Oak City’s cost allocation and determination

Abstract

Oak City is an interdisciplinary case that involves cost allocation and determination issues in a
governmental setting. Ethical considerations related to the role of accountants as expert
witnesses also are included in the case. The primary issue in this case (drawn from actual
events) is the amount of cost associated with police and fire services that should be charged
to businesses in an area adjacent to the city limits, referred to as its police jurisdiction. State
law requires the city to provide these services and permits it to charge the incremental cost of
providing these services to businesses in the jurisdiction. The definition and determination of
incremental cost is highly subjective. City officials have been allocating a portion of total costs
to the jurisdiction. A business owner sues the city, arguing that only variable costs are
relevant.

Students take the role of expert witnesses who are required to analyze available information
and to develop a position supporting either the plaintiff or the city. They are required to deal
with an unstructured problem for which various positions can be argued. They must identify
relevant information and organize this information effectively. The case also serves to alert
students to the importance of professional judgment in accounting decisions for which little
authoritative guidance is available.

Mike Johnson, finance director for Oak City, sits in his office, peering out the window. It is the
middle of February, and he is pleased with the latest reports of the city’s financial condition.
After a few years of tight budgets, the city is getting back on the right track. General fund
revenues are larger than expected and expenditures are under control. The city continues to
grow, as a recent summary of financial and demographic trends indicates (exhibit 1). This
looks like it is going to be a good fiscal year.

Suddenly, the door to his office flies open and in stomps Bob Holman, city attorney.
“Mike, you will not believe what has happened!” Bob exclaims. “The city has just been hit with
a civil suit by Anita Smith, the owner of Smith’s Lumber Company. Her business became part
of the city’s police jurisdiction in 1993 when we annexed all that expensive residential
property on the river.

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 EXHIBIT 1
Oak City: Financial and Demographic Trendsa
Expenditures
Year Population Revenues Total Police Fire Area Businesses
1985 61,212 $13,087 $13,082 $6,083 $4,744 57.5 421
1986 62,448 14,736 14,698 6,259 4,898 58.3 462
1987 65,330 15,011 14,956 6,407 5,033 60.0 488
1988 68,206 15,200 15,209 6,518 5,181 61.3 495
1989 69,455 16,102 16,083 6,840 5,526 62.1 513
1990 73,524 16,843 16,855 7,280 5,720 66.4 544
1991 76,409 17,622 17,596 7,506 5,996 66.8 569
1992 83,059 18,705 18,670 7,981 6,304 67.6 608
1993 85,922 18,987 19,194 8,312 6,408 68.2 612
1994 92,076 20,345 20,752 8,936 6,942 75.0 647
1995 96,549 22,315 22,301 9,734 7,425 76.2 655
1996 102,335 24,440 23,811 10,455 7,724 76.4 658
a
Revenues and Expenditures are in thousands and are for the General Fund. Area is in equal
miles

“She claims the city has collected excessive business license fees from her and other
business owners in the police jurisdiction since 1994. She is suing to recover excess fees
paid and attorney and court costs. She claims the city is charging her fees for costs it does
not incur, in violation of state law.

“You’ll remember that state law requires the city to provide police and fire protection to
residents of the police jurisdiction, which extends three miles beyond the city limits. While the
law permits the city to levy a license fee on all businesses located in the police jurisdiction,
the levy cannot exceed one-half of the amount charged to like businesses located within the
city limits or the actual costs incurred in servicing the police jurisdiction, whichever is lower. If
Smith can prove we have been collecting excessive fees, we may be faced with a major
class-action law suit.

“You determined those costs, Mike. I sure hope you can justify them. I’ll arrange a meeting for
first thing tomorrow morning with city officials. Come prepared to explain how you’ve been
determining the fees we’ve been charging in the police jurisdiction and the associated costs.”

Mike can hardly believe what he’ just heard. How can there be any questions about the way
he determines cost for the city’s police jurisdiction? “All I did was allocate costs,” Mike thinks
to himself.

Facts and legal background

Oak City is the largest city in its region of the state, with a population of about 100,000. Most
of the city in bounded on the west by the Black River with the city limits extended along both
the east and west banks of the river for about 15 miles.

In 1988, the state approved legislation providing for the creation of police jurisdictions
adjacent to the cities. The rationale supporting the law was to ensure basic services for
citizens at a reasonable cost. Cities were already equipped to provide services, and extending
these services to nearby residents was thought to be less costly than creating new police and
fire departments to service the jurisdictions.

As a result of this legislation, cities became obligated to provide public safety services to
businesses and individuals residing within its police jurisdiction. Police jurisdiction is defined
as all adjoining territory within three miles of the corporate limits of a city or town.
Approximately 15,000 people live in Oak City’s police jurisdiction, which contains
approximately 40 businesses.

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State law authorizes cities to collect license fees from any businesses located within the
police jurisdiction. These revenues are intended to reimburse the city for the cost it incurs in
providing services to its police jurisdiction. The law explicitly states that a city must estimate
the amount reasonably necessary to provide public protection within the police jurisdiction as
a basis for its business license fees. A city, however, cannot use the police jurisdiction to
generate net revenues for itself.

The meeting

The next morning, Mike arrives promptly at nine for the meeting. As he enters the room, he is
met by most of the city’s top officials, an indication of the importance of this case. In addition
to Bob Holman, he shakes hands with Bart Flanagan, the assistant city attorney, City Council
Chairperson Tammy Watson, and Mayor Al Tupay.

Bob Holman starts the meeting: “Until now, the city has never had any business owners
question the quality of services or the amount of fees we charge in the police jurisdiction.
Although the city’s primary responsibility for services is to its own residents, it has always tried
to provide adequate service in its police jurisdiction, in spite of the expansion we have
experienced in the last few years.”

Al Tupay joins in: “If I may say so, Bob, the problem relates directly to the city’s annexation of
property along the river. This process began only a few years ago. I was the one who
questioned whether the city could adequately service this area, especially the area west of
the river. You know how limited access is because we have only two bridges.”

“I remember, Mayor,” responds Bob. “But the city has benefited from inclusion of the
expensive residential property west of the river, and as I recall, you got quite a bit of support
from those people in the last election.”

“Yes, Mayor,” Tammy Watson adds. “And, I should point out that annexation of those
expensive residential properties was necessary to increase our tax base sufficiently to cover
the cost of the new city buildings and schools completed last year.”

Bob continues: “Whatever the cause of the problem, it’s our problem now. Smith’s Lumber
Co. is located within the northernmost part of our police jurisdiction. It is nearly 10 miles from
downtown and the nearest police and fire stations, as you can see from this map.”

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“Smith is arguing that due to the distance of her business from the city’s facilities, available
services are limited. I have to admit, she is correct on this point. Actually, her company is
closer to facilities in Burnt Creek than to those in Oak City. However, the law does not
stipulate that facilities must be near residents of the police jurisdiction, only that we must
provide the services. Neither Smith nor the city has any control over the law. She is stuck with
us, and we are stuck with her.”

Then it is Bart Flanagan’s turn: “The city’s position in this suit is that we have been lawfully
collecting the maximum fees allowed by law from Smith’s Lumber Co. According to Mike
Johnson’s calculations, we always incur greater costs in servicing the jurisdiction than the
amounts we collect in fees. I think we should let Mike explain how he has been determining
those costs.”

Mike knew he would be at the center of the controversy. “The city provides fire and police
protection to businesses and residents of our police jurisdiction,” Mike begins. “The services
are accounted for through the city’s general fund. I have prepared a table (exhibit 3) that
shows the total expenditures for these departments for each of the last three years.”

Al Tupay interrupts. “Mike, as you know, I own the franchise to all the local ‘Long-Dog’
restaurants. In my income statement the operating costs are called expenses, not
expenditures. What is the difference?”

“Well, Mayor,” Mike begins, “while there are many similarities between business and
governmental accounting, there are also many fundamental differences. One of the most
important is the use of the fund accounting model. Because state and local government have
restricted as well as unrestricted resources, it is necessary to use separate funds to account
for those resources earmarked for specific purposes. Most of the day-to-day operations of
the city are accounted for through governmental funds. In fact, we account for the majority of
our programs in the general fund, which is the most important governmental fund type. In the
private sector, business organizations usually do not have such restricted resources and,
consequently, are not require to use fund accounting.”

The mayor interrupts again, “So I understand what you are saying, ** how does this explain
the difference between expenditures and expense?

EXHIBIT 3
Expenditures Allocated to Police Jurisdiction
1996 1995 1994 Total
Total Expenditures:
Police Department $10,455,466 $ 9,734,319 $ 8,936,038 $29,125,823
Fire Department 7,723,958 7,425,118 6,942,204 22,091,279
Total Expenditures $18,179,424 $17,159,436 $15,878,241 $51,217,101
Allocated to Police Jurisdiction:
Police Department $ 585,506 $ 408,841 $ 616,587 $ 1,610,934
Fire Department 563,849 586,584 590,087 1,740,520
Total Allocation 1,399,935 1,399,655 1,365,080 4,164,670
Fees Charged to Jurisdiction 1,034,950 894,396 783,295 2,712,641
Excess of Allocation Over Fees $ 364,985 $ 505,259 $ 581,785 $ 1,452,029

“I am getting to that, Mayor, “replied Mike. “Now, those individuals who rely on the city’s
financial statements know that the city is a political entity; it is not a business established to
generate profits. To better understand the day-to-day operations of the city, users are
interested in examining the flow of financial resources through the city’s general fund.
Governments measure such flows using the modified accrual basis of accounting. Under this
method, expenditure is a measure of the outflow of financial resources. In contrast,
businesses that must calculate net income use the accrual basis of accounting, where
expense measures the consumption of resources. This means, for example, that when
business acquires a fixed asset, the asset’s cost is capitalized and depreciated. When the city

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buys a new fire truck, the cost is reported as a general fund expenditure. Depreciation
expense is not recognized because depreciation does not involve the use of financial
resources; it is not an expenditure.

“Now, I see how governmental accounting can be so confusing, especially to a novice like
me,” the mayor interjects. “Thank you, Mike, for the explanation. Please continue.”

Mike begins again: “The table (exhibit 3) that I have prepared describes the amount of those
expenditures that were allocated to the police jurisdiction, and the amount of business license
fees that were collected. Let me point out that the total fees collected from the police
jurisdiction have always been set at the maximum rate allowed by law, one-half the rate of
business license fees levied within the city. This rate is appropriate because the total cost
allocated to the police jurisdiction has always exceeded this limit. The data from the table
illustrate this fact. For example, in 1996, $1,400,000 of service costs were allocated to the
police jurisdiction with $1,035,000 of fees being collected.”

“Now, let me explain how I determined the amount of total expenditures allocated to the police
jurisdiction. I calculate the total service effort the city exerts for police and fire protection and
the portion of these efforts that are provided in the police jurisdiction. The ratio of efforts in the
jurisdiction to total service efforts is multiplied by total expenditures to get the amount to be
charged to the jurisdiction.

Exhibit 4
Allocation Rates Determined from Service Callsa
1996 1995 1994
Total Calls:
Police Department 6607 6625 6436
Fire Department 2235 2126 2095
Police Jurisdiction Calls:
Police Department 370 278 444
Fire Department 163 168 178
Ratio of Jurisdiction to Total Calls:
Police Department 0.056 0.042 0.069
Fire Department 0.073 0.079 0.085
a
A service call results when a specific request is made by
an individual or business for assistance. Usually, these are
emergency calls to investigate a crime, an accident or an
incident (such as a fire). Routine patrols and inspections are
not included as service calls.

“I used the number of service calls as a measure of service effort. Service calls and
allocations are presented in the next table (exhibit 4). The total expenditures for each of the
three years were taken from the account balances at year end. The total expenditures by
service activity for the period are shown in the table marked exhibit 5 on an item-by-item
basis. All I do is take the total expenditures for the year, multiply that by the allocation ratio,
and use that amount to determine fees charged in the police jurisdiction. I really don’t see a
problem here.”

Tammy Watson questions: “Mike, why did you use the number of service calls to allocate
expenditures to the police jurisdiction? Isn’t this allocation arbitrary?”

“Sure, Tammy,” responded Mike. “Any allocation is arbitrary. Service calls are simple to
determine and easy to use. I guess I could have used another base, say number of
businesses in the police jurisdiction relative to the number in the city, but it would be just as
arbitrary.”

Bart Flanagan steps in: “Mike you’re probably right about all allocations being arbitrary, but
Smith’s claim is that many of the costs the city is allocating would exist whether or not

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services are provided to the police jurisdiction. She is basing her suit on a recent case
decided by the state Supreme Court. In Cassidy v. Dellville, the court defined the amount of
cost that can be charged to the police jurisdiction as the incremental cost of providing
services to the jurisdiction. The court interpreted incremental cost as the costs the city would
avoid if it did not provide these services.”

“Smith claims that most of the costs for police and fire services do not change with the level of
service activity, and therefore, they are not incremental. She claims only those costs that are
incurred each time a service run is made into the police jurisdiction should be charged to that
area. Do most of our costs change in proportion to activity?”

Mike answered: “If you mean in proportion to the number of service calls, the answer is no.
Most expenditures are fixed during a particular fiscal year. In fact, I have prepared ‘exhibit 5’
to illustrate changes in the police and fire departments’ expenditures for 1994–1996. These
amounts are line-item expenditures recorded in the general fund. If you look at overtime
wages, fuel and equipment maintenance costs, they tend to vary with service hours, while
utility costs change with the number of service calls. These are the only variable expenditures
we have. All the other costs are largely fixed. I might add that service hours represent the
total labor time required to provide services, while a service call represents a call for help (fire
or police).

EXHIBIT 5
Police and Fire Department Expenditures
(Source: General Fund Financial Statements)
Police Fire
1996 1995 1994 1996 1995 1994
Wages and Salaries $ 6,134,567 $5,830,456 $5,321,110 $4,500,925 $4,392,842 $4,002,833
Overtime Wagesa 345,890 305,899 301,399 269,418 239,424 216,049
Employee Insurance 690,342 589,002 521,308 515,757 481,752 391,981
Retirement Benefits 878,345 814,290 760,511 640,759 615,718 569,383
Other Benefits 184,670 180,437 165,203 132,503 130,328 124,922
Training and Travel 53,591 48,911 43,232 38,193 34,683 33,424
c
Prevention 41,876 36,488 34,688 15,407 14,366 16,016
Uniforms 172,933 160,286 153,640 131,700 116,215 114,230
Utilitiesb 164,006 153,806 145,605 120,005 109,355 107,204
Fuela 122,357 118,444 110,291 23,125 20,155 18,743
Office Supplies 54,519 50,793 47,067 41,889 36,095 33,400
Equip. 92,088 85,484 78,879 89,066 60,113 63,159
a,d
Maintenance
Building 186,550 175,223 160,895 129,913 125,417 126,271
d
Maintenance
Equipment 636,930 585,084 503,237 677,698 608,698 650,428
Purchasese
Lease Paymentsf 696,802 599,716 588,973 397,600 439,957 474,161
Total Expenditures $10,455,466 $9,734,319 $8,936,038 $7,723,958 $7,425,118 $6,942,204

a
These costs change with changes in service hours. The percent of service hours spent in
the police jurisdiction for the years 1994 to 1996 was 3.75%, 3.5%, and 3%, respectively.
b
This cost changes with the number of service calls, though all costs change in the long run.
Costs other than a and b are assumed to be fixed in the short run.
c
These costs are associated with educational programs in local schools and civic meetings
and building inspections.
d
Maintenance of equipment and buildings is the responsibility of the respective departments
and these costs are part of the general fund.
e
Equipment (fire trucks, police cars, etc.) is purchased each year by the police and fire
departments.
f
Leases are for land, where some stations are located, and operating equipment.

“But allocating only variable costs is not reasonable. Many of the fixed costs exist because we
have to provide services in the police jurisdiction. Since annexing the property along the river,

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we have had to add new personnel and equipment. Last year, we completed the ninth fire
station in the city. These additions have been due both to growth in the city and to the added
size of the police jurisdiction. If we charged businesses in the police jurisdiction only a portion
of our variable costs, every business in the city would argue that they should be charged only
for part of variable costs. Who would pay for the fixed costs? The original legislation on police
jurisdictions is ambiguous and does not provide for any capital charges. I don’t see how
variable costs can be considered the only appropriate costs in the case.”

“Adding additional fixed costs to service the police jurisdiction is a good point,” stated Bob
Holman. “Late yesterday afternoon, I called a meeting with Fire Chief Ben Hogan and Police
Chief Martha Pate. Both have over twenty years experience with the city. I explained the
situation and asked if they could offer any insight into the operations of their departments.
Interestingly, Chief Hogan provided me with the name of a retired fire chief who would be
willing to testify that, in his opinion, one of the nine fire stations could be eliminated if we did
not service the police jurisdiction. Thus, costs associated with one fire station could be
avoided. In addition, Chief Pate stated that she thought one of eight police beats could be
eliminated by merging the two surrounding beats if the city did not have to service the police
jurisdiction. I asked them to prepare a summary of the specific cost items they thought the city
could avoid if we did not service the police jurisdiction. These items are listed in ‘exhibit 6.’

“Keep in mind that these are estimates. It is difficult to separate those costs that are
associated directly with the police jurisdiction. Also, I’m not sure which particular station or
beats would be affected or what we would do with the resources if we eliminated these
facilities and activities. Most stations and beats provide services to both the city and the
jurisdiction.”

EXHIBIT 6
Avoidable Cost Information on Police and Fire Departments
Police Department
One of eight beats could be eliminated. Four of 195 officers could be
eliminated as a result.
The following expenditures could be reduced proportionately, by eliminating
officers:
Wages and Salaries
Overtime Wages
Employee Insurance
Retirement Benefits
Other Benefits
Training and Travel
Uniforms
Two automobiles could be eliminated out of the total fleet of 120.
The following vehicle-related operating expenditures could be eliminated:
Fuel
Equipment Maintenance
Fire Department
One of the nine stations could be eliminated.
All operating, equipment and building costs associated with one fire
station could be eliminated. These costs are incurred proportionately
across stations.
All firefighters are full time. Each station is assigned three four-person
crews. Each crew works a 24-hour, on-duty shift, with 48 hours off duty.
Currently, the city employs 96 firefighters. Therefore, 12 people could
be eliminated.
Salaries, benefits and any other personnel costs associated with these
employees could be eliminated.

Al Tupay interjected: “Is there a chance we can settle this thing out of court?”

“We have to go to court, Mayor,” Bob answered. “We have to win this case. If we settle with
Smith, every business in the police jurisdiction will want a similar settlement. We stand to lose
hundreds of thousands of dollars over the next few years, and there go those wage increases
you’ve been promising city employees. Have you thought about that?”

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“Well Bob, what do you suggest we do?” Al asked.

“I think we need an expert witness. Someone who can add credibility to our position. Do you
know of anyone, Mike?”

“Sure, most of the CPA firms in town would be pleased to provide their services.”

“But can we be sure they will support our position?” asks Al, worriedly.

“I think so,” answers Mike. “The allocation method the city has been using is a simple and
easy method. I’m sure we can find an accountant who will assist us in presenting a convincing
argument. We need to emphasize that it is important for all taxpayers to bear their share of
the tax burden, including those in the jurisdiction.”

“Well,” adds Bob. “We know Smith will find someone to support her viewpoint.”

Bart adds: “We don’t have any choice. We need to find the best expert witness we can.”
Everyone agrees. After they exchange a few pleasantries, the meeting ends.

Questions and requirements

1) Provide a general definition of the term “cost” as used in accounting literature. How is
the term being used in the Oak City case? What is the central cost issue of this case?

2) Identify various methods Oak City could use for determining the “cost” of providing
services to the city’s police jurisdiction.

3) Which of these methods is the city currently using? Is this method fair to residents of
the city’s police jurisdiction? Is it consistent with State law?

4) Assume you are an employee of a local accounting firm that has agreed to provide
expert testimony for Anita Smith, plaintiff, in her case against Oak City. Your
employer has given you the task of developing an initial analysis of the case and of
writing a report supporting the position of your client. The report will provide a basis
for testimony during the case. Your report should consist of the following major
sections:
• Brief background information about the case
• A critique of the city’s position
• An analysis of the costs Oak City should be charging businesses in the police
jurisdiction, including an evaluation of the strengths and weaknesses of the
analysis
• Attachments of supporting calculations and schedules
• A list of additional data you believe might be relevant for your argument and
discussion of how the data could be use

5) Alternatively, assume you are an employee of a local accounting firm that has been
hired by Oak City to provide expert testimony in the case. Prepare a report analyzing
the costs the city should charge businesses in the police jurisdiction. Use the same
format as in part 4, but critique the plaintiff’s position.

6) Discuss any ethical issues an accountant should consider in this case. To what extent
do accountants have latitude in supporting positions taken by their clients when
accountants are providing consulting services?