Managerial/Cost Accounting
Difficulty: Intermediate | Prerequisites: Basic understanding of overhead allocation and cost drivers
This topic sits at the heart of managerial accounting: how a firm allocates indirect costs (overhead) to products. If the allocation method is wrong, product costs are wrong, and that distorts pricing, sourcing, and product-mix decisions. Seligram's Electronic Testing Operations (ETO) is a textbook case of a cost system that worked when labour was the dominant cost, then broke as technology took over. You should already be comfortable with the idea of cost pools, cost drivers, and overhead rates before diving in.
Seligram's ETO division used a single overhead rate based on direct labour dollars, which increasingly mispriced products as automation replaced manual testing. Splitting overhead into two pools (direct labour + machine hours) and then three pools (direct labour + main room hours + mechanical room hours) produced progressively more accurate product costs. The case illustrates why cost systems must evolve with the underlying cost structure of a business.
ETO (Electronic Testing Operations)
Seligram's centralised testing division, responsible for both electronic and mechanical testing of components before they ship to other divisions.
Think of it as the in-house quality-control lab that every product must pass through.
Cost pool
A grouping of individual indirect costs that share a common cost driver. The number and composition of cost pools determines how overhead is spread across products.
In simple terms, it is the "bucket" of overhead costs you are going to allocate using one rate.
Cost driver (allocation base)
The measurable factor used to assign costs from a pool to products. Common drivers include direct labour dollars, direct labour hours, and machine hours.
Think of it as the thing you believe actually causes the overhead to be incurred.
Burden rate (overhead rate)
The ratio of total overhead in a pool to the total amount of the cost driver. Multiply the burden rate by a product's usage of the driver to get its share of overhead.
In simple terms, it is the "price per unit of driver" for overhead.
Single cost pool system
An allocation method that lumps all overhead into one pool and applies it using a single driver (here, 145% of direct labour dollars).
Two cost pool system
Splits overhead into two pools: one allocated by direct labour dollars (20% rate) and one allocated by total machine hours ($80 per machine hour).
Three cost pool system
Splits overhead into three pools: direct labour (20%), main testing room machine hours ($63 per hour), and mechanical room machine hours ($113 per hour).
Product cross-subsidisation (cost distortion)
When one product absorbs more than its fair share of overhead and another absorbs less, making the first look too expensive and the second too cheap.
Think of it as one product quietly paying part of another product's bill.
ETO is Seligram's centralised testing operation for electronic components
It operates as a cost centre, transferring products to other divisions at full cost (direct costs + allocated overhead)
Testing takes place in two rooms: the main testing room (electronic testing) and the mechanical room (mechanical testing)
As technology advanced, automated testing equipment replaced manual labour, but the cost system did not keep pace
All overhead is lumped into one pool and allocated at 145% of direct labour dollars.
Cost formula: Total cost = Direct labour $ + (1.45 x Direct labour $)
Product | Direct labour ($) | Overhead at 145% ($) | Total cost ($) |
|---|---|---|---|
ICA | 917 | 1,330 | 2,247 |
ICB | 2,051 | 2,974 | 5,025 |
Capacitor | 1,094 | 1,586 | 2,680 |
Amplifier | 525 | 761 | 1,286 |
Diode | 519 | 753 | 1,272 |
The overhead rate is anchored entirely to direct labour dollars, yet direct labour has been declining steadily (the D.L. Hours Per Lot chart in Exhibit 4 shows a clear downward trend from 1985 to 1988)
The real cost drivers have shifted to technology (expensive automated test equipment) and outside vendor certification
Products that use a lot of labour but little machine time are overcosted; products that are machine-intensive but light on labour are undercosted
This cross-subsidisation distorts the product mix: managers see the wrong costs and make the wrong sourcing and pricing decisions
A labour-heavy product (like component A in Example 1 from the notes) absorbs too much overhead relative to the resources it truly consumes
A machine-heavy product (like component B in Example 2) appears cheaper than it really is, because the expensive automated equipment cost is hidden inside a labour-based rate
In both cases the product mix will not reflect actual economic cost
Overhead is split into two separate pools, each with its own driver:
Pool 1: allocated by direct labour dollars (at a 20% rate)
Pool 2: allocated by total machine hours (at $80 per machine hour)
This recognises that overhead is consumed differently in different parts of the testing process. The electronic and mechanical testing rooms do not use the same mix of labour and equipment, so a single rate cannot capture both.
Product | Direct labour ($) | Overhead on DL ($) | Machine hours | Overhead on machine hrs ($) | Total cost ($) |
|---|---|---|---|---|---|
ICA | 917 | 183 | 18.5 | 1,480 | 2,580 |
ICB | 2,051 | 410 | 40 | 3,200 | 5,661 |
Capacitor | 1,094 | 219 | 7.5 | 600 | 1,913 |
Amplifier | 525 | 105 | 5 | 400 | 1,030 |
Diode | 519 | 104 | 12 | 960 | 1,583 |
Machine hours now carry the largest share of the overhead burden, which better reflects the true cost structure of a technology-driven testing operation
Direct labour overhead shrinks to a much smaller proportion
Costs go up for Diode and ICA (both are relatively machine-intensive for their labour cost)
Costs go down for ICB, Capacitor, and Amplifier (their labour cost was inflating their overhead under the old system)
The shift shows that the single pool was systematically cross-subsidising products
\text{Total Cost} = \text{DL\$} + (1.45 \times \text{DL\$}) = 2.45 \times \text{DL\$}\text{Total Cost} = \text{DL\$} + (0.20 \times \text{DL\$}) + (80 \times \text{Machine Hours})\text{Burden Rate} = \frac{\text{Total Overhead in Pool}}{\text{Total Cost Driver Units}}To find a product's overhead from any pool, multiply the burden rate by that product's consumption of the driver.
Students often think "more cost pools = always better." Adding pools only helps if each pool captures a genuinely different pattern of resource consumption. A fourth pool that behaves identically to the third adds complexity without improving accuracy.
Students sometimes assume that the product with the highest total cost is the one being overcosted. Overcosting and undercosting depend on the relationship between a product's driver consumption and the allocation base, not on its absolute cost level.
A common error is to confuse a burden rate with a markup. The burden rate allocates existing overhead to products for internal costing. A markup is a pricing decision layered on top of cost.
Students occasionally think that switching from labour-based to machine-based allocation will always raise costs for machine-heavy products. It depends on whether those products were previously cross-subsidised in their favour or against them.
Be ready to explain why a single cost pool based on direct labour becomes unreliable when automation increases. This is the central argument of the case.
You may be asked to calculate product costs under each system and explain which products are overcosted or undercosted under the old system versus the new. Know the tables.
Expect a question on what happens to the product mix when costs are distorted: managers may outsource products that look expensive but are actually cheap, or underprice products that look cheap but consume expensive resources.
The link between cost system design and firm strategy is a favourite exam angle. A bad cost system does not just produce wrong numbers; it drives wrong decisions.
True or false: Under the single cost pool system, a product's overhead allocation depends entirely on its direct labour cost. (True)
Fill in the blank: The single pool burden rate in the existing Seligram system is ___% of direct labour dollars. (145%)
True or false: Adding machine hours as a second cost driver reduced the reported cost of ICB. (False. ICB's cost rose from 5,025 to 5,661 under the two pool system.)
True or false: A product that uses many machine hours but little labour will tend to be undercosted by a labour-based overhead rate. (True)
Fill in the blank: In the two pool system, overhead on machine hours is calculated at ___ per machine hour. (80)
Q: What is the main flaw of Seligram's existing single cost pool system?
A: The system allocates all overhead based solely on direct labour dollars, even though direct labour is declining and the real cost drivers are now technology and vendor certification. This causes systematic mispricing of products.
Q: Under the single pool system, which products are likely overcosted and which are undercosted?
A: Products with high labour hours relative to their machine usage are overcosted (they absorb too much overhead). Products that are machine-intensive but light on labour are undercosted (their true resource consumption is hidden).
Q: Calculate the total cost of the Amplifier under the two cost pool system.
A: Direct labour (525) + overhead on DL (0.20 x 525 = 105) + overhead on machine hours (5 x 80 = 400) = 1,030.
Q: Why does adding a second cost pool based on machine hours improve accuracy?
A: Because it separates the technology-driven portion of overhead from the labour-driven portion, allowing each to be allocated by the driver that actually causes it. Products that use more machine time pick up more of the equipment-related overhead, and products that use more labour pick up more of the labour-related overhead.
Q: What strategic risk does a distorted cost system create for Seligram?
A: Managers may make wrong product-mix, pricing, and outsourcing decisions. They could discontinue products that appear expensive but are actually profitable, or continue products that appear cheap but are actually unprofitable.
This case is a stepping stone to activity-based costing (ABC). If you understand why Seligram needed more cost pools, you already understand the core motivation behind ABC: different activities consume resources in different patterns, and a single volume-based driver cannot capture that. The three cost pool system here is essentially a simplified ABC model.
The concept of cost distortion also connects to transfer pricing. ETO operates as a cost centre and transfers at full cost; if those costs are wrong, the receiving division's profitability picture is wrong too.
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