A Closer Look at Overhead Costs: Answers To Review Questions

CHAPTER 7
A CLOSER LOOK AT OVERHEAD COSTS

ANSWERS TO REVIEW QUESTIONS
7.1 When we refer to manufacturing overhead costs we are describing the indirect manufacturing costs of products.
These are the factory costs that are incurred in producing products but cannot be traced directly to them. They
include all manufacturing costs other than direct material and direct labour, such as the costs of supervision,
power, factory security and so on. From a product costing perspective, we can expand our definition of
overheads to include all product-related costs other than direct costs as managers may require comprehensive
estimates of product costs for making product-related decisions (see Chapter 4). However, as Australian
accounting standard AASB 102 Inventories requires that inventory valuations in external reports of
manufacturing businesses only include manufacturing costs, a distinction is drawn between indirect costs within
the manufacturing area, called manufacturing overhead, and other indirect costs incurred along the value chain,
upstream and downstream, of the manufacturing or production area.
Upstream costs and downstream costs, regardless of whether the entity is a manufacturer or a service provider
include costs incurred before and after the production process, such as research and development, design and
supply costs, marketing, distribution and customer service costs.
The indirect costs of responsibility centres are costs assigned to a unit in an organisation such as a department or
division where a manager is held accountable for performance. Indirect costs cannot be traced directly to the
centre so they need to be assigned instead.
7.2 Cost object: is something that is assigned a separate measure of cost because management need such cost
information; for example, responsibility centres, products, projects and so on. (The various production
departments in a manufacturing firm also provide examples of cost objects. For example, the material handling
cost pool may be allocated across the various production departments that use material handling services. In a
hospital costs may be assigned to reception, a ward, a doctor, operating theatres or intensive care unit (ICU) and
so on.)
Cost pool: a collection of costs that are to be assigned to cost objects. Costs are often pooled because they have
the same cost driver. (An example of a cost pool is all costs related to material handling in a manufacturing
firm.)
Cost allocation base: is some factor or variable that is used to allocate costs in a cost pool to cost objects. (An
example of a cost allocation base may be the weight of materials handled for each production department that
uses material handling services. This base would be used to assign the costs in the material handling cost pool to
the production departments.)
Cost driver: is a factor or activity that causes a cost to be incurred. (From the example above, the allocation base
of weight of materials handled for each production department may be a cost driver depending on its causal
relationship to the costs in the cost pool.)
The difference between cost allocation bases and cost drivers is that cost drivers are allocation bases but not all
allocation bases are cost drivers. Ideally allocation bases should be cost drivers; that is, there should be a cause
and effect relationship between the costs in the cost pool and the allocation base. In practice, some allocation
bases do not have this relationship, or the relationship is imperfect. Under these circumstances the accuracy of
the cost allocations can be questioned.
Copyright © 2018 McGraw-Hill Education (Australia) Pty Ltd

IRM Langfield-Smith, Smith, Andon, Hilton, Thorne Management Accounting 8e
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7.3 As shown in Exhibit 7.2 (Estimating the cost of a cost object), in estimating the cost of a cost object, direct costs
are traced directly to the cost object and indirect costs (those with no direct linkage to the cost object) are
collected into cost pools and assigned to the cost object by means of allocation bases, preferably cost drivers.
Some possible examples of cost objects and their direct and indirect costs for the NGOs involved in the tsunami
relief efforts (described in the ‘Real life’ in ‘Allocating indirect costs: some general principles’) follow:
Cost objects Direct costs Indirect costs

Programs to deliver  Campaign and administrative  General office and administrative
immediate disaster relief costs that can be directly traced to costs of NGO (depreciation of
specific program office equipment, general
stationery and postage, rent,
 Salaries of program designer and
cleaning, general accounting and
planners
office staff salaries, bank fees etc)
 Salaries of appeal workers
 Salaries of CEO and top
 Salaries of relief workers in management
disaster area
 Legal, insurance and risk
 Transport of staff and relief goods management costs not directly
to disaster area traceable
 Accommodation for relief  Marketing, advertising,
workers publishing and other costs for
general awareness and fund
 Technical and logistical
raising campaigns
consulting costs
 Consulting and advocacy activity
 Food and clean water
costs of seeking change in
 Medicines government and institutional
policies
 Temporary shelter
 External audit and reporting costs
Projects to:  Administrative costs that can be  General office and administrative
directly traced to specific projects costs of NGO (depreciation of
 rebuild after a disaster
office equipment, general
event  Salaries of project designers and
stationery and postage, rent,
planners
 construct additional cleaning, general accounting and
infrastructure  Salaries of staff involved in office staff salaries, bank fees etc)
project field work
 deliver long-term  Salaries of CEO and top
community  Transport of staff and materials to management
development field
 Legal, insurance and risk
 Accommodation for field staff management costs not directly
traceable
 Technical and engineering
consulting costs  Marketing, advertising,
publishing and other costs for
 Building and infrastructure
general awareness and fund
materials
raising campaigns
 Consulting and advocacy activity
costs of seeking change in
government and institutional
policies
 External audit and reporting costs

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7.4 A cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to a cost object.
One possible allocation base for assigning marketing costs to the various attractions of a large theme park would
be the number of people patronising the park’s attractions. This would assume that the number of people
attending a certain part of the theme park would be an indication of the marketing resources consumed by each
attraction. Notice that in most cases the sales revenue generated by the various components of the theme park
would not be a viable allocation base since most theme parks have a single admission fee for the entire park.
Note that some people would consider ‘corporate’ marketing of this nature should not be allocated to the various
subunits of the business, as it is very hard to determine a causal cost driver. In activity-based costing
terminology the marketing could be regarded as a facility cost.
7.5 The development of departmental overhead rates involves a two-stage process.

In stage one, overhead costs are assigned to the firm’s production departments. First, overhead costs are
distributed to all departments, including both support and production departments. Second, support department
cost allocation takes place which involves costs being allocated from the support departments to the production
departments. At the end of stage one, all overhead costs have been assigned to the production departments.
In stage two, overhead application occurs as the costs that have been accumulated in the production departments
are applied to the products that pass through the departments using the overhead rate set for each production
department.
7.6 A support department is a unit in an organisation that is not involved directly in producing the organisation’s
goods or services. However, a support department does provide services that enable the organisation’s
production process to take place. Production departments, on the other hand, are units that are directly involved
in producing the organisation’s goods and services.
Examples of ‘production’ departments in a travel agency may include ticketing and bookings departments and so
on. Examples of support departments in a cafe chain may include washing dishes (either manual or stacking and
unstacking dishwashers), cleaning, ordering/buying (some franchises rely on ordering from a central unit and
some require purchasing at the local market), bookings desk, head office, laundry and accounting.
7.7 Activity-based costing can be used to assign manufacturing overhead costs to products in two stages. In the first
stage overhead costs are assigned to activity cost pools (that is, activities). In the second stage, activity costs are
assigned from the activities to products in proportion to the products' consumption of each activity, measured by
the amount of activity driver consumed. In traditional costing systems, when a two-stage allocation process is
used, the first stage is to assign overhead costs to production departments and the second stage is to assign the
overhead costs from the production departments to products in proportion to the products' consumption of the
departmental overhead cost drivers.
7.8 Using departmental overhead rates instead of a single plantwide overhead rate can improve the accuracy of
product cost information. The allocation bases used for each department are likely to be more realistic in
representing the relationship between overhead costs and the product, compared to using just one plantwide rate.
However, using departmental overhead rates requires the distribution of overhead costs to departments, the
allocation of support department costs to production departments and the collection of cost driver data by
production departments. While this approach usually provides more useful information than the single cost pool
approach, it is more expensive to operate and still can provide misleading information. A problem with this
approach is that costs with different behaviour patterns are added together before allocation to the product. It is
difficult to identify a realistic cost driver for a cost pool that includes setup costs, space costs and indirect
material costs, for example.
Using activity-based costing should improve the accuracy of cost information. Allocating costs to activities
rather than departments enables the identification of even more appropriate allocation bases. For example, ABC
uses both volume and non-volume-based cost drivers as allocation bases and attempts to aggregate costs that
have similar behaviour patterns. Again, however, there is an additional cost in analysing costs and cost drivers at
an activity level rather than at a department level.

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7.9 A cost driver is an activity or factor that causes costs to be incurred. A volume-based cost driver is a cost driver
that is a measure of or proxy for the volume of production. An assumption underlying the use of a volume-based
cost driver is that costs are caused, or driven, by the volume of production . Examples include direct labour
hours, machine hours and direct material volume.
Non-volume-based cost drivers are cost drivers that are not directly related to the number of units produced. For
example in manufacturing the set up costs are not driven directly by the units of output since each batch can vary
in volume. In a bank, non-volume-based costs can include human resource management (driven by staff
numbers), cleaning (driven by floor space or room numbers), and IT servicing (possibly driven by the number of
computers).
7.10 Labour cost is a commonly used base for allocating overhead costs to cost objects including projects such as
those undertaken by FFA. Although such projects may be self funded by the member countries they result in
additional overhead costs being incurred by the FFA. As these overhead costs cannot be specifically traced cost
effectively to the individual projects, an appropriate allocation base is needed to allocate them to the individual
projects to avoid cross-subsidisation of projects from member contributions and donations.
It is likely that there is some relationship between the level of salary costs for the projects and the increase in
overhead costs incurred by the FFA (as larger, higher cost projects are likely to require more support from FFA),
though the correlation is unlikely to be perfect. In the absence of a stronger logical connection and a more
practical, cost effective allocation base the use of salary costs as the allocation base may be reasonable.
However, it is not surprising that the member countries questioned and sought independent advice on the
accountability of the seemingly high overhead recovery rate of 66% of salary costs, because to them the
overhead recovery is an uncontrollable cost.
7.11 The primary benefit of using a predetermined overhead rate instead of an actual overhead rate is to provide
timely information for decision making, planning and control. Also the predetermined rate removes fluctuations
inherent in monthly actual overhead rates. While the use of actual overhead rates removes the need to account
for over- or under-allocated overhead, this is because it relies on data that are not known until after the event, so
it cannot be used in a timely fashion. Notice that in both approaches, it is necessary to calculate an overhead rate,
as overhead costs cannot be traced directly to products.
7.12 The denominator volume is the measure of cost driver volume used to calculate the manufacturing overhead rate.
The most common measure is the budgeted volume of cost driver for the coming year. Theoretical capacity is
the maximum level of production that the plant can run at, without ever stopping. Practical capacity assumes the
business operates at the maximum level that its resources allow under normal, efficient operating conditions.
Product costs will be higher using practical capacity, as the denominator measure of cost driver volume will be
lower, resulting in higher overhead rates. For a car manufacturer, the cost of the car would go up, bearing the
cost of the overheads created by the excess capacity. Raising the price if demand is declining is unlikely, and
managerial attention would be required. Using theoretical capacity as the denominator will result in lower
overhead rates and product costs, but there will be higher levels of underapplied overhead. This scenario is
usually untenable.
7.13 Management accountants allocate indirect costs to responsibility centres to help managers understand the effects
of their decisions, to encourage particular patterns of resource usage and to support the product costing system.
For example production departments may source services from support departments and where these services are
supplied for ‘free’ there may be a tendency to over-consume them. Where they are charged to departments, the
departmental managers are held responsible for these costs and need to be careful about the amount of these
services they consume. Also, where departmental overhead rates are used for product costing, it is necessary to
allocate the costs of support departments to production departments, to calculate departmental overhead rates for
the production departments.
The problems encountered in allocating a proportion of costs of the Prime Infrastructure Group (which changed
its name to Babcock and Brown Infrastructure on 1 July 2005) to its responsibility centre of Dalrymple Bay Coal
Terminal (DBCT) related to the disentanglement of overheads associated with DBCT’s operations from the costs
of other activities within the Prime group. The amount of overhead allocated by Prime to DBCT affected the
overhead cost per loaded tonne sought to be recovered by DBCT in the total price per loaded tonne of coal
charged to terminal users. The terminal users have little option but to use the terminal facility because of its
monopolistic nature. The competition authority, to ensure fair and reasonable access for terminal users, needed
to approve the terms and conditions of terminal access. It sought an independent review of Prime’s method of
allocating overhead to DBCT, which found that Prime had not reliably estimated the amount of overhead

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relating to DBCT. This ‘Real life’ example illustrates the impact that overhead cost allocation choices can have,
not only on product costs and product prices, but also industry competitiveness.

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7.14 Budgeted support department costs should be allocated rather than actual support department costs. If actual
costs were allocated, the activities of the department that provides the services could compromise the results of
the department that uses these services as well as their ability to plan activities. The incentive for cost control in
the department that provides the services may be reduced if they just transfer those excesses to the next
department. The allocation on the basis of budgeted figures highlights the good or poor results in the sourcing
department.
7.15 Under the direct method of support department cost allocation, all support department costs are allocated
directly to the production departments, and none of these costs are allocated to other support departments. Under
the step-down method, a sequence is first established for allocation of support department costs. Then the costs
incurred in the first support department in the sequence are allocated among all other departments that follow in
the sequence, including other support departments. The method proceeds in a similar fashion through the
sequence of support departments, never allocating back to a support department that has had its costs allocated.
Under the reciprocal services method, a system of simultaneous equations is established to reflect the reciprocal
provision of services among support departments. Then, all of the support departments’ costs are allocated
among all of the departments that use the various support departments’ output of services. The reciprocal
services method of support department cost allocation is the only method that fully accounts for the reciprocal
provision of services among departments.
7.16 As stated in the previous answer, under the reciprocal services method all of the support departments’ costs are
allocated among all of the departments that use the various support departments’ output of services. It is the only
method that fully accounts for the reciprocal provision of services among departments. However, this degree of
accuracy may not be necessary for the purpose and sometimes makes very little difference to the resulting
costings. The degree of inaccuracy of the reciprocal and step down methods depends on the amount of overhead
in each cost pool and the level of support provided between departments. As the method of allocating support
department costs becomes more detailed and sophisticated the cost of maintaining the system increases.
7.17 The term reciprocal services refers to two or more support departments providing support services to each other.
In a university, for example, the IT department provides support services to the human resource (HR)
department but the human resource department also provides HR support to the IT department. In fact, IT gives
support to all other departments (e.g. maintenance, grounds, student administration, faculty administration,
library, security) and receives support from many of them (maintenance of facilities, HR, security).
7.18 The contribution margin statement is used to highlight the separation of variable and fixed costs. The total
contribution margin is equal to sales revenue less the variable cost of goods sold (sometimes called the variable
manufacturing expenses) and the variable selling and administrative expenses. The fixed expenses deducted
below the contribution margin include both fixed manufacturing overhead and fixed selling and administrative
expenses.
In the absorption costing income statement, the cost of goods sold expensed, for each month, includes variable
manufacturing costs and the predetermined fixed manufacturing overhead cost applied to products sold. The
expenses deducted after that are the selling and administrative expenses, which include both fixed and variable
components.
7.19 Both absorption and variable costing systems assign direct material, direct labour and variable manufacturing
overhead costs to products in exactly the same way, but they differ over their treatment of fixed manufacturing
overhead. Absorption costing includes fixed manufacturing overhead as a part of product cost. Variable costing
excludes fixed manufacturing overhead from product cost and expenses it in the period in which it is incurred.
The key distinction between variable and absorption costing is the timing of fixed manufacturing overhead
becoming an expense. Eventually, fixed overhead is expensed under both product costing systems. Under
variable costing, fixed overhead is expensed immediately, when it is incurred. Under absorption costing, fixed
overhead is inventoried and not expensed until the accounting period during which the manufactured goods are
sold.

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7.20 Variable product costs are particularly useful for short-term decisions, such as whether to make or buy a
component, and pricing—especially when variable selling and administrative costs are included. The fixed costs
will be incurred anyway and in the short term they should be disregarded. In making these decisions, the variable
costs provide a good measure of the differential costs that need to be assessed. The information needed for short-
term decision making is discussed in Chapter 19.
Under variable costing, profit is a function of sales. The classification of costs as fixed or variable makes it
simple to project the effects that changes in sales have on profit. Managers find this useful for decision making.
Also, cost volume profit analysis (which we discuss in Chapter 18) requires a variable costing format.
Planned costs must take account of cost behaviour if they are to provide a reliable basis for control. In addition,
the link between sales and profit performance, under variable costing, ensures a performance measure that
managers understand easily.
Fixed costs are an important part of the costs of a business, especially in the modern manufacturing
environment. Variable costing provides a useful perspective of the impact that fixed costs have on profits by
bringing them together and highlighting them, instead of having them scattered throughout the statement.
Absorption product costs include unitised fixed overhead, which can result in suboptimal decisions, especially as
fixed costs are not differential costs in the short term. However, in the modern business environment, with a high
level of fixed overhead, a relatively small percentage of manufacturing costs may be assigned to products under
variable costing. Also, in the longer term a business must cover its fixed costs too, and many managers prefer to
use absorption cost when they make cost-based pricing decisions. They argue that fixed manufacturing overhead
is a necessary cost incurred in the production process. When fixed costs are omitted, the cost of the product is
understated.

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SOLUTIONS TO EXERCISES
EXERCISE 7.21 (20 minutes) Predetermined overhead rates for various cost drivers:
manufacturer
NOTE: Budgeted sales revenue, although given in the exercise, is irrelevant to the solution.
1 Predetermined overhead rate = budgeted manufacturing overhead

budgeted level of cost driver
(a) $546 000 = $36.40 per machine hour

15 000 machine hours
(b) $546 000 = $18.20 per direct labour hour

30 000 direct labour hours
(c) $546 000 = $0.867 per direct labour dollar or 86.7%

$630 000* of direct labour cost
* Budgeted direct labour cost = 30 000 hours × $21

Actual overhead rate = actual manufacturing overhead
actual level of cost driver
(a) $510 000 = $30.91 per machine hour

16 500 machine hours
(b) $510 000 = $18.89 per direct labour hour

27 000 direct labour hours
(c) $510 000 = $0.84 per direct labour dollar or 84%

$607 500* of direct labour cost
* Actual direct labour cost = 27 000 hours × $22.50
2 Denyer Ltd will not know the data for actual costs and cost drivers until the end of the year. For timely decision
making it is necessary to have estimates and use predetermined rates.
EXERCISE 7.22 (20 minutes) Predetermined plantwide overhead rate: printing firm
budgeted manufacturing overhead
1 Predetermined overhead rate = budgeted level of cost driver
$546 000
15 000 machine hours = $36.40 per machine hour
2 Business cards 600  $36.40 = $21 840
Wedding invitations 300  $36.40 = $10 920
Promotion flyers 200  $36.40 = $7280
3 Actual Applied Overapplied or underapplied

manufacturing  manufacturing = overhead
overhead overhead
$51 000  (1100)($36.40) = $10 960 underapplied

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EXERCISE 7.23 (30 minutes) Predetermined plantwide overhead rate; alternative cost
drivers
1 Predetermined overhead rate = budgeted level of cost driver
$546 000
(a) 30 000 direct labour hours = $18.20 per direct labour hour
(b) $546 000 = $1.30 per direct labour dollar or
$420 000 130 of direct labour cost
2 (a) Business cards 800 direct labour hours  $18.20 = $14 560
Wedding invitations 600 direct labour hours  $18.20 = $10 920
Promotion flyers 400 direct labour hours  $18.20 = $7280
(b) Business cards (800 direct labour hours)($22.50)  1.30 = $23 400
Wedding invitations (600 direct labour hours)($22.50)  1.30 = $17 550
Promotion flyers (400 direct labour hours)($22.50)  1.30 = $11 700
3 Actual Applied Overapplied or underapplied

manufacturin  manufacturing = overhead
g overhead overhead
(a) $51 000  (1800)($18 20) = $18 240 underapplied overhead
(b) $51 000 – (1800)($22.50) = $1650 overapplied overhead
(1.30)†
† Actual direct labour cost = 1800  $22.50
In hindsight, direct labour dollars seems the most appropriate cost driver, as it results in the lowest level of
underapplied/overapplied overhead. It therefore appears to better represent the behaviour of overhead costs. However,
it is difficult to make this judgment based on just one month’s data.
EXERCISE 7.24 (10 minutes) Two-stage allocation process: hospital

In a hospital, examples of costs are: overhead costs from the activity cost pools and the products using cost drivers.
Support departments include, patient records, personnel, pharmacy and administration/finance (these provide services
to the production departments).
Production departments include orthopaedics, internal medicine and surgery (these provide healthcare services directly
to the patients).
In stage one, the support departments’ overhead costs are calculated and allocated to the production departments.
In stage two, the services used in the production departments have additional overhead costs allocated to the products
of the department. For example, in the surgery department, overhead cost is allocated for medications and the use of
consultants or other specialists involved in the surgery on an individual patient.
EXERCISE 7.25 (10 minutes) Departmental overhead rates: manufacturer

Applied manufacturing overhead per deluxe saddle and accessory set:
Tanning department 110 m2  $8 $ 880
Assembly department 4 machine hours  $22 88
Saddle department 45 direct labour hours  $10 450

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$1418

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EXERCISE 7.26 (15 minutes) Volume-based cost driver versus ABC: manufacturer
1 Material handling cost per mirror:
$180 000
× 500 = $1500 ¿
[( 60 )(500 ) + ( 60) ( 500 ) ]∗¿
* The total number of direct labour hours.
An alternative calculation, since both types of product use the same amount of the cost driver, is the
following:
$180 000
= $1500 ¿
120∗¿
* The total number of units (of both types) produced.
2 Material handling cost per lens = $1500. The analysis is identical to that given for requirement 1.
3 Material handling cost per mirror:

$180 000
×8
( 8 + 32 )¿
= $600
60
* The total number of material moves.
4 Material handling cost per lens:

$180 000
× 32
( 8 + 32 )¿
= $2400
60
* The number of material moves for the lens product line.
EXERCISE 7.27 (20 minutes) Normal costing; alternative denominator volumes: engineering
firm
1 Practical capacity will be greater than the actual volume of production. Overhead will be underapplied at the end
of the coming year. Job costs and tender quotes will be lower than their actual costs because the overhead cost
will be understated.
2 A change from practical capacity to the budgeted volume will increase the overhead rate and, therefore, increase
job costs and tender quotes. This will make it more difficult to win tenders.
3 If normal volume were used, by the end of this year actual production will be lower than the normal volume, as
the company is expected to be in the ‘trough’ of its normal business cycle. Overhead would be underapplied, but
not by as much as it would have been if practical capacity had been used as the denominator volume. Next year
the company will be in the peak of its two-year cycle and, if normal volume is used as the denominator volume,
overhead will be overapplied. Over the two-year cycle, the underapplied and overapplied overhead should even
out, assuming that actual production behaves as expected over its normal cycle.
Job costs and tender quotes under normal volume will be understated this year and overstated next year,
compared to their actual cost. The average cost over the two years should approximate the actual production
cost.

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EXERCISE 7.28 (10 minutes) Direct method of support department cost allocation: bank
Direct customer service departments using services

Deposit Loan
Cost to be
Provider of service allocated Proportion Amount Proportion Amount
Human Resources $ 720 000 (50/80) $ 450 000 (30/80) $270 000
Computing 1 200 000 (60/80) 900 000 (20/80) 300 000
Total $ 1 920 000 $1 350 000 $570 000
Grand total $1 920 000
EXERCISE 7.29 (15 minutes) Step-down method of support department cost allocation:
bank
Direct customer service departments

using services
Human
resources Computing Deposit Loan
Costs prior to allocation $720 000 $1 200 000
Allocation of Human Resources
Department costs $720 000 144 000 (2/10) $360 000 (5/10) $216 000 (3/10)
Allocation of Computing
Department costs $1 344 000 1 008 000 (60/80) 336 000 (20/80)
Total costs allocated to each
department $1 368 000 $552 000
Total cost allocated to direct
customer service departments
$ 1 920 000
EXERCISE 7.30 (25 minutes) Reciprocal services method of support department cost
allocation: bank
First, specify equations to express the relationships between the support departments.
Notation: H denotes the total cost of Human Resources
C denotes the total cost of Computing
Equations: H = 720 000 + 0.20C (1)
C = 1 200 000 + 0.20H (2)
Solution of equations: Substitute from equation (2) into equation (1).
H = 720 000 + 0.20(1 200 000 + 0.20H)
= 720 000 + 240 000 +0 .04H
0 .96H = 960 000
H = 1 000 000
Substitute the value of H into equation (2).
C = 1 200 000 + 0.20(1 000 000)

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C = 1 400 000

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Next, use the calculated total allocation figures in the cost allocation using the reciprocal services method:
Support departments Direct customer service departments

Human Resources Computing Deposit Loan
Traceable costs $720 000 $1 200 000
Allocation of Human
Resources Department costs (1 000 000) 200 000(0.2) $500 000(0.5) $300 000(0.3)
Allocation of Computing
Department costs 280 000(0.2) (1 400 000) 840 000(0.6) 280 000(0.2)
Total cost allocated to each
direct customer service
department $1 340 000 $580 000
Total costs allocated
$1 920 000
EXERCISE 7.31 (20 minutes) (appendix) Variable and absorption costing: manufacturer
1 Porter Ltd
Income statement under absorption costing
Year ended 31 December
Sales revenue (36 000 units at $45/unit) $1 620 000
Less: Cost of goods sold (36 000  $35/unit)* 1 260 000
Gross margin 360 000
Less Selling and administrative expenses:
:
Variable $108 000
Fixed 30 000
138 000
Net profit $222 000

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2
Porter Ltd
Contribution margin statement under variable costing
Year ended 31 December
Sales revenue (36 000 units at $45/unit) $1 620 000
Less Variable expenses:
:
Variable manufacturing costs
(36 000  $27/unit) $972 000
Variable selling & administrative costs 108 000
1 080 000
Contribution margin 540 000
Less Fixed expenses
:
Fixed manufacturing overhead $300 000
Fixed selling and administrative expenses 30 000
330 000
Net profit $ 210 000
* Assuming that the production of 25 000 units equalled the normal capacity, the fixed manufacturing overhead per unit is
$8 ($300 000/37 500 units).
3 (a) The absorption costing profit is higher because 1500 units produced are carried forward as finished goods
inventory. Each unit carries forward a cost of $8 for manufacturing overhead that is expensed under
variable costing. Therefore using the absorption costing method the costs in the income statement are
$12 000 lower than when using the contribution margin approach, where total fixed costs are expensed as
period costs.
(b) The short cut method is based on the change in closing inventory, which represents costs incurred in the
current period which will be released against future revenue. Where production is greater than sales (as in
this case) the higher value of closing inventory deducted from the cost of goods available for sale shows a
lower cost of goods sold— and, therefore, a higher gross profit. The calculation for this is shown below.
Increase (decrease) fixed manufacturing cost

 = difference in profit
in units in inventory per unit
1500 units  $8 = $12 000 more under
absorption costing

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SOLUTIONS TO PROBLEMS
PROBLEM 7.32 (30 minutes) Plantwide and departmental overhead rates: manufacturer
Instructors please note before setting this problem: The actual overhead of $300 000 is for the whole plant (that is,
Fabrication plus Assembly Departments).
1 Total budgeted overhead = $270 000 + $135 000 = $405 000
Budgeted direct labour hours = 22 500 + 90 000 = 112 500
Predetermined overhead rate = $405 000/112 500 = $3.60 per direct labour hour
2 Laser:
31 500 hours  $3.60 = $113 400 (overhead)
[$113 400 + $90 000 (prime costs)]/11 250 units = $18.08 per unit
Inkjet:
93 000 hours  $3.60 = $334 800 (overhead)
[334 800 + $675 000 (prime costs)]/112 500 units = $8.98 per unit (rounded)
3 Departmental overhead rates:
Fabrication = $270 000/45 000 = $6 per machine hour
Assembly = $135 000/90 000 = $1.50 per direct labour hour
4 Laser:
Applied overhead = (15 000  $6) + (30 000  $1.50) = $135 000
Cost per unit = (135 000 + 90 000)/11 250 = $20 per unit
Inkjet:
Applied overhead = (30 000  $6) + (72 000  1.50) = $288 000
Cost per unit = $(288 000 + 675 000)/112 500 = $8.56 per unit
5 (a) Plantwide overhead rate:
Applied overhead (124 500 labour hours  $3.60) $448 200
Actual overhead 450 000
Underapplied overhead $1 800
(b) Departmental overhead rates:
Applied overhead (45 000 machine hours  $6) $270 000 in Fabrication
Applied overhead (102 000 labour hours  $1.50) $153 000 in Assembly
Total applied overhead $423 000
Actual overhead 450 000
Underapplied overhead $ 27 000
6 One would expect the departmental overhead rates to be the best approach. However, in this case the plantwide
rate results in less underapplied/overapplied overhead. Perhaps direct labour hours is a better cost driver for
‘Fabrication’ than machine hours. As the question does not identify the actual overhead costs for each
department separately, it is not possible to identify which department contributes most to the underapplied
overhead and, therefore, assess the appropriateness of each department’s cost driver.

16
PROBLEM 7.33 (25 minutes) Predetermined plantwide overhead rate; different time periods;
pricing: manufacturer
Quarterly
Estimated Estimated direct predetermined
manufacturing labour hours overhead rate
1 (a) overhead (DLHs) (per DLH)
First quarter $200 000 25 000 $8.00
Second quarter 160 000 16 000 $10.00
Third quarter 100 000 12 500 $8.00
Fourth quarter 140 000 14 000 $10.00
$600 000 67 500
(b) (i) & (ii) Part A200 produced January April

Direct labour rate per hour $30.00 $30.00
Number of DLHs per unit 20 20
Overhead rate per DLH $8 $10
Direct material 200 $200

Direct labour 600 $600
Overhead 160 $200
$960 $1 000
2 (a) January ($960 × 1.10) $1056

(b) April ($1000 × 1.10) $1100
Quarterly
Estimated Estimated direct predetermined
manufacturing labour hours overhead rate
3 overhead (DLHs) (per DLH)
First quarter $200 000 25 000
Second quarter 160 000 16 000
Third quarter 100 000 12 500
Fourth quarter 140 000 14 000
Totals $600 000 67 500 $8.89 (rounded)
4 (a) & (b) Part A200 produced January April

Direct material $200.00 $200.00
Direct labour 600.00 600.00
Overhead ( 20 DLH × overhead
rate of $8.89 per DLH) 177.80 177.80
$977.80 $977.80

17
5 Price is cost plus 10% markup
i.e. $977.80 × 1.10 $1075.58
6 The annual rate is preferred, as it averages out (that is, normalises) the effects of fluctuations in overhead costs
and cost driver volumes over the year. Notice that with quarterly overhead rates, the firm may underprice its
product in January and overprice it in April. Note also that an increase in prices in two quarters of the year could
further decrease demand for the product, which would then further increase its cost and price per unit.
PROBLEM 7.34 (45 minutes) Departmental overhead rates and activity-based costing:
manufacturer
1 (a) Former product costing system: traditional system based on a single volume-related cost driver.
(b) Current product costing system: departmental overhead rates based on different cost drivers.

18
Support Department
Costs Allocation

19
(c) Contemplated product costing system: activity-based costing.
Overhead costs are assigned to activity cost pools

associated with significant activities
Overhead
costs
assigned to
activities.
2 Suggested activity cost pools and activity drivers are shown in 1 (c) above.

20
PROBLEM 7.35 (50 minutes) Plantwide versus departmental overhead rates; product
pricing: manufacturer
1 Schedule of budgeted overhead costs:

Department A Department B
Variable overhead
A 20 000 direct labour hours  $32........................................ $640 000
B 20 000 direct labour hours  $8......................................... $160 000
Fixed overhead................................................................................ 400 000 400 000
Total overhead................................................................................. $1 040 000 $560 000
Grand total of budgeted overhead (A + B): $1 600 000
total budgeted overhead

Predeterminedoverhead rate =
total budgeted direct labour hours
$1 600000
= = $4 0 per hour
40 000
2 Product prices:
Basic Advanced
Total cost....................................................................................... $2 200 $3 000
Markup, 10% of cost..................................................................... 220 300
Price............................................................................................... $2 420 $3 300

Department A Department B
Budgeted overhead (from requirement 1)..................................... $1 040 000 $560 000
Budgeted direct labour hours......................................................... 20 000 20 000
Predetermined overhead rates........................................................ $1040000 $ 560 000

20000 D LHrs 20 000 DLHrs
$52 per $28 per

direct labour hour direct labour hour

21
4 Revised product costs:
Basic Advanced
Direct material............................................................................... $800 $1600
Direct labour.................................................................................. 600 600
Manufacturing overhead:
Department A:
Basic 5 × $52 ................................................................... 260
Advanced 15 × $52 .......................................................... 780
Department B:
Basic 15 × $28 ................................................................. 420
Advanced 5 × $28 ............................................................. _ ____ 140
Total $2 080 $3 120
5 Revised product prices:

Basic Advanced
Total cost....................................................................................... $2 080 $3 120
Markup, 10% of cost..................................................................... 208 312
Price ........................................................................................... $2 288 $3 432
6 CONSTELLATION PERIPHERALS LTD

Memorandum
Date: Today
To: President, Constellation Peripherals Ltd
From: I M Student
Subject: Departmental overhead rates
Until now the company has used a single, plantwide overhead rate in calculating product costs. This approach
resulted in a product cost of $2200 for the basic product and a cost of $3000 for the advanced product. Under the
company’s pricing policy of adding a 10 per cent markup, this yielded prices of $2420 for the basic product and
$3300 for the advanced product.
When departmental overhead rates are calculated, it is apparent that the two production departments have very
different cost structures. Department A is a relatively expensive department to operate, while Department B is
less costly. It is important to recognise the different rates of cost incurrence in the two departments, because our
two products require different amounts of time in the two departments. The basic product spends most of its time
in Department B, the inexpensive department. The advanced product spends most of its time in Department A,
the more expensive department. Thus, using departmental overhead rates shows that the basic product costs less
than we had previously realised; the advanced product costs more. The revised product costs are $2080 and
$3120 for the basic and advanced products, respectively. With a 10 per cent markup, these revised product costs
yield prices of $2288 for the basic product and $3432 for the advanced product. We have been overpricing the
basic product and underpricing the advanced product.
I recommend that the company switch to a product costing system that incorporates departmental overhead rates.

22
PROBLEM 7.36 (30 minutes) Activity-based costing calculations
1 Cost rates per unit of each cost driver:
(a) (b) (c) (b) ¿ (c)

Activity Quantity of Cost rate per unit
Activity cost pool cost driver of cost driver
Machine setup................. $200 000 200 setups $1 000 per setup
Material receiving........... 120 000 80 000 kg $1.50 per kg
Inspection........................ 160 000 1 600 inspections $100 per inspection
Machinery-related........... 840 000 60 000 machine hours $14 per machine hour
Engineering..................... 280 000 7 000 engineering hours $40 per engineering hour
Total overhead................. $1 600 000
2 Overhead assigned to each product line:

Overhead assigned to Overhead assigned to
Basic product line Advanced product line
Activity
Machine setup..........................
$ 50 000 (50 setups  $1000) $150 000 (150 setups  $1000)
Material receiving....................
45 000 (30 000 kg  $1.50) 75 000 (50 000 kg  $1.50)
Inspection.................................
70 000 (700 inspections  $100) 90 000 (900 inspections  $100)
Machinery-related....................
280 000 (20 000 machine hrs  $14) 560 000 (40 000 machine hrs  $14)
Engineering..............................
120 000 (3 000 eng. hrs  $40) 160 000 (4 000 eng. hrs  $40)
Total overhead..........................
$565 000 1 035 000
3 Overhead assigned per unit of each type of printer:

Basic............................................................................................. $565 ($565 000 ¿ 1000 units)
Advanced...................................................................................... $1035 ($1 035 000 ¿ 1000 units)
4 Comparison of total product cost assigned to each product under three alternative product costing systems:
Basic Advanced
Plantwide overhead rate*........................................................ $2 200 $3 000
Departmental overhead rate**................................................ 2 080 3 120
†
Activity-based costing ........................................................... 1 965 3 235
* From the data given in the preceding problem.

** From the solution to the preceding problem.
†
The assigned overhead as calculated in requirement 3 above, plus the direct material and direct labour costs given in
the data for the preceding problem:
Basic...................................................................................... $1965 = $1400 + $565

Advanced.............................................................................. $3235 = $2200 + $1035

23
PROBLEM 7.37 (45 minutes) Plantwide versus departmental overhead rates; actual and
normal costing: manufacturer
1 Predetermined overhead rate = budgeted cost driver
(a) Plantwide overhead rate based
$180 000
on direct labour hours = 45 000
= $4 per direct labour hour
Manufacturing overhead cost of A Frame = 5  $4
= $20
(b) Plantwide overhead rate based
$180 000
on machine hours = 120 000 hours
= $1.50 per machine hour
Manufacturing overhead cost of A Frame = 6.5  $1.50
= $9.75
(c) (i) Cutting Department overhead rate
$60 000
based on direct labour hours = 3 0 000 hours
= $2 per direct labour hour

(ii) Welding Department overhead
$120 000
rate based on machine hours = 96 000 hours
= $1.25 per machine hour

Manufacturing overhead cost
of ‘A Frame’ = (4 DL hours  $2) + (4 machine hours  $1.25)
= $13.00
The overhead cost based on departmental rates is likely to be most accurate as it recognises that different cost
drivers cause the overhead costs in each department, and the method specifically recognises the A Frame’s
consumption of these cost drivers.
2 Actual manufacturing overhead rates Cutting Welding

Actual overhead $54 000 $108 000
Actual cost driver 29 400 DL hours 90 000 Machine hours
Actual overhead rates $1.84/DL hour $1.20/Machine hour
(rounded)
Overhead cost of A Frame = (4 DL hours  $1.84) + (4 Machine hours  $1.20) = $12.16
The actual manufacturing overhead costs incurred are indirect costs that cannot be assigned to products, such as
the A Frame, unless cost drivers and overhead rates are used.

24
3 The estimate of overhead costs based on actual departmental rates is most accurate as it reflects the actual costs
incurred. However, this information would not be timely, as actual overhead rates could not be calculated until
after the end of the year.

25
PROBLEM 7.38 (60 minutes) Overhead application using a predetermined overhead rate;
practical capacity versus normal volume: manufacturer
1 (a) (i) Predetermined overhead rate at practical capacity:

Budgeted manufacturing overhead
Budgeted direct labour hours $1 026 000*
at practical capacity = 135 000
= $7.60/direct labour hour
* ($6 × 135 000) + 216 000 = $1 026 000
(ii) Predetermined overhead rate at normal volume:

Budgeted manufacturing overhead
Budgeted direct labour hours $936 000*
at normal volume = 120 000
= $7.80 per direct labour hour

* $720 000 + 216 000 = $936 000
(b) Cost of Job 77

Overhead rate based on:
Practical capacity Normal capacity
Cost in beginning work in process inventory $54 000 $54 000
Direct material 45 000 45 000
Direct labour (2600 hours  $20.00 per hour)* 52 000 52 000
Applied manufacturing overhead
(2600 hours  $7.60 per hour) practical 19 760
(2600 hours  $7.80 per hour) normal 20 280
Total cost $170 760 $171 280
direct labour wages $160 000
* Direct labour rate = direct labour hours = 8 000 = $20.00 per hour
(c) Manufacturing overhead applied to Job 79:

Practical capacity:
Direct labour hours  predetermined overhead rate
= 2400 hours  $7.60 per hour
= $18 240
Normal volume:
Direct labour hours  predetermined overhead rate
= 2400 hours  $7.80 per hour
= $18 720

26
2 Practical capacity rate: Total manufacturing overhead applied during November.
Total direct labour hours  predetermined overhead rate
= 8000  $7.60
= $60 800
Normal volume rate: Total manufacturing overhead applied during November:
Total direct labour hours  predetermined overhead rate
= 8000 hours  $7.80
= $62 400
3 (a) Actual manufacturing overhead incurred during November:

Indirect labour wages $20 000
Supervisory salaries 12 000
Indirect material (supplies) 12 000
Production equipment costs 8 100
Building occupancy costs, factory facilities 8 400
Total $60 500
(b) Overapplied overhead for November, practical capacity rate:
Applied manufacturing overhead – Actual manufacturing overhead
= $60 800 – $60 500
= $300 overapplied
Overapplied overhead for November, normal volume rate:
Applied manufacturing overhead – Actual manufacturing overhead
= $62 400 – $60 500
= $1900 overapplied
The practical and normal volume overhead rates were based on a budgeted monthly volume of 11 250 hours
(135 000 hours/12 months) and 10 000 hours (120 000 hours/12 months) respectively. The actual volume was
only 8 000 hours; thus we would expect overhead to be underapplied, all else being equal. However, whether
overhead is under or overapplied also depends on the behaviour of the actual overhead costs throughout the year
as well as the behaviour of the cost driver, direct labour hours. In this case the actual overhead costs incurred
during the month of November were significantly less than one twelfth of the year’s budgeted manufacturing
overhead of $1 026 000 ($85 500) at practical capacity volume and $936 000 ($78 000) at normal volume. This
situation may signal that further investigation of the costing records is required. The overapplied overhead is less
using the practical capacity rate, because the rate is 20 cents less per hour being based on an extra 15 000 direct
labour hours above the normal volume level.
4 As practical capacity is unlikely to be achieved at all times throughout the year, using the practical capacity rate
is likely to result in some underapplied overhead and therefore understated product cost.
Normal volumes are average over the normal business cycle, which may span two to three years, or longer.
Overhead will be underapplied, and products undercosted, in years when the business operates below the normal
volume and vice versa.
Moreover, both these overhead rates assume that manufacturing overhead is volume driven. The overhead at
HHCL comprises both fixed and variable overhead costs. Indeed in most businesses there are likely to be
significant levels of non-volume-driven (that is, fixed) overheads. Under these circumstances neither of these
conventional overhead rates will result in accurate product costs.

27
PROBLEM 7.39 (40 minutes) Support department cost allocation: manufacturer
1 Direct method:
Production department
Machining Finishing
Cost to be
HR $300 000 (3/9) $100 000 (6/9) $200 000
Maintenance 250 000 (6/15) 100 000* (9/15) 150 000*
Design 350 000 (5/8) 218 750 (3/8) 131 250
Total support department costs
allocated $418 750 $481 250
Overhead costs traceable to
production departments 800 000 500 000
Total overhead cost $1 218 750 $981 250
Budgeted machine hours (MH) for
Machining Department 30 000
Budgeted direct labour hours (DLH)
for Finishing Department 15 000
Overhead rate per hour (total
overhead ÷ MH and DLH) $40.63* $65.42*
* Rounded
2 Sequence for step-down method:

1st: HR (serves 2 other service departments)
2nd: Maintenance (serves 1 other service department)
3rd: Design (serves no other service departments)

28
3 Step-down method:
Service departments Production departments
HR Maintenance Design Machining Finishing
Costs prior to
allocation $300 000 $250 000 $350 000
Allocation of HR
Department costs $300 000 15 000 (5/100) 15 000 (5/100) $90 000 (30/100) $180 000 (60/100)
Allocation of
Maintenance
Department costs 265 000 16 562.50* (5/80) 99 375* (30/80) 149 062.50 (45/80)
Allocation of Design
Department costs 381 562.50 238 476.60 (50/80) 143 085.90 (30/80)
Total cost allocated to
each department 827 851.60 472 148.40
Overhead costs traceable to production departments 800 000 500 000
Total overhead cost 1 627 851.60 972 148.40
Budgeted machine hours (MH) for Machining Department 30 000
Budgeted direct labour hours (DLH) for Finishing Department 15 000
Overhead rate per hour (total overhead ÷ MH and DLH) $54.26* $64.81*
* Rounded

29
PROBLEM 7.40 (40 minutes) Support department cost allocation; departmental overhead
rates; product costing: manufacturer
1 (a) Direct method:
Production Department
Moulding Assembly
Cost to be
Repair $100 000 (3/18) $16 (15/18) $83
666.67* 333.33*
Engineering 580 000 (85/100) 493 000 (15/100) 87 000
Total support department costs $509 $170
allocated 666.67 333.33
$1 009 $910
Total overhead cost 666.67 333.00
Direct hours:
DMH (20  2000) 40 000
DLH (80  2000) 160 000
Overhead rate per hour (total
overhead ÷ DH) $25.24* $5.69*
Check on allocation procedure:
Support department costs allocated to Moulding $509
666.67
Support department costs allocated to Assembly 170
333.33
Total costs to be allocated ($100 000 + $580 000) $680 000
* Rounded
(b) The overhead cost will be (3  $25.24) + (5  5.69) = $104.17

30
2 (a) Step-down method:
Support departments Production departments
Repair Engineering Moulding Assembly
Costs prior to allocation $100 000 $580 000
Allocation of Repair
Department costs 100 000 10 000 (2/20) $15 000 (3/20) $75 000 (15/20)
Allocation of Engineering 501 500
Department costs 590 000 (85/100) 88 500 (15/100)
Total support department
cost allocated $516 500 $163 500
Total overhead cost $1 016 500 $903 500
Direct hours (DH):
DMH (20  2000) 40 000
DLH (80  2000) 160 000
Overhead rate per hour
(total overhead ÷ DH) $25.41* $5.65*
Support department costs allocated to Moulding $516 500
Support department costs allocated to Assembly 163 500
Total costs allocated ($100 000 + $580 000) $680 000
* Rounded
(b) The overhead cost will be (3  $25.41) + (5  5.65) = $104.47

31
PROBLEM 7.41 (30 minutes) Reciprocal service method; departmental overhead rates;
product costing: manufacturer
1 (a) Reciprocal services method:
Equations:
R =100 000 + 0.2E
E = 580 000 + 0.1R
Where:
R denotes the total cost of the Repair Department
E denotes the total cost of the Engineering Department
Solution of equations:
R = 100 000 + 0.2(580 000 + 0.1R)
R = 100 000 + 116 000 + 0.02R
0.98R = 216 000
R = 220 408.20
E = 580 000 + 0.1(220 408.20)
E = 602 040.82
Allocation:
Support departments Production departments

Repair Engineering Moulding Assembly
Traceable costs $100 000 $580 000
Allocation of Repair $165 306.10
Department costs (220 408.20) 22 040.82 (0.1) $33 061.22 (0.15) (0.75)
Allocation of Engineering
Department costs 120 408.16 (0.2) (602 040.82) 409 387.76 (0.68) 72 244.90 (0.12)
Total support department
cost allocated $442 449 $237 551
Total overhead cost $942 449 $977 551
Direct hours (DH):
DMH (20  2000) 40 000
DLH (80  2000) 160 000
Overhead rate per hour
(total overhead ÷ DH) $23.56 $6.11
Support department costs allocated to Moulding $442 449
Support department costs allocated to Assembly 237 551
Total $680 000

32
2 The direct allocation method ignores any service rendered by one support department to another. Allocation of
each support department’s total cost is made directly to the production departments. The step-down method
recognises one support department’s usage of services, but ignores the other’s usage of services. The reciprocal
services allocation method recognises all support department service to other support departments through the
use of simultaneous equations. This allocation procedure is more accurate and may lead to better information
that would be of greater value to management. However, as always, in deciding on the method to use
management needs to weigh up the costs associated with the various methods against the benefits that they offer.
PROBLEM 7.42 (45 minutes) (appendix) Absorption versus variable costing: manufacturer
1
Cost per unit Variable Absorption
Direct material $6.00 $6.00
Direct labour 3.00 3.00
Variable overhead 4.00 4.00
Fixed overhead * 2.00
$13.00 $15.00
budgeted fixed overhead
* Fixed overhead =
budgeted level of production
$ 400 000
=
200 000
= $2 per unit
2 (a)
YoYum Ltd
Absorption costing income statement
for the year ended 30 June
Sales revenue (190 000 units sold at $19 per unit) $3 610 000
Less: Cost of goods sold (at absorption cost of $15 per unit) 2 850 000
Less: Selling and administrative expenses:
Variable (at $2 per unit) 380 000
Fixed 70 000 450 000
Net profit $310 000

33
(b)
YoYum Ltd
Variable costing income statement
for the year ended 30 June
Sales revenue (190 000 units sold at $19 per unit) $3 610 000
Less: Variable expenses:
Variable manufacturing costs (at variable cost of $13 per unit) 2 470 000
Variable selling and administrative costs (at $2 per unit) 380 000 2 850 000
Less: Fixed expenses:
Fixed manufacturing overhead 400 000
Fixed selling and administrative expenses 70 000 470 000
Net profit $290 000
3 Cost of goods sold under absorption costing $2 850 000

Variable cost of goods sold 2 470 000
Difference in cost of goods sold 380 000
Fixed manufacturing overhead as period expense under variable costing 400 000
Total differences between the two methods (20 000)
Net profit under variable costing 290 000
Net profit under absorption costing 310 000
Difference in net profit $(20 000)
4 Difference in fixed overhead expensed under absorption and variable costing

= change in inventory (in units)  predetermined fixed overhead rate per unit
= 10 000 units  $2 per unit
= $20 000
As shown in requirement 2, reported profit is $20 000 lower under variable costing.

34
5
Units sold 190 000
Sales price $ 20.00
Direct material $ 6.50
Direct labour $ 3.00
Variable overhead $ 4.00
Fixed overhead $ 2.00
(a) Absorption costing

Units Cost Total
Sales revenue 190 000 $ 20.00 $ 3 800 000.00
Less: Cost of goods sold 190 000 $ 15.50 $ 2 945 000.00
Gross margin $ 855 000.00
Less: Selling and admin. exp. 190 000 $ 2.00 $ 380 000.00
Fixed expense $ 70 000.00
Net profit $ 405 000.00
(b) Variable costing

Units Cost Total
Sales revenue 190 000 $ 20.00 $ 3 800 000.00
Less: Variable expense 190 000 $ 13.50 $ 2 565 000.00
Variable selling and admin. exp. 190 000 $ 2.00 $ 380 000.00
Contribution margin $ 855 000.00
Less: Manufacturing overhead $ 400 000.00
Fixed expense $ 70 000.00
Net profit $ 385 000.00
PROBLEM 7.43 (50 minutes) (appendix) Normal costing; profit under absorption and
variable costing: manufacturer
1 (a)
Sleepsound Pty Ltd
Income Statement under Absorption Costing
Year Ended 30 June
Sales revenue (13 500 at $60/unit) $810 000
Less: Cost of goods sold (13 500  $19.40)* 261 900
Less: Selling and administrative expenses
Variable 13 500
Fixed 90 000
103 500
Net profit $444 600

35
(b)
Sleepsound Pty Ltd
Income Statement under Variable Costing
Year Ended 30 June
Sales revenue (13 500 units at $60/unit) $810 000

Less: Variable expenses
Variable manufacturing costs
(13 500 at $14.40) 194 400
Variable selling & administrative costs 13 500
207 900
Less: Fixed expenses
Fixed selling and administrative expenses 90 000
Net profit $437 100
*As there are no work in process inventories, or beginning finished goods inventory, all manufacturing costs are related to
finished goods.
Direct material $120 000
Direct labour 60 000
Variable manufacturing overhead 36 000
Variable cost of manufacture $216 000 or $14.40/unit
Absorption cost of manufacture $291 000 or $19.40/unit
2 The absorption costing profit is $7500 higher because 1500 units produced are carried forward as finished goods
inventory. Each unit carries forward a cost of $5.00 for manufacturing overhead that is expensed under variable
costing.
3
Inventory calculations (units):
Finished goods inventory, January 1 ............................................................................. 0 units
Add: Units produced ...................................................................................................... 15 000 units
Less: Units sold .............................................................................................................. 13 500 units
Finished goods inventory, December 31 ....................................................................... 1 500 units
Finished Goods Absorption Costing Variable Costing

1500 units  $19.40 $29 100
1500 units  $14.40 $21 600

36
4 The major arguments for variable costing are:
(a) Variable costing provides useful information for short-term decisions, such as whether to make or buy a
component, and pricing.
(b) Under variable costing, profit is a function of sales and the classification of costs as fixed or variable
makes it simple to plan costs and profits.
(c) Cost volume profit analysis requires a variable costing format.
(d) Variable costing provides a useful perspective of the impact that fixed costs have on profits by bringing
them together and highlighting them, instead of having them scattered throughout the statement.
The major arguments for absorption costing are:
(a) In the modern business environment, there is likely to be a high level of fixed overhead and, therefore, a
relatively small percentage of manufacturing costs may be assigned to products under variable costing. At
Sleepsound more than one-quarter of the manufacturing cost is fixed manufacturing overhead.
(b) In the longer term a business must cover its fixed costs too, and many managers prefer to use absorption
cost in cost-based pricing decisions. They argue that fixed manufacturing overhead is a necessary cost
incurred in the production process.
Generally the arguments in favour of variable costing are considered to outweigh those in favour of absorption
costing. If fixed overhead costs are high, a significant proportion of manufacturing costs may not be assigned to
products under variable costing. However, absorption costing does not solve this problem effectively because of
the distortions caused by using volume-based cost drivers to assign fixed manufacturing overhead costs to
products. Perhaps it would be better to recommend a new approach to costing, such as activity-based costing,
rather than either of these two traditional costing systems.

37
SOLUTIONS TO CASES
CASE 7.44 (50 minutes) Support department cost allocation; plantwide versus departmental
overhead rates; product costing; cost drivers: manufacturer
1 (a) Plantwide overhead rate:

Departments (numbers in thousands)
Moulding Component Assembly Total
Total manufacturing
department overheads $21 000 $16 200 $22 600 $59 800
Support departments:
Power 18 400
Maintenance 4 000
Total estimated overhead $82 200
Estimated direct labour hours (DLH):

Moulding 500
Component 2 000
Assembly 1 500
Total estimated direct labour hours 4 000
Plantwide overhead rate: = estimated overhead

estimated DLH
= $82 200
4 000
= $20.55 per direct labour hour
(b) Overhead cost of Elite case = (4 + 3 + 2)  $20.55 = $184.95

38
Departments (numbers in thousands)
Support Manufacturing
Power Maintenanc Moulding Component Assembly
e
Departmental overhead costs $18 400 $4 000 $21 000 $16 200 $22 600
(a Allocation of maintenance
) costs (direct method).
Proportions: 90/125,
25/125, 10/125 (4 000) 2 880 800 320
(b Allocation of power costs
) (direct method). ($18 400):
Proportions: 360/800,
320/800, 120/800 (18 400) 8 280 7 360 2 760
Total allocated
departmental overhead $0 $0 $32 160 $24 360 $25 680
costs
(c) Cost driver 875 MH 2 000 DLH 1 500 DLH
$36.75* $12.18 $17.12
Rate (departmental overhead ÷ units of cost driver) per MH per DLH per DLH
*Rounded
3 Overhead cost of Elite case = (5 machine hrs  $36.75) + (3 labour hrs  $12.18) + (2 labour hrs  $17.12)
= $254.53
4 Rising Fast Pty Ltd should use departmental rates to assign overhead to its products. The criterion for choosing
an allocation base is a close relationship between cost incurrence and use of the base. This relationship exists
with different bases in different departments, necessitating the use of departmental rates. Rising Fast’s
departments are dissimilar in that the Moulding Department is machine intensive while the other two
departments are labour intensive.

39
CASE 7.45 (40 minutes) Plantwide and departmental overhead rates for decision making:
manufacturer
To: Mr Adam Cornish
From: Cost management analyst
Subject: Tender process
Top Plating’s costing system is based on a single predetermined plantwide overhead rate of $2.75 per labour hour.*
This uniform rate is flawed as the coating department incurs higher overhead costs per labour hour. Look at the
following analysis:
* Budgeted overhead/budgeted labour hours = ($540 000 + $1 440 000)/60 000 × 12 = $2.75 per labour hour
Preparation Coating
Overhead per month 45 000 120 000
Overhead per labour hour $1.50 ($45 000/30 000) $4 ($120 000/30 000)
Using departmental rates:
Job no. Labour hours in prep Overhead Labour hours in coating Overhead Total cost
1 12 000 18 000 3 000 12 000 30 000
2 3 000 4 500 12 000 48 000 52 500
3 15 000 22 500 0 0 22 500
4 0 0 15 000 60 000 60 000
5 7 500 11 250 7 500 30 000 41 250
This would give us a better grasp of the overhead costs. Job 1, which we lost, was probably significantly overcosted
and Job 2, which we won, may have been significantly underpriced. There is another problem here as Job 5, for which
the costing was correct, was still lost.
We need to investigate three factors:
1 Whether the margins we are charging are too high in the current economic climate. Given that we have spare
capacity, we could cut our margins in the short run. We do not want to get into a bidding war and it may be
preferable to emphasise our quality or other areas in which we can perform better than the competition.
2 Whether our overhead cost structure is too high. Are our competitors undercutting us on jobs like number 5
because they have a leaner overhead structure? Or does the problem go back to inefficiencies in the factory, as a
result of which we are using too much material and labour? We need to investigate whether our cost structures
are similar to our competitors.
3 If the general market is quiet, should we be expecting to recover all of our fixed costs on every job? Given that
our fixed costs are significant, we may need to look at just the variable costs of each order for the short run.
At this juncture I would recommend a bidding policy based on the departmental overhead rates. However, there
needs to be more work done to understand why we are uncompetitive and perhaps a move to cut our costs.

40
CASE 7.46 (40 minutes) Absorption and variable costing: manufacturer
1 Absorption costing income statements:
Year 1 Year 2

$125 000a
Sales revenue ................................................................................................................. $125 000d
Less: Cost of goods sold:
Beginning finished goods inventory ...............................................................
$ 0 $ 10 500e
63 000b
Cost of goods manufactured ............................................................................ 56 000f
Cost of goods available for sale ......................................................................
$ 63 000 $ 66 500
c
Ending finished goods inventory .....................................................................
10 500 0
Cost of goods sold ...........................................................................................
$ 52 500 $ 66 500
Gross margin ..................................................................................................................
$ 72 500 $ 58 500
Selling and administrative expenses ..............................................................................
45 000 45 000
Operating profit .............................................................................................................
$ 27 500 $ 13 500
a
2500 units  $50 per unit
b
$21 000 + $42 000 (i.e. both variable and fixed costs)
c
500 units  ($63 000/3 000 units)
d
e
Same as Year 1 ending inventory
f
$14 000 + $42 000 (i.e. both variable and fixed costs)

41
2 Variable costing income statements:
Year 1 Year 2
a
Sales revenue .................................................................................................................
$125 000 $125 000d
Less: Cost of goods sold:
Beginning finished goods inventory ...............................................................
$ 0 $ 3 500e
21 000b
Cost of goods manufactured ............................................................................ 14 000f
Cost of goods available for sale ......................................................................
$ 21 000 $ 17 500
c
Ending finished goods inventory .....................................................................
3 500 0
Cost of goods sold ...........................................................................................
$ 17 500 $ 17 500
Variable selling and administrative costs ..........................................................
$ 25 000 $ 25 000
Total variable costs: .......................................................................................................

$ 42 500 $ 42 500
Contribution margin .......................................................................................................
$ 82 500 $ 82 500
Less: Fixed costs:
Manufacturing .................................................................................................
$ 42 000 $ 42 000
Selling and administrative ...............................................................................
20 000 20 000
Total fixed costs ..............................................................................................
$ 62 000 $ 62 000
Operating profit .............................................................................................................
$ 20 500 $ 20 500
a
b
The variable manufacturing cost only, $21 000
c
500 units  ($21 000/3 000 units)
d
e
Same as Year 1 ending inventory
f
The variable manufacturing cost only, $14 000

42
3 Reconciliation of reported income under absorption and variable costing:
Absorption Costing Variable Costing

Year 1 Income Statement Income Statement
Cost of goods sold ............................................................ $52 500 $17 500
Fixed cost (expensed as period expense)........................... 20 000* 62 000†
Total .................................................................................. $72 500 $79 500
Difference (cost greater on variable

costing income statement) .............................................. $7000
Reported profit .................................................................. $27 500 $20 500
Difference in reported profit (profit

greater on absorption costing profit
statement) ........................................................................ $7000
* Fixed selling and administrative cost only
†
Both fixed selling and administrative cost and fixed manufacturing overhead
Absorption Costing Variable Costing

Year 2 Income Statement Income Statement
Cost of goods sold ............................................................ $66 500 $17 500
Fixed cost (expensed as period expense)........................... 20 000 62 000
Total .................................................................................. $86 500 $79 500
Difference (cost greater on absorption
costing income statement) .............................................. $7000
Reported profit .................................................................. $13 500 $20 500
Difference in reported profit (profit

greater on variable costing profit
statement) ........................................................................ $7000
NOTE: As additional explanation instructors may wish to cover the following:
Actual Difference in Absorption

Change in Fixed Fixed Costing Profit
Inventory Overhead Overhead Minus Variable
Year (in units) Rate Expensed Costing Profit
1 500 increase  $14 $ 7000 $7000
2 500 decrease  $14* $(7000) (7000)
* The 500 units which were sold in year 2, but which were manufactured in year 1, include an absorption-
costing product cost of $14 per unit for fixed overhead. Since these 500 units were manufactured in year 1,
it is the year 1 fixed-overhead rate that is relevant to this calculation, not the year 2 rate.

43
Explanation: At the end of Year 1, under absorption costing, $7000 of fixed overhead remained stored in
finished goods inventory as a product cost (Year 1 fixed-overhead rate of $14 per unit  500 units = $7000).
However, in Year 1, under variable costing, that fixed overhead was expensed as a period cost.
In Year 2, under absorption costing, that same $7000 of fixed overhead was expensed when the units were sold.
However, under variable costing, that $7000 of fixed overhead cost had already been expensed in Year 1 as a
period cost.
4 Total profit across both years:

(a) Absorption costing: $27 500 + $13 500 = $41 000
(b) Variable costing: $20 500 + $20 500 = $41 000
5 Total sales revenue across both years:

Total of all costs expensed across both years:
Total sales revenue minus total costs expensed across both years:
(a) Absorption costing: $250 000 – $209 000 = $41 000
(b) Variable costing: $250 000 – $209 000 = $41 000
6 The total sales revenue across both of Chalk Talk’s first two years of operation is the same under absorption
and variable costing, $250 000, as shown in requirement 5. Sales revenue has nothing to do with the costing
method used. Chalk Talk sold 5000 units in Years 1 and 2 combined, at a sales price of $50. This results in total
sales revenue for the two years of $250 000.
The total of the costs expensed across Years 1 and 2, is the same under both variable and absorption costing, $209 000, as
shown in requirement 5. The reason for this result is that Chalk Talk produced the same number of units that the
company sold, across the two-year period. Chalk Talk produced and sold 5000 units during Years 1 and 2
combined. Thus, the same amount of manufacturing cost is expensed, during the two-year period, under
absorption and variable costing.
Chalk Talk’s combined profit across the two-year period is $41 000 under both absorption and variable costing
(requirement 4). This result must occur, of course, because total sales revenue and total expenses are the same
under both costing methods over the two-year period.
As the analysis in requirement 3 shows, Chalk Talk’s profit is distributed differently across Years 1 and 2 under
absorption and variable costing. Both costing methods yield the same reported profit across the two-year
combined period, but the profit is not the same within each year under the two costing methods. Absorption
costing yields a $7000 higher profit in Year 1 and a $7000 lower profit in Year 2. This result occurs because
under absorption costing, Chalk Talk’s expenses are $7000 lower in Year 1 and $7000 greater in Year 2.
Thus, the timing with which expenses are recognised causes the difference between absorption and variable costing.
Under absorption costing, some of Chalk Talk’s Year 1 fixed manufacturing overhead is not expensed until Year
2, when the units are sold. In contrast, under variable costing all of the Year 1 fixed manufacturing overhead is
expensed in Year 1 as a period cost.

44
7 (a) At the end of Year 1 Chalk Talk had 500 units in its finished goods inventory (production minus sales).
The year-end balance in finished goods inventory is higher under absorption costing because fixed
manufacturing overhead cost is included in the inventory cost as a product cost. In contrast, under variable
costing fixed manufacturing overhead is not included in the inventory cost as a product cost.
(b) At the end of Year 2 Chalk Talk has no finished goods inventory on hand. The two-year total production
of 5000 units is equal to the two-year total sales. Since there is no finished goods inventory at the end of
Year 2, the value of finished goods inventory on the balance sheet is zero no matter what product costing
system is used.
(c) Yes, this relationship will be true at any balance sheet date. For any balance sheet date when the company
has non-zero finished goods inventory, the cost of that inventory measured under absorption costing will
be greater than the cost measured under variable costing. Under absorption costing, fixed manufacturing
overhead is inventoried as a product cost. However, under variable costing, fixed manufacturing overhead
is not inventoried as a product cost. It is treated as a period cost instead and expensed during the period in
which it is incurred.
(d) Finished Goods Inventory

End of Year 1 End of Year 2 Amount of Decline
Absorption costing $10 500 $0 $10 500
Variable costing 3 500 0 3 500
(e) Amount of Decline in Finished

Goods Inventory Balance During Year 2
Absorption costing .........................................................................................................

$10 500
Variable costing .............................................................................................................
3 500
Difference $ 7 000
Reported Profit for Year 2

Absorption costing .........................................................................................................
$13 500
Variable costing .............................................................................................................
20 500
Difference $ (7 000)
Reported profit for Year 2 is $7000 lower under absorption costing. This amount matches the difference
in the amount by which the year-end finished goods inventory balance declined during Year 2 under
absorption versus variable costing. During Year 2, the company sold more units than it produced. Under
absorption costing, $7000 of inventoried fixed manufacturing overhead was expensed during Year 2.
Under variable costing, this fixed manufacturing overhead had already been expensed during Year 1.
Therefore, the year-end balance in finished goods inventory declined during Year 2 by $7000 more under
absorption costing than under variable costing.
(f) Yes, this relationship will always hold true at any balance sheet date. There are two ways to think about
this issue.
(i) As explained in the text, during any time period during which inventory increases (that is, production
exceeds sales), income reported under absorption costing will exceed income reported under variable
costing. This result occurs because under absorption costing, some fixed manufacturing overhead
costs will be stored as product costs and inventoried under absorption costing, but these fixed
manufacturing overhead costs would be expensed as period costs under variable costing.

45
Retained earnings, at any given balance sheet date, is the sum total of all income reported for the firm
across its entire life since its inception (less the sum total of dividends declared). During the entire
life of the enterprise, the company cannot have sold more units in total than it ever produced.
Therefore, over the entire life of the enterprise, inventory cannot possibly have decreased. It will
either have remained at zero or it will have increased. Thus, if we think of the entire life of the
enterprise as its one and only accounting period, inventory has either increased or remained at zero,
and income reported under absorption costing will be at least as great as income reported under
variable costing for that lifetime accounting period.
The following diagram may help to understand the foregoing explanation:
Entire life of the enterprise

up to the current time
Time
One accounting period

Inception of (e.g. month, quarter, Current point
enterprise year, etc.). (During a in time
discrete time period
such as this, inventory
could either increase or
 decrease,
During this life time depending
accounting on inventory has either increased or returned to zero, but it
period,
Inventory is either
cannot have decreased.
the relationship
some positive
Inventory is between production and
 For this life time accounting period, income reported
amountunder absorption costing is greater than or
or zero
zero sales.)
equal to income reported under variable costing.
 Thus, at the end of this life time accounting period, retained earnings reported under absorption
costing will be greater than or equal to retained earnings reported under variable costing.
(ii) Another way to explain the answer to this question involves the basic accounting equation:
Assets = Liabilities + Owners’ Equity

 
Inventory (I) is Retained earnings (RE)
included in assets. is included in owners’
equity.
Ia  Iv Therefore REa  REv

where a denotes absorption costing and v denotes variable costing.
The only elements in the accounting equation that are affected by the choice of absorption or variable
costing are inventory (I) and retained earnings (RE). To maintain the accounting equation, if I (and
therefore assets) are greater under absorption costing, then liabilities and equities must be greater
under absorption costing. Therefore, RE is greater under absorption costing.

46

A Closer Look at Overhead Costs: Answers To Review Questions

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CHAPTER 7

A CLOSER LOOK AT OVERHEAD COSTS

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Cost objects Direct costs Indirect costs

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7.5 The development of departmental overhead rates involves a two-stage process.

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1 Predetermined overhead rate = budgeted manufacturing overhead

(a) $546 000 = $36.40 per machine hour

(b) $546 000 = $18.20 per direct labour hour

(c) $546 000 = $0.867 per direct labour dollar or 86.7%

* Budgeted direct labour cost = 30 000 hours × $21

(a) $510 000 = $30.91 per machine hour

(b) $510 000 = $18.89 per direct labour hour

(c) $510 000 = $0.84 per direct labour dollar or 84%

3 Actual Applied Overapplied or underapplied

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3 Actual Applied Overapplied or underapplied

EXERCISE 7.24 (10 minutes) Two-stage allocation process: hospital

EXERCISE 7.25 (10 minutes) Departmental overhead rates: manufacturer

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3 Material handling cost per mirror:

4 Material handling cost per lens:

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Direct customer service departments using services

Grand total $1 920 000

Direct customer service departments

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Support departments Direct customer service departments

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Increase (decrease) fixed manufacturing cost

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(b) (i) & (ii) Part A200 produced January April

Direct material 200 $200

2 (a) January ($960 × 1.10) $1056

4 (a) & (b) Part A200 produced January April

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Overhead costs are assigned to activity cost pools

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1 Schedule of budgeted overhead costs:

Grand total of budgeted overhead (A + B): $1 600 000

total budgeted overhead

3 Departmental overhead rates:

Predetermined overhead rates........................................................ $1040000 $ 560 000

$52 per $28 per

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5 Revised product prices:

6 CONSTELLATION PERIPHERALS LTD

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(a) (b) (c) (b) ¿ (c)

2 Overhead assigned to each product line:

3 Overhead assigned per unit of each type of printer:

* From the data given in the preceding problem.

Basic...................................................................................... $1965 = $1400 + $565