Introduction
The percentage on direct material cost is a basis used in absorption costing to allocate manufacturing overhead costs to units produced. This method ensures that the cost of manufacturing overheads is distributed proportionally across all production units, providing a more accurate reflection of production costs.
Historical Context
Absorption costing, also known as full costing, has been a fundamental principle in managerial accounting since the early 20th century. Its primary goal is to include all manufacturing costs – both fixed and variable – into the product cost. The approach of using a percentage on direct material cost emerged as a way to simplify and standardize the allocation of overheads.
Formula and Calculation
The formula for calculating the percentage on direct material cost is as follows:
For example, if the total manufacturing overhead is $50,000 and the total direct material cost is $200,000, the percentage on direct material cost would be:
This means that for every dollar of direct material cost, $0.25 is allocated for manufacturing overhead.
Types/Categories
- Fixed Overhead Allocation: Applies when overhead costs remain constant irrespective of production volume.
- Variable Overhead Allocation: Applies when overhead costs fluctuate with changes in production volume.
Key Events and Usage
- Industrial Revolution: The advent of mass production necessitated systematic cost allocation methods, leading to the development of absorption costing.
- Modern Manufacturing: Advanced manufacturing and cost accounting techniques leverage the percentage on direct material cost to refine product costing.
Detailed Explanation
Absorption costing ensures that all costs incurred in the manufacturing process are captured, providing a holistic view of production expenses. Allocating overheads as a percentage of direct material cost is practical for businesses where direct materials form a significant portion of the total cost.
Importance and Applicability
- Accurate Costing: Provides a more accurate product cost by including all manufacturing overheads.
- Decision-Making: Assists managers in making informed pricing, budgeting, and production decisions.
- Financial Reporting: Ensures compliance with accounting standards that require absorption costing.
Considerations
- Cost Structure: Suitable for industries with a high proportion of direct material costs.
- Cost Behavior: Requires understanding of fixed and variable overhead behavior.
- Data Accuracy: Dependent on accurate tracking of direct material costs and overhead expenses.
Related Terms with Definitions
- Absorption Costing: An accounting method that includes all manufacturing costs in the cost of a product.
- Variable Costing: Only variable manufacturing costs are included in the product cost.
- Direct Material Cost: The cost of raw materials directly traceable to the production of a product.
Comparisons
- Percentage on Direct Labor Cost: Allocates overheads based on labor costs rather than material costs.
- Machine Hour Rate: Allocates overheads based on machine hours used in production.
Interesting Facts
- The use of direct material cost for overhead allocation is popular in industries like textiles and electronics, where material costs dominate.
Famous Quotes
“Cost accounting is enemy number one of productivity.” — Eliyahu M. Goldratt
Proverbs and Clichés
- “You get what you pay for.”
- “Penny wise, pound foolish.”
Expressions, Jargon, and Slang
- Overhead Absorption: The process of allocating overhead costs to products.
- Full Costing: Another term for absorption costing.
FAQs
Q: What is the main advantage of using percentage on direct material cost?
A: It simplifies the allocation of overheads and aligns overhead costs with material costs, providing consistent and fair cost distribution.
Q: Are there limitations to this method?
A: Yes, it may not accurately reflect overhead allocation in industries where direct labor or machine hours are more significant than material costs.
References
- Horngren, C.T., Datar, S.M., Rajan, M.V. (2012). Cost Accounting: A Managerial Emphasis. Pearson.
- Drury, C. (2015). Management and Cost Accounting. Cengage Learning.
Final Summary
The percentage on direct material cost is an efficient and widely used method in absorption costing for allocating manufacturing overheads. It helps in providing a clear, comprehensive picture of production costs, thereby assisting in better financial management and decision-making. This method, while not without its limitations, is a valuable tool in industries where direct material cost is a significant portion of total production expenses.
