Source: PCC Case (A), Exhibits 3–5
Tags: overhead rate, plantwide overhead, cost allocation, budgetary process, chart of accounts, operator hours, fully absorbed cost, fee structure, indirect costs, cost driver, cost pool, overhead rate calculation
Difficulty: Intermediate | Prerequisites: Part 1 of this series (PCC overview and operations); familiarity with overhead allocation, cost pools, and cost drivers.
This part digs into how PCC actually costs its clients: the budgetary process, the chart of accounts, the overhead rate calculation, and the fee structure. Understanding these mechanics is essential before you can critique the system (which exam questions will ask you to do). If you are not comfortable with what a plantwide overhead rate is and how it works, review that material first.
PCC uses a single plantwide overhead rate of $55.84 per operator hour (for 2003) to allocate all indirect costs to clients. The rate is calculated by dividing total budgeted indirect costs by total budgeted operator hours. Client profitability is determined by comparing the fee revenue against the fully absorbed cost (direct operator wages plus allocated overhead). The system is borrowed from manufacturing and has significant limitations for a service firm with heterogeneous clients.
Plantwide overhead rate (single overhead rate)
A single rate used to allocate all indirect costs to cost objects (here, clients) using one cost driver. PCC uses operator hours as the sole driver. In simple terms, every indirect dollar gets spread across clients in proportion to how many operator hours they consume, regardless of what actually drives those costs.
Fully absorbed cost
The total cost assigned to a client, combining direct costs (operator wages, training wages) and allocated indirect costs (overhead). Think of it as the "loaded" cost PCC reports for each client.
Overhead rate calculation
Total budgeted indirect costs / Total budgeted operator hours = Overhead rate per operator hour. For 2003: the rate is $55.84 per operator hour.
Direct costs (at PCC)
Costs traced directly to specific clients: operator wages for answering calls (account 10000) and operator training wages (account 10500).
Indirect costs (at PCC)
All other costs, allocated via the overhead rate. This includes operator benefits, overtime, unused operator time, support staff wages and benefits, managerial salaries and benefits, depreciation, communications, supplies, utilities, and miscellaneous expenses (accounts 20000 through 60300).
Chart of accounts
The standardised list of cost categories PCC uses for budgeting and tracking expenses (Exhibit 3). It defines two direct accounts and thirteen indirect accounts.
Budgeted operator hours
The denominator in the overhead rate calculation. Estimated by taking last year's actual hours per client, then adjusting for predicted changes in call volume. For 2003, total budgeted operator hours were 204,600 (204.6 thousand).
Cost driver
The factor used to allocate indirect costs to cost objects. PCC uses a single cost driver: operator hours. The case implicitly questions whether this is the right (or only) driver needed.
Variance analysis (PCC context)
PCC compares actual indirect spending monthly against the annual budget. Accounts exceeding budget are flagged for managerial review. The budget is not revised during the year, even if conditions change significantly.
Step 1: Estimate operator hours per client. Start with actual hours from the prior year, then adjust for predicted changes in call volume. If a client consumed 50 FTE last year and expects a 10% increase, the budget assigns 55 FTE.
Step 2: Estimate indirect costs by account. The CFO (Mary Roby) and her staff consult each department head to estimate the coming year's spending for every indirect account. These estimates are summed to produce each account's budget (Exhibit 4 shows this for account 21000, Support Staff Wages).
Step 3: Calculate the overhead rate. Total budgeted indirect costs / Total budgeted operator hours.
The budget is set annually and not revised mid-year, even if conditions change. Monthly variance reports flag overspending for managerial review.
Two direct cost accounts:
10000: Operator Wages (answering calls), assigned directly to clients
10500: Operator Training Wages, assigned directly to clients
Thirteen indirect cost accounts (20000 through 60300):
20000: Operator Benefits (health care, retirement)
20100: Operator Overtime (paid at 150% of normal)
20200: Unused Operator Time (idle time that cannot be assigned to a client)
21000: Support Staff Wages (secretarial, buildings and grounds staff)
21050: Support Staff Benefits
30000: Managerial Salaries (management team, supervisors, RRT manager, training manager, finance)
30050: Managerial Benefits
40100: Depreciation, Equipment (primarily computer systems)
40200: Depreciation and Property Taxes, Building
50100: Communications (telephone lines, internet)
60100: Supplies
60200: Utilities
60300: Miscellaneous
Total budgeted indirect costs for 2003: $11,426,000 (from Exhibit 5)
Total budgeted operator hours for 2003: 204,600 (i.e. 204.6 thousand hours)
Overhead rate = $11,426,000 / 204,600 = $55.84 per operator hour
Direct costs: sum the operator wages (answering calls + training) dedicated to that client.
Indirect costs: multiply the client's operator hours (including an allowance for down time) by the overhead rate ($55.84).
Fully absorbed cost = Direct costs + Allocated indirect costs.
Key point: PCC uses operator hours rather than operator dollars to avoid penalising clients who happen to have more experienced (and therefore higher-paid) operators assigned to them.
Each operator supports two clients. Down time is split 50-50 between those two clients, regardless of the actual ratio of time spent on each.
Down time is limited to about 10% of total available time through weekly monitoring and reassignment of operators.
Fees are based on operator hours (FTEs) expended on the client over the year.
Each client contract is negotiated separately. PCC's objective is to charge an hourly fee that exceeds the fully absorbed hourly cost by enough to generate an acceptable return.
All operator hours carry the same reported cost, so differences in hourly fees across clients reflect negotiating dynamics, not differences in resource consumption.
Clients are billed monthly based on FTEs dedicated to them that month.
At year-end, PCC provides each client an efficiency report showing total down time and training time for all operators dedicated to that client.
In 2001, Smith Electronics left, and PCC could not replace the lost volume. The overhead previously spread across five clients now falls on four.
In 2002, Gunn Computers renewed at a lower profit margin after contentious negotiations.
By end of 2003, PCC is losing money on the Krag Wireless account and faces contract renewals with both Krag Wireless and Mason Software.
Krag Wireless's CFO has warned PCC it will seek competitive bids. Mason Software wants "reasonable" fees.
Purdy acknowledges costs have risen, partly from higher service levels and partly from lost efficiency.
Total revenue fell from $19,432 (2001) to $16,485 (2002) after losing Smith Electronics, then recovered to $18,038 (2003) with four clients.
Total operator wages fell from $5,464 (2001) to $4,670 (2002) and rose to $5,115 (2003).
Total overhead remained stubbornly high: $10,247 (2000), $11,084 (2001), $11,107 (2002), $11,426 (2003).
Call centre profit dropped sharply from $2,884 (2001) to $708 (2002) when Smith Electronics left, recovering only to $1,496 (2003).
Budgeted operator hours: 205.0 (2000), 218.5 (2001), 186.9 (2002), 204.6 (2003). The 2002 drop reflects the lost client.
PCC's cost system is a textbook example of what happens when a service firm borrows a manufacturing costing model without adapting it. The CFO explicitly says she took the system from her previous manufacturing employer and applied it. This is common in practice: many service firms start with whatever their finance team knows, then discover it does not fit.
The fee-negotiation problems PCC faces (clients pushing back on prices, especially Gunn Computers and Krag Wireless) are a direct consequence of cost-system design. When your costs are wrong, your prices are wrong, and your negotiations start from the wrong baseline.
Students often confuse the overhead rate with the fee rate. The overhead rate ($55.84/hour) is an internal cost-allocation rate. The fee rate is the price charged to clients, which is negotiated separately and is intended to exceed the fully absorbed cost.
Students sometimes think operator benefits are a direct cost because they relate to operators. They are not. At PCC, only operator wages (accounts 10000 and 10500) are direct. Benefits, overtime, and unused time are all indirect.
The budget being fixed for the year does not mean actual spending equals the budget. Variances are computed monthly. It means the benchmark itself is not revised.
Students sometimes assume the overhead rate changed when Smith Electronics left. The rate changes each year based on new budget estimates. In 2002, budgeted hours dropped to 186.9 thousand and overhead stayed roughly flat, so the rate would have been higher that year (around $59.43/hour), squeezing margins.
⚠️ You should be able to calculate the 2003 overhead rate from Exhibit 5 data: $11,426,000 / 204,600 hours = $55.84/hour. Expect a calculation question.
⚠️ Be ready to explain why using operator hours as the sole cost driver is problematic. Different clients consume different mixes of RRT time, training resources, communications bandwidth, and supervisory attention. A single rate assumes all clients consume overhead in the same proportion as they consume operator hours.
⚠️ The case is designed to motivate activity-based costing (ABC). You will likely be asked to identify alternative cost drivers and cost pools. For example, RRT costs could be driven by the number of undocumented problems per client, not operator hours.
⚠️ Understand the profit impact of losing a client in a high-fixed-cost environment. Overhead barely dropped when Smith Electronics left ($11,084 in 2001 to $11,107 in 2002), but operator hours fell from 218.5 to 186.9 thousand.
Fill in the blank: The 2003 overhead rate at PCC is ______ per operator hour. (Answer: 55.84 dollars.)
True or False: PCC revises its budget mid-year if conditions change significantly. (False. The budget is fixed for the year.)
Fill in the blank: PCC has ______ direct cost accounts and ______ indirect cost accounts. (Two direct, thirteen indirect.)
True or False: The overhead rate uses operator dollars as the cost driver. (False. It uses operator hours, to avoid penalising clients with more experienced operators.)
True or False: All clients pay the same hourly fee. (False. Each contract is negotiated separately.)
Q: Calculate the 2003 overhead rate using data from Exhibit 5. Show your working.
A: Total budgeted overhead for 2003 = 11,426 thousand. Total budgeted operator hours = 204.6 thousand = 204,600 hours. Overhead rate = 11,426,000 / 204,600 = 55.84 per operator hour.
Q: Why does PCC use operator hours rather than operator dollars as its cost driver?
A: Operators are paid based on experience, with experienced operators earning about 25% more than new hires. PCC does not assign operators to clients based on experience level. Using dollars would penalise a client simply because it happened to have more experienced operators on its account, which would not reflect actual resource consumption.
Q: Explain why PCC's overhead barely declined in 2002 despite losing Smith Electronics. What does this imply about the nature of PCC's overhead costs?
A: Total overhead went from 11,084 thousand (2001) to 11,107 thousand (2002), a slight increase. This implies that most of PCC's overhead costs are fixed or semi-fixed: managerial salaries, depreciation, building costs, and communications do not decrease proportionally when one client leaves. Only variable components (like some operator benefits or supplies) would decline with volume, and these are a small share of total overhead.
Q: Describe the budgeting process PCC uses to estimate account 21000 (Support Staff Wages). Why does this account require input from multiple department heads?
A: The CFO talks to each department head to estimate their support staff wages for the coming year: Jack Ryan for RRT wages, Dick Morgan for buildings and grounds, plus estimates for the CEO's executive assistant, and each department's secretarial staff. The account requires multiple inputs because support staff are employed across every department, not just one.
Q: What strategic risks does PCC face heading into the Krag Wireless and Mason Software contract renewals at end of 2003?
A: PCC is currently losing money on Krag Wireless and must raise fees to cover higher costs. Krag has signalled it will seek competitive bids. If PCC raises fees too aggressively, it risks losing Krag, which would repeat the Smith Electronics scenario: fixed overhead spread across even fewer clients, further raising the per-hour cost and squeezing margins on the remaining accounts. Mason Software is less price-sensitive but still wants reasonable fees.
The single overhead rate at PCC is the canonical setup for introducing activity-based costing (ABC). Part 3 of this series will explore how ABC would allocate costs differently and produce different client-profitability pictures.
The fixed-cost stickiness when Smith Electronics left connects to cost behaviour analysis (fixed vs variable costs) and to the concept of relevant range: PCC's overhead structure was built for five clients, and running at four-client capacity means carrying excess fixed costs.
The fee-negotiation dynamics connect to target costing and pricing strategy: PCC needs to understand its true cost per client before it can set a price that covers costs and earns a return.
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