Managerial/Cost Accounting
Difficulty: Intermediate | Prerequisites: Part 1 of these notes (single and two cost pool systems)
Part 1 showed why Seligram's single cost pool failed and how a two pool system improved accuracy. This part takes it further: separating the main testing room from the mechanical room creates a three pool system that captures the fact that mechanical testing is nearly twice as expensive per machine hour as electronic testing. It then asks what to do with a brand-new machine that serves only two customers, a question that tests whether you understand when to create a new cost pool versus folding costs into an existing one.
The three cost pool system splits machine-hour overhead by room (main at 63 per hour, mechanical at 113 per hour), producing the most accurate product costs of the three approaches. When a new machine is introduced for only two customers, the case shows that giving it a separate cost pool creates an absurdly high burden rate; folding it into the main test room keeps the rate sensible.
Three cost pool system
An overhead allocation approach using three separate pools and drivers: direct labour dollars (20% rate), main testing room machine hours (63 per hour), and mechanical room machine hours (113 per hour).
Think of it as giving each room its own "price tag" for machine time, rather than averaging them together.
Main testing room (electronic testing room)
The room where electronic testing takes place. Its overhead rate per machine hour is lower (63) because the equipment mix is less capital-intensive than the mechanical room.
Mechanical room
The room where mechanical testing takes place. Its overhead rate per machine hour is higher (113), reflecting more expensive equipment and different resource consumption patterns.
Burden rate comparison
The exercise of comparing what happens to the overhead rate when a new machine is placed in its own separate cost pool versus being folded into the main test room pool. The case uses this to illustrate the volume effect on burden rates.
Total cost = Direct labour cost + (0.20 x DL cost) + (63 x Main room hours) + (113 x Mechanical room hours)
Product | Direct labour | Overhead DL | Main room hrs | Overhead (main) | Mech room hrs | Overhead (mech) | Total cost |
|---|---|---|---|---|---|---|---|
ICA | 917 | 183 | 8.5 | 536 | 10 | 1,130 | 2,766 |
ICB | 2,051 | 410 | 14 | 882 | 26 | 2,938 | 6,281 |
Capacitor | 1,094 | 219 | 3 | 189 | 4.5 | 509 | 2,011 |
Amplifier | 525 | 105 | 4 | 252 | 1 | 113 | 995 |
Diode | 519 | 104 | 7 | 441 | 5 | 565 | 1,629 |
The mechanical room carries a much higher burden rate (113 per machine hour) than the main room (63 per machine hour), nearly 1.8 times as much
Products that spend more time in the mechanical room, such as ICB (26 hours) and ICA (10 hours), now pick up significantly more overhead
The Amplifier, which spends only 1 hour in the mechanical room, sees its cost drop to 995, the lowest of all products
Separating the rooms reveals cost differences that were invisible when machine hours were pooled together
Product | Single pool | Two pools | Three pools |
|---|---|---|---|
ICA | 2,247 | 2,580 | 2,766 |
ICB | 5,025 | 5,661 | 6,281 |
Capacitor | 2,680 | 1,913 | 2,011 |
Amplifier | 1,286 | 1,030 | 995 |
Diode | 1,272 | 1,583 | 1,629 |
ICA and ICB rise with each refinement, confirming they were systematically undercosted by the single pool system (their machine-intensive, mechanical-room-heavy profile was hidden behind a labour-based rate)
Capacitor and Amplifier fall with each refinement, confirming they were overcosted under the single pool
Diode rises from single to two pools, then rises slightly again to three pools, suggesting it too was modestly undercosted
The three pool costs are the most accurate because the burden is distributed by the drivers that actually cause each type of overhead, rather than being averaged across the whole operation
Seligram is acquiring a new, expensive testing machine that will serve only two customers. The question is whether to put it in its own separate cost pool or fold it into the main test room pool.
Scenario | Burden rate (1 year) | Burden rate (3 year) |
|---|---|---|
New machine as separate cost pool | 2,062 | 221 |
New machine as part of main test room | 88 | 74 |
The machine's fixed costs (depreciation, maintenance, setup) are substantial, but its volume in the first year is tiny because only two customers use it. Dividing large fixed costs by a small number of machine hours produces a burden rate of 2,062 per machine hour, which is absurdly high and would make those two customers' products look unreasonably expensive.
Over three years, volume grows enough to bring the rate down to 221, but this is still much higher than the main room rate.
Fold the new machine into the main test room pool. The main room's large volume of machine hours absorbs the new machine's fixed costs without significantly distorting the rate (88 in year one, 74 over three years). This avoids penalising the two customers who use the machine while still capturing its costs in the overhead allocation.
The notes recommend using 88 (the one-year rate with the machine folded into the main room) rather than the three-year averaged rate. This is the more conservative choice for the first year, and it avoids relying on volume projections that may not materialise.
This is how manufacturers decide whether to set up a dedicated production line (with its own cost pool) or share equipment across products. A pharmaceutical company introducing a low-volume speciality drug faces the same question: does the drug get its own cost pool, or does its testing cost fold into the broader lab overhead? The answer hinges on volume and fairness to other products.
The principle also applies in service firms. A consulting firm that buys expensive analytics software used by only two clients faces the same trade-off between a separate and a shared cost pool.
Students often think the three pool system is "better" simply because it has more pools. The improvement comes from the fact that the two rooms have genuinely different cost structures (113 vs 63 per machine hour). If both rooms had similar rates, splitting them would add complexity without much accuracy gain.
A common mistake is to assume the new machine should always get its own cost pool because it is new and different. The case demonstrates that volume matters: a separate pool with tiny volume produces a wildly inflated rate.
Students sometimes confuse the one-year and three-year burden rates. The one-year rate reflects actual current volume; the three-year rate smooths over ramp-up. Neither is universally "correct," but the case favours the one-year rate as the safer first-year choice.
Some students read the cost comparison table and conclude that ICB is the most expensive product to test. ICB has the highest absolute cost, but that does not mean it is overcosted. Its cost is high because it genuinely consumes the most resources across all three drivers.
Be prepared to calculate product costs under the three pool system using the formula: DL + 0.20 x DL + 63 x main room hrs + 113 x mech room hrs.
Know the cost comparison table across all three systems and be ready to explain the direction of change for each product.
The new machine question is a classic exam setup. You may be asked to argue for or against a separate cost pool and to support your answer with the burden rate numbers.
Understand why volume matters for burden rates. A fixed cost spread over few units produces a high rate; spread over many units, a low rate. This is the core logic behind the new machine decision.
Fill in the blank: The mechanical room burden rate is ___ per machine hour. (113)
True or false: The Capacitor's cost rises from the two pool to the three pool system. (True, from 1,913 to 2,011.)
True or false: Placing the new machine in its own cost pool produces a lower burden rate than folding it into the main room. (False. The separate pool rate is 2,062 vs 88.)
Fill in the blank: Under the three pool system, ICB's total cost is ___. (6,281)
True or false: The recommended burden rate for the first year, with the new machine in the main room, is 74. (False. 74 is the three-year rate. The recommended first-year rate is 88.)
Q: Why does the three cost pool system separate machine hours by room?
A: Because the mechanical room and main testing room have different cost structures. The mechanical room's overhead rate (113 per machine hour) is nearly twice the main room's (63 per machine hour). Pooling them together averages out this difference and misallocates cost between products that use the rooms in different proportions.
Q: Under the three pool system, why does ICB's cost rise to 6,281 from 5,661 under the two pool system?
A: ICB spends 26 hours in the mechanical room, the most of any product. Under the two pool system, those hours were charged at an averaged machine-hour rate. Under the three pool system, they are charged at the higher mechanical room rate of 113 per hour, adding substantially more overhead.
Q: Should the new machine be placed in its own cost pool? Why or why not?
A: No. A separate pool produces a burden rate of 2,062 per machine hour in year one because the machine's fixed costs are divided by very few hours. Folding it into the main test room spreads those costs over a much larger hour base, producing a rate of 88. The separate pool would make the two customers' products appear unreasonably expensive and could lead to wrong pricing or sourcing decisions.
Q: What is the difference between the one-year and three-year burden rates for the new machine in the main room, and which should you use?
A: The one-year rate is 88; the three-year rate is 74. The case recommends the one-year rate for the first year because it reflects actual current volume rather than projected future volume that may not materialise.
Q: Compare the Amplifier's cost across all three systems and explain the trend.
A: Single pool: 1,286. Two pools: 1,030. Three pools: 995. The Amplifier's cost falls with each refinement because it uses little machine time (5 total hours under two pools; 4 main + 1 mechanical under three pools) and modest labour (525). The single pool overcharged it by loading all overhead onto its labour cost.
The three pool system is a bridge to full activity-based costing (ABC). In ABC, each significant activity gets its own cost pool and driver. The Seligram case stops at three pools, but the logic extends: if you had five different types of testing, you might want five pools. The question is always whether the added accuracy justifies the added complexity.
The new machine decision connects to capital budgeting. When you acquire a new asset, you need to think about how its costs will be allocated and what that does to product costs in the short run versus the long run.
This also ties into the concept of cost behaviour and fixed versus variable costs. The new machine's costs are largely fixed; spreading them over low volume makes them look variable and very high per unit.
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