Overview
The percentage on direct labour cost is a method used in absorption costing to allocate production overheads to the cost units produced. This basis provides an equitable way to distribute overhead costs based on the direct labour costs incurred during production.
Historical Context
Absorption costing has its roots in early 20th-century manufacturing practices when companies needed consistent and rational methods to allocate overhead costs. The percentage on direct labour cost became popular as a reliable means to proportionally distribute these overheads, recognizing the relationship between direct labour and production activity.
Types/Categories of Costing Methods
- Job Order Costing: Specific to individual jobs.
- Process Costing: Applied to homogeneous products.
- Activity-Based Costing: Overheads allocated based on activities.
- Absorption Costing: Overheads included in the cost of production, including direct labour cost percentage method.
Key Concepts and Formulas
In absorption costing, overhead costs are allocated to products based on various bases. The formula for the percentage on direct labour cost is:
This formula provides a percentage that is applied to the direct labour costs to allocate overheads.
Chart/Diagram
graph TD
A[Total Overhead Costs] --> B[Total Direct Labour Costs]
B --> C[Divide Total Overhead Costs by Total Direct Labour Costs]
C --> D[Multiply by 100]
D --> E[Overhead Absorption Rate]
Importance and Applicability
The percentage on direct labour cost is significant in manufacturing settings where labour costs are a substantial component of the total production costs. This method ensures that products consuming more labour also absorb a fair share of overheads, promoting accurate product costing and pricing.
Examples and Considerations
Example:
- Total Overhead Costs: $50,000
- Total Direct Labour Costs: $25,000
- Overhead Absorption Rate: (50000 / 25000) * 100 = 200%
If a product requires $1,000 in direct labour costs, the absorbed overhead would be $2,000.
Related Terms and Comparisons
- Direct Labour Cost: The wages paid to workers directly involved in production.
- Overhead Costs: Indirect costs not directly traceable to products.
- Absorption Costing vs. Variable Costing: Absorption includes all overheads; variable excludes fixed overheads.
Interesting Facts
- In the early 20th century, Frederick Taylor’s scientific management principles highlighted the importance of accurate cost allocation to improve efficiency.
Inspirational Stories and Quotes
Quote:
“In the world of business, the rearview mirror is always clearer than the windshield.” – Warren Buffett
Proverbs and Clichés
- “Every penny counts.”
- “Measure twice, cut once.”
Jargon and Slang
- Cost Driver: A factor that causes a change in the cost of an activity.
- Cost Pool: A grouping of individual costs for allocation purposes.
FAQs
Q1: Why use percentage on direct labour cost for overhead allocation? A1: It ensures equitable distribution of overheads based on labour intensity, reflecting actual production activity.
Q2: What industries benefit the most from this method? A2: Manufacturing industries with significant labour costs in production.
References
- Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost Accounting: A Managerial Emphasis.
- Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2014). Managerial Accounting.
Summary
The percentage on direct labour cost is a crucial method in absorption costing, providing a proportional way to allocate overheads based on direct labour expenses. Its historical significance, formulaic approach, and practical application in various industries make it a cornerstone in cost accounting practices.
