Challenge of Allocating Costs to the Three SMUs in Fine Foods Inc



The memo proposes that management should consider identifying the cost drivers and monitor its activities to control their costs. In assessing whether to accept special orders, management needs to accurately compute the contribution margin by only considering the variable costs. Fixed costs should only help in determining the break-even point for special orders. Performance evaluation should as well focus on factors that are within employees control rather than incorporating non-controllable costs elements to evaluate the employees working in the SMU2 sector. The major concern of the SMU2 department is the use of inappropriate cost allocation model for the MP product where material costs, labour costs and variable costs are allocated to the product based on estimates. The allocation of material and labour costs to the MP product is acceptable since these are direct costs incurred in the product manufacturing. Allocation of factor overheads especially remaining factory costs should, however, be reviewed. These overheads should not be allocated to MP on a fixed percentage basis since MP special order sales only account for 2% of the revenue. Allocating the overheads on a fixed proportion, therefore, inflates the costs and reduces the contribution margin. In addition, the allocation of media and promotion costs for SMU1 and SMU2 further fails to consider the cost drivers of the activities. Marketing costs should not be allocated depending on the weight of the products but the revenue derived from the effectiveness of such advertisement. This was, management will have to identify the increase in sales resulting from the incremental costs of the advertisement.