Question & Answer

Calculation of indirect cost rates

Wright Medical Centre has identified the following activities and cost drivers for the coming financial year.

Required

Calculate the activity cost rate for each activity.

Direct and indirect costs; and cost driver selection

        LO2,3

Venture Buses operates throughout the south-eastern suburbs of Melbourne, with its depot located in Cheltenham. Every day, fuel is delivered and stored in tanks located in the depot. This fuel is used by all the buses and administration vehicles. The accountant has been requested to develop a system to assign the cost to the different vehicles in the depot. He has asked your assistance in coming up with a way to identify the fuel costs.

Required

(a) From the perspective of the depot, is the cost of fuel a direct or indirect cost?

(b) From the perspective of the vehicles attached to the depot, can the cost be classified as either direct or indirect?  Briefly explain.

(c) What system would be required to have the cost classified as direct? 

(d) If the accountant decided to go with an indirect cost classification, how could the cost be allocated?

(e) Identify some factors that would determine which method would be the best for the assignment of fuel costs to the vehicles.

         Cost driver selection

For each of the following activities undertaken to bake pastries and cakes, identify a suitable cost driver to allocate costs.

(a)          Mixing ingredients

(b)          Baking pastries and cakes

(c)           Decorating cakes

(d)          Packing pastries and cakes on trays

(e)           Sales

(f)           Dispatch to customers

          Direct and indirect costs; fixed, variable, and mixed costs

Your sister turned her hobby into a small business called Glazed Over. She is a potter and manufactures and sells bowls that can be used for decoration or for birdbaths. She has one employee who works 40 hours a week no matter how many bowls are made. She has asked your advice in developing a cost function for the bowls so that she can estimate costs for the next period.

Required

The following list of costs comes from your sister’s general ledger. Assume the cost object is an individual unit (i.e. bowl). Categorise each cost as direct or indirect (D or I), and as fixed, variable or mixed (F, V or M).

(a) Employee wages

(b) Clay used to make bowls

(c) Depreciation on the kilns

(d) Glaze (the finish painted on the bowls)

(e) Brushes for the glaze

(f) Electricity

(g) Business licence

(h) Advertising

(i) Pottery studio maintenance (cost of weekly cleaning service)

(j) Packing materials for the bowls

18    Direct and indirect costs

Frida’s Tax Practice has two departments, tax and audit. The tax department has two product lines, business returns and individual returns. A list of costs and three cost objects from Frida’s Tax Practice follow.

Required

For each cost, identify whether it is direct or indirect for each cost object.

During a recent management meeting at Sunset Consulting Services, a team member questioned why the costing system had multiple indirect cost pools given it would be easier just to have one.  Provide a brief response to explain why the business has adopted multiple indirect costs pools.

Refer to the Partridge Insurance Illustration in the chapter. Explain how         the support departments can be classified as both cost objects and cost        pools in the costing system.

          List at least three possible allocation bases that could be used to allocate accounting department costs to other departments. Give one advantage and one disadvantage of using each allocation base.

What are the advantages and disadvantages of using estimated support cost allocation rates?

Explain the difference between operating departments and support departments

A product is started in department 1 and completed in department 2. Is department 1 a support department or an operating department? Explain.

What factors should be considered when choosing allocation bases?

Outline the key steps in a costing framework.

Explain how cost data is sourced in a costing framework.

What should determine the choice of cost allocation method (direct, step-down and reciprocal) discussed in this chapter?

Explain the similarities and differences between support department costs and manufacturing overhead costs.

Explain the differences and similarities among the direct, step-down, and reciprocal methods.

Discuss the importance of selecting an appropriate cost driver for cost allocation.

Explain the difference between a direct cost and indirect cost.

How do organisations identify the costs of a cost object?

What is a cost object? Give 3 examples.

For what purposes do organisations need cost information?

Cost function using high-low method

Mernda Health Care Centre recently began to offer day surgery procedures. The Centre was not experienced in the costing of such services and, as a temporary measure, the subsidised patient-day charge was set at $100. This charge was similar to other providers in the region. Management decided to review the charge once cost data was available for the first two months of operations. The following data was collected by the accounting department, together with the number of patient days.

Required

(a)   Classify each cost as fixed, variable or mixed, using patient days as the cost driver.

(b)   Use the high-low method to separate mixed costs into their fixed and variable components.

(c)    The accounting department has estimated that the average patient days per month will be 2000. If the Centre is to be operated as a not-for-profit, how much will it need to charge per patient day?

(d)   Suppose the Centre averages 2500 patient days per month. How much would need to be charged per patient day for the Centre to cover costs?

(e)    Explain why the per-patient-day charge decreased in (d) above.

(f)    Briefly explain the benefit of the classification of costs in the planning for the Centre.

30 Cost function using high-low method

Wentworth Ltd sold 100 000 1 litre bottles of mineral water last year at $4 per unit and made a profit of $50 000. This year the costs for Wentworth Ltd remained the same, it sold 120 000 units at the same price, and made a profit of $80 000.

Required

(a)   Determine the total fixed costs per year and the total variable cost per unit for Wentworth Ltd using the high-low method.

(b)   Write an equation for the cost function based on your answer to (a)

Adjusting data for use with regression; outlier

Smeyer Industries is a large entity with more than 40 departments, each employing 35 to 100 persons. Recent experience suggests that the cost function used to estimate overhead in Department IP-14 is no longer appropriate. The current function was developed three years ago. Since then, a number of changes occurred in the facilities and processes used in Department IP-14. The changes happened one at a time. Each time a change was made, the cost accountant felt the change was not major enough to justify calculating a new overhead cost function. Now it is clear that the cumulative effect of the changes has been large.

You have been assigned the task to develop a new cost function for overhead in Department IP-14. Initial analysis suggests that the number of direct labour hours is an appropriate cost driver. Departmental records are available for nine months. The records reveal the following information.

An assistant has analysed the data for March through July and made the appropriate adjustments except for the following items (for which the assistant was unsure of the proper treatment).

                           (i)              The semi-annual property tax bill for Department IP-14 was paid on June 30. The entire amount of $3,000 was charged to overhead for June.

                         (ii)              The costs to install a new piece of equipment with a life of 10 years in the department were charged to overhead in April. The installation costs were $4,300.

                       (iii)              Factory depreciation is allocated to Department IP-14 every month. The department’s share, $8,000, is included in overhead.

                       (iv)              A strike closed the plant for three weeks in July. Several non-union employees were kept on payroll during the strike. Their duties were general housekeeping and 'busy work' These costs were charged to overhead.

You also have the details for the overhead account for the months of August and September. They are presented in the following table. You were hired on October 1 and have been keeping the department accounts since then. Therefore, you know that the data for October and November are correct, except for any adjustments needed for the preceding items.

Required

(a)          Using the information provided, adjust the monthly cost data to more accurately reflect the overhead costs incurred during each month.

(b)          Discuss whether the data for July should be included in the estimate of future costs. Use a scatter plot to help you answer this question.

(c)           Develop a cost function by regressing overhead costs in Department IP-14 on direct labour hours. Discuss whether your cost function would be reasonable for estimating future overhead costs. Ignore any items you will discuss in part (d).

(d)          Identify and discuss any additional adjustments that might be needed to more accurately measure overhead costs for the regression in part (c).

(e)           Explain why adjustments probably need to be made to information from accounting records when estimating a cost function.