Seligram, Inc.

: Electronic Testing Operations

 Assignment Questions

1. What caused the existing system at ETO to fail?

2. Calculate the reported costs of the five components
described in
a. The existing system
b. The system proposed by the accounting manager
c. The system proposed by the consultant
3. Which system is preferable? Why?
4. Would you recommend any changes to the system you
prefer? Why?
5. Would you treat the new machine as a separate cost center
or as part of the main test room?
Q1. What is ETO’s competitive situation?
• ETO tests electronic components.
• These components are supplied by its customers.
• ETO therefore has no direct material costs, only direct labor
and overhead.
• Testing processes are becoming more complicated and
require increasingly more expensive and less labor-intensive
equipment.
• In addition, customers are moving to Just-in-Time (JIT)
production, which leads to smaller, more frequent lots.
• However, statistical quality-control procedures remove the
need to test every lot.
Q2. Describe ETO’s existing cost system?
Q3. How is the 145% burden rate calculated?
• The existing cost system is very simple.
• It contains only one cost center (the entire facility).
• All overhead is collected into a single cost pool, and the total
overhead cost is divided by the total number of direct labor
dollars consumed to give a single direct labor dollar burden
rate. (see Exhibit 1 & 3)
The Existing Cost System
Q4. What are the reported costs of the five
products listed in Exhibit 6?
• One-Center System
Direct Labor Overhead
Product $ @ 145% Total
IC A 917 1330 2247
IC B 2051 2974 5025
Capacitor 1094 1586 2680
Amplifier 525 761 1286
Diode 519 753 1272
Q5. What is wrong with the existing system?
• The major flaw in the existing system is that it assumes that
all products consume direct labor and overhead in the same
proportion.

• This assumption is designed into the cost system by the use of

only one cost pool and direct labor dollars as the second-
stage allocation base.

• This assumption is flawed.

• Some products are produced on simple labor intensive

equipment and other require very expensive automated
equipment.

• Therefore, it is extremely unlikely that all products consume

direct labor and overhead in the same proportion.
Q6. Why did they implement the existing
system in the first place?
• The assumption that all products consume overhead and
direct labor in the same proportion was probably quite
accurate when the facility was first opened.
• All of the testing was labor intensive and undertaken on
simple machines.
• While some products consumed more overhead per direct
labor hours than others, the variations probably were not
that great.
• However, over the years, the introduction of new
technologies and testing equipment not only changed the
ratio of direct labor to overhead consumption, but also has
increased the variation across products of that ratio.
• The existing cost system cannot capture the economics of this
product diversity.
• The system has slowly become obsolete.
• Management has become aware of the obsolescence
primarily because of customer complaints.
• The inability of the existing system to capture the relationship
between the consumption of labor and overhead for
different types of product can lead to under / over costing.
Q7. How did ETO propose redesigning the cost
system to overcome its failings?
• There are two techniques that ETO uses to improve its cost system.
• The first is to increase the number of cost centers, the other is to
change the second-stage allocation base.
• Increasing the number of cost centers enables the cost system to
capture differences in the way overhead is consumed in different
parts of the production process.
• For example, the three-center system differentiates between the
electronic and mechanical testing rooms.
• The cost system still assumes, however, that all products in each
center consume overhead in the same proportion as the allocation
base.
• Changing the second-stage allocation base allows the system to
capture better the consumption of overhead by individual
products.
• In the electronic test room, direct labor hours have ceased to be a
good estimate of the effort expended on the testing process.
Q8. What is the structure of the cost system suggested
by the center’s accounting manager?
 Two-Center Proposed System

• Two cost pools

• Overheads being divided into Engineering and Admin
Technical (Allocation Basis – Direct Labor Dollar)
• 2nd is on the Test Rooms (Allocation Base – Machine
hours)
Q9. What are the reported costs of the five
products listed in Exhibit 6 using this cost
system?
• Two Center System

Overhead (Machine Hrs) Overhead (DL$)

Direct Labor Test Room ($) Admin & Tech ($)
Product $ (=$80.10 per hr.) Hours 20% of Direct Labor Total
IC A 917 1482 18.5 183 2582
IC B 2051 3204 40 410 5665
Capacitor 1094 601 7.5 219 1914
Amplifier 525 401 5 105 1031
Diode 519 961 12 104 1584

• For $80.10 and 20% calculations (see Exhibit 5 & 6)

Q10. What insights are provided by the new
cost system (i.e. two-center) that were not
provided by the one – center system?
• ICA, ICB, and the diode all consume a relatively large number
of machine hours as compared to the capacitor and the
amplifier. (see Total cost of ICA, ICB and diode have increased
from one center)
• Thus switching to machine hours in the test room causes
more costs to be allocated to these products.
• Their supported costs therefore go up.
• The reported costs of the other two products in contrast
decrease, since they consume a relatively low number of
machine hours.
Q11. What is the structure of the cost system
suggested by the consultant?
 Three-Center Proposed System

• Three cost pools

• Overheads being divided into Engineering and Admin
Technical (Allocation Basis – Direct Labor Dollar)
• 2nd is on the Main Test Rooms (Allocation Base –
Machine hours)
• 3rd is on the Mechanical Test Rooms (Allocation Base
– Machine hours)
Q12. What are the reported costs of the five
products listed in Exhibit 6 using this cost
system?
• Three – Center System

Overhead
Overhead Overhead Direct
(Machine Main - Machine Mech Labor
hrs) ($) (Machine hrs. ($) (Machine ($)20% of
Direct Labor (=$63.73 hrs) (=$113.29 hrs.) Direct
Product $ per hr) Hours per hr) Hours Labor Total
IC A 917 542 8.5 1133 10 183 2775
IC B 2051 892 14 2946 26 410 6299
Capacitor 1094 191 3 510 4.5 219 2014
Amplifier 525 255 4 113 1 105 998
Diode 519 446 7 566 5 104 1635

• For $63.73, $113.29 and 20% calculations (see Exhibit 5 & 6)

Q13. What insights are provided by the three
center cost system that were not provided by the
other two?
• The mechanical burden rate is $113.29 per machine hr
compared to $63.73 for the main test room. Therefore,
components that consume relatively more mechanical
machine hrs compared to main machine hrs will have higher
reported product costs. These are ICA, ICB, capacitor and the
diode.
• For some products, the two corrections reinforce each other,
whereas for others, they counteract. For example, the
reported cost of ICB goes up 13% with the introduction of the
second cost center and up an additional 11% with the
introduction of the third center. In contrast, the reported cost
of the capacitor goes down with the introduction of the
second center and up with the introduction of the third one.
• Ratio’s of Reported Costs
Product One Center Two Center Three Center Two/One Three/Two Three/One
IC A 2247 2582 2775 1.15 1.07 1.24
IC B 5025 5665 6299 1.13 1.11 1.25
Capacitor 2680 1914 2014 0.71 1.05 0.75
Amplifier 1286 1031 998 0.80 0.97 0.78
Diode 1272 1584 1635 1.25 1.03 1.29
Total 12510 12776 13721 5.03761 5.2400 5.3022
Absolute 0.2024 0.0622 0.2646
Change 20% 6% 26%

• The magnitude of the overall changes decreases as the

number of centers increases. While this decrease is
dependent upon the order in which cost centers are
introduced, if the system designer understands the economics
of production, he or she should be able to identify where
adding on additional cost centers will have the greatest effect.
• The three systems report different costs for each product. It
is natural to question which is the more accurate system.
• Levels of product-cost accuracy can be depicted by a target
(see below figure). “True” product costs are represented by
the bull’s eye.
• With most traditional cost systems, the level of accuracy is
somewhere on the fringes of the target. As the system is
refined to give greater and greater accuracy, it moves closer
and closer to the “true” cost.
• The selection of an optimum cost system is based on trade-
offs between increased accuracy and the cost of system
redesign.
The Accuracy Target
Q14. Should the new machine be a separate
cost center?
• Burden Rate for New Machine (See Exhibit 7)

Burden Variable Depreciation Other Total

$2,25,000
(1,50,000 +
Machine Costs $1,00,000 $5,00,000 75,000) $8,25,000
Ist Year Machine hrs 4000 x 10% = 400 hrs
Burden rate/
machine hr $250 $1,250 $562.50 $2,062.50

Machine Costs $1,00,000 $1,25,000 $1,50,000 $3,70,000

Machine hrs 4000 x 60% = 2400 hrs

Nth year
Burden rate/
machine hr $41.67 $52.08 $62.50 $156.25
• Main Test Room Burden Rates with new Machine Included
Depreciation
Burden Variable ($) ($) Other ($) Total ($)
Existing Costs 8,87,379 88,779 11,26,958 21,03,116
2,25,000
(1,50,000 +
Machine Costs 1,00,000 5,00,000 75,000) 8,25,000
Ist Year
Total Costs 9,87,379 5,88,779 13,51,958 29,28,116
Machine hrs 33,000 + 400 = 33,400 hrs
Burden rate/
machine hr 29.56 17.63 40.48 87.67
Existing Costs 8,87,379 88,779 11,26,958 21,03,116
Machine Costs 1,00,000 1,25,000 1,50,000 3,75,000
Nth year Total Costs 9,87,379 2,13,779 12,76,958 24,78,116
Machine hrs 33,000 + 2,400= 35,400
Burden rate/
machine hr 27.89 6.04 36.07 70.0
• The new machine burden rate of @2,062.50 per hour for the
first year is very different from $63.73 out of the main test
center.
• Using the double-declining-balance depreciation method on
the new machine creates a problem because, the
depreciation expense varies so dramatically from year to year.
• For simplicity, if we use one-eighth of the cost of the machine
to give an average picture, we get a machine burden rate of
$156.25 per machine hour.
• This is sufficiently different from the main test room rate of
$63.73 per machine hour to require the machine be treated
as a separate cost center.
• If you want to think only about the variable costs, then you
can compute the variable burden rate.
• Then these are $27.89 ($8,87,379 / 33,000 hrs) for the main
room under the three-center cost system without the
machine, and $250 and $41.67 for the first and subsequent
years for the new machine alone.
• These rates also suggest that the machine should be treated
as a separate center.
Read the Case: Siemens Electric Motor Works
(Learning Outcome – Activity Based Costing)