CHAPTER SEVEN A CLOSER LOOK AT OVERHEAD COSTS '.

323 manufacturing overhead costs

300 (or factory burden costs or indirect
-based costing (ABC) system 300 manufacturing costs) 292
300 non -manufacturing costs 292
306 non-volume-based cost driver 304
overhead rate 305 normal costing 305
(or master budget) volume 306 normal volume 307
ution margin (or contribution or normalised overhead rate 306
-ble costing) statement 325 plantwide overhead rate 296
293 practical capacity 307
294 production department 298
298 reCiprocal services 310
295 reciprocal services method 315
293 step-down method 313
• unit of activity driver 300 support (or service) department 292
I 293 support department cost allocation 299
306 theoretical capacity 307
I overhead rates 297 total contribution margin 325
293 two-stage cost allocation process 297
312 variable cost of goods sold 325
ufacturing overhead costs 324 variable costing 323
293 variable manufacturing
292 overhead costs 324
292 volume-based cost driver 303

lain the differences between manufacturing overhead, upstream and downstream costs, and the indirect costs
responsibility centres. LO 7.1
at are cost objects, cost pools and allocation bases? What role do they play in cost allocation? What is the
rence between cost allocation bases and cost drivers? LO 7 .2
estimating the cost of a cost object, how are direct costs and indirect costs assigned to the cost object? Using the
NGOs involved in the tsunami relief efforts (described in the 'Real life' titled 'Measuring tsunami recovery costs: an
rhead or not?' in the section 'Allocating indirect costs: some general principles') choose a cost object and give two
mples of direct and indirect costs for that cost object. LO 7.2 REALLIFE
at does the term cost allocation base mean? What is a suitable cost allocation base for assigning marketing costs
he various attractions at a large theme park (such as Dreamworld or Movie World on the Gold Coast)? LO 7.2. 7.3
cribe the process of two-stage cost allocation in the development of departmental overhead rates, using the
s overhead cost distribution, support department cost allocation and overhead application. LO 7.4
' nguish between a support department and a production department. Give an example of a production
artment in a large travel agency, and a support department in a cafe chain . LO 7 .4
plain the difference between activity-based costing for manufacturing overhead and a traditional costing system
uses departmental overhead rates. LO 7.5
• PART TWO COSTS AND COSTING SYSTEMS

7.8 Describe some costs and benefits of using (a) departmental overhead rates and (b) activity-based costi n
product costing. LO 7 .6
7.9 What is meant by the term cost driver? What is a volume-based cost driver? What is a non-volume-based cost
Give three examples of non-volume-driven costs in a bank and suggest a possible driver for each of those costs. LO
7.10 Refer to the 'Real life' titled 'How should the Pacific Islands Forum Fisheries Agency allocate its overheads?'
section 'Issues in estimating overhead rates~ and evaluate the FFA's decision to allocate overhead costs to
funded projects based on salary costs. LO 7.7 REAI .Lln;
7.11 Explain the costs and benefits that need to be considered when choosing between the use of predetermi n
actual overhead rates. LO 7 .7
7.12 What do we mean by the denominator volume? Describe the effect on product cost for a car manufactur
changing the denominator volume for calculating the overhead rate from one based on practical capacity to
based on theoretical capacity. LO 7 .8
7.13 Why do management accountants allocate indirect costs to responsibility centres? Refer to the 'Real life'
'Overhead costs and price setting at Dalrymple Bay Coal Terminal' in the section 'Allocating indirect costs
responsibility G:entres'. What problems were encountered in allocating Prime Infrastructure Group's costs to Dal
Bay Coal Terminal (DBCT) and what effect did this have on DBCT's cost per loaded tonne? LO 7 .9 REALLIFE
7.14 'Actual support department costs should be allocated rather than budgeted costs, as these are more accurate.
you agree? Explain your answer. LO 7. 10
7.15 Explain briefly the main differences between the direct, step-down and reciprocal services methods of su
department cost allocation. LO 7.10
7.16 'The reciprocal method is the most appropriate method of support department cost allocation as it takes
account all service flows between departments.' Do you agree? Explain your answer. LO 7 .10
7.17 Explain the term reciprocal services and give examples of the reciprocal services offered by support depa
in a university. LO 7 . 10
7.18 (appendix) What are the major differences between a contribution margin statement and an absorption
income statement? LO 7 .11
7.19 (appendix) What is the key difference between variable and absorption costing? LO 7 .11
7.20 (appendix) Would you recommend variable costing or absorption costing as a source of information for man
Explain your answer.

E7 :21 Predetermined overhead rates for various cost drivers: manufacturer

The following data relate to Denyer Ltd for the year just ended:
L07.3
7.7 Budgeted sales revenue
$3075l
Actual manufacturing overhead
$510 001
Budgeted machine hours
15001
Budgeted direct labour hours
30 OOU
Budgeted direct labour rate
$ 21
Budgeted manufacturing overhead
$546 DOn
Actual machine hours
16500
Actual direct labour hours
27 000
Actual direct labour rate
$ 22.50
 CHAPTER SEVEN A CLOSER LOOK AT OVERHEAD COSTS •

Required:
1. Calculate the firm's predetermined and actual overhead rates for the year using each of the following cost
drivers:
(a) machine hours
(b) direct labour hours
(c) direct labour cost.
2. Would you recommend using an actual overhead rate or a predetermined overhead rate for Denyer Ltd?
Explain your answer.

Predetermined plantwide overhead rate: printing firm

The following annual data relate to Facsimile Printing Pty Ltd :

Budgeted machine hours 15000

Budgeted direct labour' llOurs 30000
Budgeted direct labour cost $420000
Budgeted manufacturing overhead $546000

During the month of June the firm worked on three products-business cards, wedding invitations and
promotion flyers-using the following inputs:

Business cards Wedding invitations Promotion flyers

Actual machine hours 600 300 200

Actual direct labour hours .800 600 400

Actual manufacturing overhead costs for June were $51 000 and the actual direct labour rate was $22.50
per hour.

Required:
Assume that the firm uses machine hours as its overhead cost driver:
1. Calculate the firm's predetermined plantwide overhead rate.
2. Estimate the overhead costs of each of the three products.
3. Compare the actual overhead cost to the amount of overhead applied to the three products in June.

Predetermined plantwide overhead rate; alternative cost drivers

Repeat the requirements for Exercise E7.22, assuming that Facsimile uses the following as overhead cost
drivers:
(a) direct labour hours
(b) direct labour dollars.
In hindsight, which cost driver seems to be the most appropriate: machine hours, direct labour dollars or
direct I'abour hours? Explain your answer.

Two-stage allocation process: hospital

Review Exhibit 7.5, which outlines the the steps involved in the two-stage allocation process for overhead
costs . Describe examples of each of these steps for a hospital where the cost object is a patient-day of
hospital care (i.e. one day of care for one patient).
In developing your answer, you wi'" need to identify appropriate production departments that are directly
involved with the treatment of patients and support departments indirectly involved with treatment. You will
also need to identify which support department costs should be allocated to which production departments,
and then consequently to a patient-day for a particular area of hospital care.

Departmental overhead rates: manufacturer

Country Leatherworks, which manufactures saddles and other leather goods, has three departments. The
assembly department manufactures various leather products, such as belts, purses and saddlebags, using an
• PART TWO COSTS AND COSTING SYSTEMS

(b) machinery department-equipment maintenance and equipment setup

(c) cutting department-cutting out metal and other parts to be used in various products
(d) fabrication department-forming and trimming operations on various parts and components
(e) assembly department-assembly of final products.
The pool accessory industry has recently experienced a significant reduction in demand as increa
water prices have forced many pool owners to convert their swimming pools into more water-efficient ga
As a result, Sea Lion's profits have been squeezed. In response, the firm has moved to increase p
efficiency and altered its accounting system to get a more accurate picture of its product costs. The aim is
enable management to price products more competitively. The most significant change in the
system is the introduction of departmental overhead rates . The cost drivers used in the three prod
departments are the following:
(a) cutting-machine hours
(b) fabrication-number of parts processed
(c) assembly-direct labour hours.
So far, the new accounting system seems to be effective. Management feels that the reported p
costs are more in line with its intuition about what various products cost to manufacture. The accou
manager, however, is considering further improvement in the accounting system through the introduction
activity-based costing .
Required:
1. Draw three diagrams to depict the three different product costing systems discussed in
description:
(a) the former system, which uses a plantwide overhead rate
(b) the current system, which uses three departmental overhead rates
(c) the contemplated system, which will use activity-based costing to assign
costs to products.
(Hint: Refer to Exhibits 7.5 and 7.7. Make sure to show in your diagrams the roles of the predeterm i
overhead rates, departments, cost distribution, support department cost allocation, cost application,
stage cost allocation, activity cost pools, activity drivers and products.)
2. For the activity-based costing system, suggest the activity cost pools and activity drivers that could be

P7.35 Plantwide versus departmental overhead rates; product pricing: manufacturer

Constellation Peripherals Ltd manufactures two different multifunction printers (MFPs) for the bU5'iness
L07.3 Cost estimates for the two 'models for the current year are as follows:
7,4
Basic Advanced

Direct material $SOO $1600

Direct labour (20 hours @ $30 per hour) 6()O 600
Manufacturing overhead;' ~ SOO
Tota l $2'200 $3000
--
. The predetermined overhead rate is $40 per direct labour hour.

Each model MFP requires 20 hours of direct. labour. The basic model requires 5 hours in department A
15 hours in department B. The advanced model requires 15 hours in department A and 5 hours in departme
The budgeted overhead costs in these two production departments are as follows:

Department A Department B

Variable cost $32 per direct labour hour $S per direct labour hour
Fixed cost S400000 $400000

The firm's management expects to operate at a level of 20 000 direct labour hours in each prod
department during the current year.
 CHAPTER SEVEN A CLOSER LOOK AT OVERHEAD COSTS •

Required:
1. Show how the company's predetermined overhead rate was determined.
2. If the firm prices each model MFP at 10 per cent over its cost, what will be the price of each model?
3. Suppose the company were to use predetermined departmental overhead rates. Calculate the rate for
each of the two production departments.
4. Calculate the product cost of each model, using the departmental overhead rates calculated in requirement 3.
5. Calculate the price to be charged for each model, assuming the company continues to price each product
at 10 per cent above cost. Use the revised product costs calculated in requirement 4.
6. Write a memo to the managing director of Constellation PeripheralrS making a recommendation as to
whether the firm should use a plantwide overhead rate or departmental rates. Consider the potential
implications of the overhead rates and the firm's pricing policy. How might these considerations affect the
firm's ability to compete in the marketplace?

Activity-based costing calculations

Refer to the data given in Problem P7.35. The company has implemented an activity-based costing system for
its manufacturing overhead costs, with the activity cost pools and activity driver data below.

Activity drivers

Activi,t y Activity cost Total Basic product line Advanced product line
Machine setup $ 200 000 200 setups 50 setups 150 setups
Material receiving 120 000 80 000 ki lograms 30 000 kilograms 50 000 kilograms
Inspection 160 000 1 600 inspections 700 inspections 900 inspections
Machinery-related 840 000 60 000 MH* 20 OOOMH 40 OOOMH
Engineering 280 000 7 000 EHt 3 000 EH 4 000 EH
Total overhead $1 600 000
• MH = machine hours.

'EH = engineering hours.

Constellation Peripherals plans to produce 1000 units of each model MFP.

Required:
1. For each activity, calculate the cost per unit of activity driver (e.g. the cost per setup).
2. Determine the total overhead to be assigned to each product line under activity-based costing.
3. Calculate the overhead assigned per unit of each type of MFP under activity-based costing.
4. Prepare a table comparing the total product cost assigned to each type of MFP using a plantwide overhead
rate, departmental overhead rates and activity-based costing. (This requirement relies on the solution to
Problem P7.35.)

Plantwlde versus departmental overhead rates; actual and normal costing: manufacturer
Noteperfect Ltd manufactures sheet music stands in two separate departments, cutting and welding. The
following data relate to the year just ended:

Cutting department Welding department Total plant

Budgeted manufacturing overhead $60 000 $120 000 $180 000

Actual manufacturing overhead 54 000 108 000 162 000

Budgeted machine hours 24 000 96 000 120 000

Actual machine hours 27 000 90 000 117 000

Budgeted direct labour hours 30 000 15 000 45 000

Actual direct labour hours 29400 11 700 41 100