Question

Encryption, Inc. (EI), sells and maintains fax encryption hardware and software. EI hardware and software are attached to both sending and receiving fax machines that encode/decode data, preventing anyone from wiretapping the phone line to receive a copy of the fax.
Two EI product groups (Federal Systems and International) manufacture and sell the hardware and software in different markets. Both are profit centers. Federal Systems contracts with federal government agencies to manufacture, install, and service EI products. Existing contracts call for revenues of $2 million per quarter for the next eight quarters.
International is currently seeking foreign buyers. Expected quarterly revenues will be $1 million, but with equal likelihood revenues can be $2 or $1 million in any given quarter.
Federal Systems and International each have their own products that differ in some ways but share a common underlying technology. Fax encryption is a new technology and offers new markets. Transferring manufacturing and marketing ideas across products and customers provides important synergies.
The variable cost of Federal Systems and International is 30 percent of revenues. The only fixed cost in EI is its Engineering Design group.
Engineering Design is EI's R…D group. It designs new hardware and software that Federal Systems and International sell. Quarterly expenses for Engineering Design will be $0.80 million for the next two years. These expenses do not vary with revenues or production costs.
Engineering Design costs are to be included in calculating profits for the Federal Systems and International groups. Two ways of assigning the Engineering Design costs to Federal Systems and International are (1) group revenues, and (2) an even 50-50 split.

Required:

a. Prepare financial statements for Federal Systems and International illustrating the effects of the alternative ways of handling Engineering Design costs.

Answer 1

Quarterly Financial Statement for Federal Systems and International

Particular	Federal System (Alt 1: Revenue based) ( In Million)	Federal System (Alt 2: 50:50 split) ( In Million)	International (Alt 1: Revenue based) (In Million)	International (Alt 2: 50:50 split) ( In Million)	GrandTotal ( In Million)
Revenue	2.00	2.00	1.50 (WN:1)	1.50 (WN:1)	3.50
(-)Variable cost	(0.60)	(0.60)	(0.45)	(0.45)	(1.05)
Contribution	1.40	1.40	1.05	1.05	2.45
(-) Fixed cost ( Based on group revenue)	(0.46)	(0.40)	(0.34)	(0.40)	(0.80)
Profit	0.94	1.00	0.71	0.65	1.65

Working notes:

1. We have calculated the revenue for International by taking average of 1M and 2M as there is equal likelihood (50:50) of occurance for each. Hence (1M + 2M) / 2 = 1.5 M.

2. Revenue based allocation of fixed engineering design cost is calculated as follow:

Total Group revenue = Revenue of federal + International

= 2.00 M + 1.50 M

= 3.5 M per quarter

Total fixed engineering design cost = 0.80 M per quarter

Therefore allocation will be:

Product revenue / Group revenue * Fixed engineering design cost

Federal = 2.00 M / 3.50 M * 0.80 M

= 0.46 M approx

International = 1.50 M / 3.50 M * 0.80 M

= 0.34 M approx

Same way we have calculated 50: 50 split by assigning 50% of fixed engineering cost to both the product groups i.e. 0.80 M * 50% = 0.40 M.

3. Financial statement is prepared based on quarterly figures, alternatively it can be prepared based on full year by considering 4 quarters aggregate figures.