
This means issues that have persisted in Jim’s warehouse company are to be solved as
follows:
 The importance of costing to good financial management is required by Jim’s financial
data which has not been organized and managed accurately .The ability to identify,
measure, interpret, and present costs as they relate to an organization’s economic flow of
goods and services, both historically and in a forward-looking context, is necessary for an
informed understanding of the organizational drivers of profit and value. Thus, Jim’s
company did not have good economic flow of goods and the organizational drivers did
not add value to his services offered.
 Fitness for Purpose Cost Information:
It should be prepared in a manner which did not existed in Jim’s Company. Appropriate to
the specific context and purpose of its use, of which there are three principal applications

External reporting – historical and descriptive

Performance evaluation and analysis – interpretative and diagnostic

Planning and decision support – analytical and predictive
 Business Model/Reality Driven:
Cost models should be designed and maintained to reflect the cause-and-effect
interrelationships and the behavioural dynamics of the way the organization functions. The
information needs of decision makers at all levels of an organization should be considered, by
incorporating an organization’s business and operational models, strategy, structure, and
competitive environment. As we can conclude from the information that Jim’s company
had allocated the entire central overheads to one warehouse division segment rather than
charging these costs to the consolidated income statement of the organization.
 Materiality/Cost Effectiveness:
The design, implementation, and continuous improvement of costing methods, data
collection, and systems should reflect a balance between the required level of accuracy and
the cost of measurement (i.e., cost benefit trade-off), based on the competitive situation of the
organization. Jim’s company should use Activity Based costing for Central overheads
allocation to avoid over allocation of the costs.
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 Comparability Over Time and Consistency:
Cost information should be collected and analysed systematically and in such a way as to
ensure comparability over time between different warehouses and ensuring the routine
information system so that every level of management gets to know about each level of cost
allocation and bases.
e) Do you agree with Jim that overheads are the cause of all his problems?
According to the case study Jim Davies thinks that the company allocates and apportions
overheads to his warehouse causes failure to achieve his pre-set targets. This is because;
 Product Costs Aren’t Traceable to The Product:
Absorption costing requires the allocation of what may be a considerable amount of overhead
costs to product a large proportion of a product's costs may not be directly traceable to the
product. In case of Jim’s situation where he is a manager of distribution warehouse and the
goods which his warehouse is buying, and selling do not let to trace the costs of the products
and services rendered by them.
 Double Allocation of Costs:
In addition, double allocation of costs has been analysed by Jim’s company where once the
cost was allocated on the basis trading account as well as the profit and loss account.
Conversely, as stated in the case study all the costs for all the buildings have been allocated
and charged to the central building account and further apportioned to all the departments on
the bases of floor areas acquired indicates double allocation of costs. Furthermore, the net
result of this process is that all costs of the overhead departments are fully apportioned to
frontline departments such as warehouses which again indicates the multiple and reciprocal
allocation of costs among the product and service department with the entire organization.
 The OAR Must Be Updated on Regular Bases:
It can also be evaluated that overhead absorption rate (OAR) must be updated on regular
bases because they are derived from budgeted information and therefore, they are subject to
the change. So, in Jim’s case the ‘staff in the departments have to fill in an individual
timesheet every three years. They are asked to estimate the amount of time they spend on
each activity of the company and then these time sheets are analysed and used as the basis to
apportion costs in the appropriate trading account. The last time sheet analysis was completed
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in 1990.’ The net result shows that even the activity level and the bases aren’t giving proper
results for analysis and decision making.
Other than overheads what other problems might have appeared:
 Can Change Profit and Loss:
Absorption costing can cause a Jim’s company profit level to appear better than it is during a
given accounting period. This is because all fixed costs are not deducted from revenues
unless all the company's manufactured products are sold. In addition to skewing a profit and
loss statement, this can potentially mislead both company management and investors.
 Doesn't Help Improve Operational Efficiency:
Absorption costing fails to provide as good an analysis to Jim regarding the cost and volume
as variable costing does. If fixed costs are an especially large part of total production costs, it
is difficult to determine variations in costs that occur at different production and distribution
levels. This makes it more difficult for Jim’s management to make the best decisions for
operational efficiency.
 Not Useful for Comparison of Product Lines:
Variable costing is more useful than absorption costing if a company wishes to compare the
potential profitability of different product lines and portfolios. It is easier to discern the
differences in profits from producing one item over another by looking solely at the variable
costs directly related to production.
f) How Would You Go About Implementing Any Alternative?
As per Jim Davies business operations regarding to logistics and distribution in and out of
warehouses, we can evaluate that the type of traditional costing method which is absorption
costing should be changed. This is because when using multiple costs allocation causes a
problem and hinders in decision making for Jim. Thus, a better costing method which should
be implemented is activity-based costing.
Activity based costing is since the production of goods (not in case of Jim) rendering services
such as distribution of goods and services are well as serving those customers which require
activities and activities that use resources and resources involve costs. Basically, per unit of
the cost of each activity is calculated and multiplied with the number of units of activity
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consumed by the products, customers and services to calculate total costs of these objects. It
should be noted that activity-based costing is different from traditional absorption costing
only with the reference to the overhead allocation. However, direct costs are treated in the
same way under both activities based costing and traditional absorption costing method.
To put into effect Jim Davies can implement Activity Based Costing with gaining as benefits
which are as follows:

Multiple Cost Drivers:
The application of Activity Based Costing usually results in more accurate costs rather than
double or multiple level of cost allocation resulting in confused decisions and budget
planning. So, the pre-set target of Jim to achieve 5% of profit after deducting all the costs can
be made possible once when using activity-based costing where more realistic sales price can
be determined due to the use of multiple cost drivers at multiple levels of the business
process. So that over allocation of costs doesn’t happen again as absorption costing has this
issue with it.

Process Improvement:
When comparing absorption costing method with activity-based costing (ABC) one will not
be focusing on the cost’s allocation, but better business processes can achieve and
implemented in ABC. Likewise, development of new services can be rendered by Jim’s
warehouse can lead to the change in service with the change in costs. The sales staff use
activity-based costing to reduce the process costs in terms of effective communication and
marketing strategies where Jim can focus on other processing activities to achieve its pre-set
targets more than 5%. Nevertheless, it is helpful in fixing the cost of a product or a service.
Thus, accurate costing would lead to determine realistic prices and increasing chances for
profitability as Jim can meet his aim.

Better Planning and Decision Making:
Accurate costs for Jim’s warehouse will help him in making better plans, preparing more
reliable budgets and pricing decisions and quotations to his reliable customers. For instance,
when staff is being monitored via a supervisor or any automated machine assessing the labor
or employee’s productivity; filling in the time sheet analysis will make it easy as whether the
staff is giving their full time of activity or not. Other case maybe measuring the employee
turnover rate this may indicate the Jim’s warehouse efficiency and effectiveness as how they
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can make better decisions to hire new employees or giving them pre-set targets to achieve it.
Thus, activity-based costing can remove all type of constraints when all records are kept in
line so that better planning and decision making can be implemented on the bases of these
results.

More Realistic:
Activity Based Costing is more realistic and will help Jim to assign more overheads to
complex products as a warehouse might contain several footwear and clothing varieties and
chains and will charge less to simple products.

Application:
It is also stated that activity-based costing is very useful in service sector organization like
(distribution and warehousing) where the production overheads tend to have a much
prevalent part of the total cost for the Jim Davies Company. And is best suited to his
organization rather than using absorption costing which involves double allocation of costs.
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