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Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd
IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e
1
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.
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 - Measuring tsunami recovery costs: an overhead or not?’ on page 276)
follow:

2
Cost objects Direct costs Indirect costs
Programs to deliver
immediate disaster relief
• Campaign and administrative costs
that can be directly traced to
specific program
• Salaries of program designer and
planners
• Salaries of appeal workers
• Salaries of relief workers in
disaster area
• Transport of staff and relief goods
to disaster area
• Accommodation for relief workers
• Technical and logistical consulting
costs
• Food and clean water
• Medicines
• Temporary shelter
• General office and administrative
costs of NGO (depreciation of
office equipment, general
stationery and postage, rent,
cleaning, general accounting and
office staff salaries, bank fees etc)
• Salaries of CEO and top
management
• Legal, insurance and risk
management costs not directly
traceable
• Marketing, advertising, publishing
and other costs for general
awareness and fund raising
campaigns
• Consulting and advocacy activity
costs of seeking change in
government and institutional
policies
• External audit and reporting costs
Projects to:
• rebuild after a disaster
event
• construct additional
infrastructure
• deliver long-term
community development
• Administrative costs that can be
directly traced to specific projects
• Salaries of project designers and
planners
• Salaries of staff involved in project
field work
• Transport of staff and materials to
field
• Accommodation for field staff
• Technical and engineering
consulting costs
• Building and infrastructure
materials
• General office and administrative
costs of NGO (depreciation of
office equipment, general
stationery and postage, rent,
cleaning, general accounting and
office staff salaries, bank fees etc)
• Salaries of CEO and top
management
• Legal, insurance and risk
management costs not directly
traceable
• Marketing, advertising, publishing
and other costs for general
awareness and fund raising
campaigns
• Consulting and advocacy activity
costs of seeking change in
government and institutional
policies
• External audit and reporting costs

3
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 advertising 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 advertising 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’ advertising 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 advertising 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 bank may include cheque processing, tellers, loan departments and so
on. Examples of support departments in a restaurant 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.

4
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. Using theoretical capacity as the denominator will result in lower
overhead rates and product costs, but there will be higher levels of underapplied overhead.
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
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.

5
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.

6
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.

7
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 =
driver
cost
of
level
budgeted
overhead
ing
manufactur
budgeted
(a) $546 000
15 000 machine hours
= $36.40 per machine hour
(b) $546 000
30 000 direct labour hours
= $18.20 per direct labour hour
(c) $546 000
$630 000*
= $0.867 per direct labour dollar or 86.7%
of direct labour cost
*Budgeted direct labour cost = 30 000 hours x $21
Actual overhead rate = actual manufacturing overhead
actual level of cost driver
(a) $510 000
16 500 machine hours
(b) $510 000
= $18.89 per direct-labour hour
(c) $510 000
$607 500*
= $0.84 per direct labour dollar or 84%
of direct labour cost
*Actual direct-labour cost = 27 000 hours x $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
budgeted level of cost driver
$546 000
15000 machine hours
2 Business cards 600  $36.40 = $21 840
Wedding invitations 300  $36.40 = $10 920
Promotion flyers 200  $36.40 = $7280
3 Actual
manufacturing
overhead
−
Applied
manufacturing
overhead
=
Overapplied or underapplied
overhead
$51 000 − (1100)($36.40) = $10 960 underapplied

8
Exercise 7.23 (30 minutes) Predetermined plantwide overhead rate; alternative cost drivers
budgeted manufacturing overhead
budgeted level of cost driver
(a)
$546 000
= $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
manufacturing
overhead
−
Applied
manufacturing
overhead
=
Overapplied or underapplied
overhead
(a) $51 000 − (1800)($18 20) = $18 240 underapplied overhead
(b) $51 000 – (1800)($22.50)(1.30)† = $1650 overapplied overhead
† 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) 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
$1418
Exercise 7.25 (15 minutes) Volume-based cost driver versus ABC: manufacturer
1 Material handling cost per mirror:
$180000
60
( ) 500
( )+ 60
( ) 500
( )
é
ë ù
û*
´ 500 = $1500
* 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
120*
= $1500
* The total number of units (of both types) produced.

9
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 + 32
( )
*
´8
60
= $600
* The total number of material moves.
4 Material handling cost per lens:
$180 000
8 + 32
( )
*
´ 32
60
= $2400
* The number of material moves for the lens product line.
Exercise 7.26 (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.
Exercise 7.27 (10 minutes) Direct method of support department cost allocation: bank
Direct customer service departments using services
Deposit Loan
Provider of service
Cost to be
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

10
Exercise 7.28 (15 minutes) Step-down method of support department cost allocation: bank
Human
resources Computing
Direct customer service departments
using services
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

11
Exercise 7.29 (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)
C = 1 400 000
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 7.30 (20 minutes) (appendix) Variable and absorption costing
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

12
2
PorterLtd
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)
in units in inventory

fixed manufacturing cost
per unit
= difference in profit
1500 units  $8 = $12 000 more under
absorption costing

13
SOLUTIONS TO PROBLEMS
Problem 7.31 (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.

14
Problem 7.32 (25 minutes) Predetermined plantwide overhead rate; different time periods;
pricing: manufacturer
1 (a)
Estimated
manufacturing
overhead
Estimated direct
labour hours
(DLHs)
Quarterly
predetermined
overhead rate
(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 x 1.10) $1056
(b) April ($1000 x 1.10) $1100
3
Estimated
manufacturing
overhead
Estimated direct
labour hours
(DLHs)
Quarterly
predetermined
overhead rate
(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 x overhead
rate of $8.89 per DLH) 177.80 177.80
$977.80 $977.80

15
5
Price is cost plus 10% markup
i.e. $977.80 x 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.

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