Seligram, Inc.

: Electronic Testing Operations

COMM 354 Fall 2011

Professor Sandra Chamberlain

Case Two Analysis

Part A

With the existing cost system, there is only one cost driver which is direct labour. The total
overhead in the existing cost system is a mix of direct costs and indirect costs. The numbers can
be misleading because certain costs such as security, stores/warehousing and
holidays/vacations are indirect costs to the cost object which cannot be traced back to specific
products or activities. For example, under this cost system, the building depreciation would have
to be measured based on direct labour hour. However, companies record depreciation expense
under the methods allowed under IFRS or APSE such as straight-line method or double decline
method. By doing so, the fixed costs and indirect costs which cannot be traced to direct labour
hour increase the numerator which makes the burden rate greater than the one which only has
direct costs in the numerator.

With the accounting managers approach, the companys able to use two cost drivers to
separate machine cost and direct labour cost. By measuring manufacturing costs based on
machine hour, ETO would be able to get a more accurate total burden cost. However, from
exhibit 6, it is clear to see that the machine hours used in mechanical room is greater than the
hours used in main room. By using one single machine-hour rate for both rooms, ETO will
experience higher costs in main room than it is supposed to have which can also be misleading.
Therefore, it is still not the best approach.

Among the three cost systems, the consultants approach seems to be the most accurate one.
By noticing the different machine hours used in two rooms, this system breaks down the total
machine costs for each product into main room costs and mechanical room costs. By doing so,
ETO will get two different machine-hour rates for two different rooms and apply those two
burden rates, the machine cost for each different product will be derived more accurately than
it under the one machine-hour rate approach.

However, the administrative cost in the direct labour cost pool seems to be the result of cost
allocation. The administrative costs are indirect costs which do not depend on how many labour
hours incur in the operation. Therefore, it would be better to introduce a four-cost-pool system
which allows ETO to separate the engineering costs and the admin costs. Some products may
require more technical support from engineers monitoring and testing whereas other products
may require less or none. It is not accurate to apply the same burden rate with admin costs in it
to products that require different levels of engineering technical support. (See Appendix 1 for
detailed calculations)
Part B
If ETO doesnt use a separate cost pool for the new machine, by using double declining method
calculating new machines depreciation expense, ETO will incur a much bigger depreciation
expense in the first year and that will increase their machine-hour burden rate. That means
other customers of ETO have to bury with costs that are irrelevant to their products. This may
cause ETO to lose their existing customers due to the higher costs that will be transferred to the
price they charge.

From the appendix 2, its easy to see that the machine-hour burden rate for subsequent years
by introducing the new machine is lower than the existing machine-hour rate $80. By charging a
lower depreciation expense in the later useful years for the new machine with a higher
utilization rate, the total machine-hour burden rate will decrease from $87.14 (1st year) to $74
(3rd year) to $73.12 (4th to 6th year) and to $68.73 (7th year). Since the new machines
depreciation expense and the machine hours used cut down machine-hour burden rate,
customers may ask for a lower testing price because the cost for ETO has become lower, or to
the extent of outsourcing the testing services with a more economic company.

Therefore, ETO should transfer this new machine costs straight to their respective one or two
customers so it can stay cost competitive with its existing customers.
Part C

Reasons to include depreciation expense in the overhead cost pool

To reflect the fair value of assets

To allocate the cost of assets to periods in which the assets are expected to be used.
Even though depreciation expense is considered as a sunk cost, it should be recognized
to match with its related revenue.

With double decline balance method

Higher depreciation charge for the first year of assets life

Gradually decrease the amount of depreciation charges in subsequent years.

Reason for the use of double decline balance method

Realistically reflects expected benefit of an asset from the use of the asset
e.g. when machine is relatively new and is used at its full capacity, it is believed
to generate more benefit than when it is old. Moreover, more maintenance
costs will be needed as the machine gets worn out.

Reasons not to use double decline balance method In the Seligram Inc. Case

Only 10% of available machine hours were utilized in the first year
Expected benefits for the first year would not properly match with $500,000 of
depreciation charge
If the double decline balance method is used, depreciation charges will significantly
decrease over time
In contrast to the decrease in depreciation charges, the utilization of the machine
increased to 60% by third year violates the matching principle.

Suggestion

Use units of production depreciation method:

i.e. to record depreciation charge in proportion to units of production, match
benefits generated by the machine with depreciation expense.
Appendix 1
Appendix 2