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Lecture 8

ADMS 1000 Lecture Notes - Lecture 8: Cost Driver, Cost Accounting, The SequencePremium


Department
Administrative Studies
Course Code
ADMS 1000
Professor
Keith Lehrer
Lecture
8

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ADMS 1000 Lecture 8 Notes Choice of an Allocation Base for Overhead Cost, Computation
of Unit Costs, Labour Cost and Manufacturing Overhead Costs
Introduction
Ideally, the allocation base used in the predetermined overhead rate should drive the
overhead cost.
A cost driver is a factor that causes overhead costs, such as machine-hours, beds
occupied, computer time, or flight-hours.
If a base is used to compute an overhead rate that does not “drive” overhead costs,
then the result will be inaccurate overhead rates and distorted product costs.
For example, if direct labour hours are used to allocate overhead, but in reality,
overhead has little to do with direct labour-hours, then products with high direct labour-
hour requirements will be allocated too much overhead and will be over costed.
Most companies use direct labour-hours or direct labour cost as the allocation base for
manufacturing overhead.
However, major shifts are taking place in the structure of costs in many industries.
In the past, direct labour accounted for up to 60% of the cost of many products, with
overhead cost making up only a small portion of the remainder.
This situation has been changing for two reasons.
First, sophisticated automated equipment has taken over functions that used to be
performed by direct labour workers.
Since the costs of acquiring and maintaining such equipment are classified as overhead,
this increases overhead while decreasing direct labour-hours.
Second, products are themselves becoming more sophisticated and complex and
change more frequently.
This increases the need for highly skilled indirect workers such as engineers.
As a result of these two trends, direct labour cost is decreasing relative to overhead as a
component of product costs.

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In companies where direct labour and overhead costs have been moving in opposite
directions, it is difficult to argue that direct labour “drives” overhead costs.
Accordingly, in recent years, managers in some companies have used activity-based
costing principles to redesign their cost accounting systems.
Activity-based costing is a costing technique that is designed to reflect more accurately
the demands that products, customers, and other cost objects make on overhead
resources.
The activity based approach is discussed in more detail.
Although direct labour may not be an appropriate allocation base in some industries, in
others it continues to be a significant driver of manufacturing overhead.
Indeed, most manufacturing companies in North America continue to use direct labour
as the primary or secondary allocation base for manufacturing overhead.
The key point is that the allocation base used by the company should really drive, or
cause, overhead costs, and direct labour is not always an appropriate allocation base.
Computation of Unit Costs
With the application of ABY Precision Machining’s $216 manufacturing overhead to the
job cost sheet in Exhibit 54, the job cost sheet is almost complete.
There are two final steps.
First, the totals for direct materials, direct labour, and manufacturing overhead are
transferred to the Cost Summary section of the job cost sheet and added together to
obtain the total cost for the job.
Then the total cost ($1,940) is divided by the number of units (2) to obtain the unit cost
($970).
As indicated earlier, this unit cost is an average cost and should not be interpreted as
the cost that would actually be incurred if another unit was produced.
Much of the actual overhead would not change at all if another unit was produced, so
the incremental cost of an additional unit is something less than the average unit cost of
$970.
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