Definition
Percentage on Direct Labour Cost is a basis used primarily in absorption costing methodologies for distributing production overheads to cost units. This method aims to allocate overhead costs in proportion to the direct labour costs incurred. The overarching objective is to ensure that overheads are fairly and systematically charged to each unit of production, aligning with the accounting principles of expense recognition and matching.
Formula
The formula for calculating the percentage on direct labour cost is:
\[ \text{Overhead Absorption Rate} = \left( \frac{\text{Total Production Overheads}}{\text{Total Direct Labour Cost}} \right) \times 100 \]
Examples
Example 1: Small Manufacturing Company
Imagine a small manufacturing company with the following details:
- Total Production Overheads: $50,000
- Total Direct Labour Cost: $200,000
Using the formula, the overhead absorption rate would be:
\[ \left( \frac{50,000}{200,000} \right) \times 100 = 25% \]
This means that 25% of the direct labour cost for each product will be allocated as overhead.
Example 2: Large Industrial Plant
For a large industrial plant:
- Total Production Overheads: $1,200,000
- Total Direct Labour Cost: $4,000,000
The overhead absorption rate calculation would be:
\[ \left( \frac{1,200,000}{4,000,000} \right) \times 100 = 30% \]
Here, 30% of the direct labour cost is attributed to production overheads.
Frequently Asked Questions (FAQs)
Q1: Why is the percentage on direct labour cost method used?
- A1: This method is used because direct labour cost is often a significant component of total production costs. It provides a logical basis for allocating overheads proportionate to the labour intensity involved in production activities.
Q2: How is this method different from other absorption costing methods?
- A2: Unlike machine hour rate or direct material cost methods, the percentage on direct labour cost specifically ties overhead allocation to the cost incurred for direct labour, making it more relevant in labour-intensive production environments.
Q3: What are the advantages of using this method?
- A3: It is simple to apply and ensures that overheads are allocated relative to the labour consumed, promoting fairness and consistency in cost accounting.
Q4: Can this method be used in all types of industries?
- A4: While it is versatile, this method is best suited for industries where direct labour is a major part of the production cost structure.
Q5: What are some limitations of this method?
- A5: It may not be accurate in scenarios where overheads do not correlate well with labour cost, such as in highly automated manufacturing processes.
Related Terms
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Absorption Costing: A costing method that includes all manufacturing costs—direct materials, direct labour, and both variable and fixed manufacturing overheads—as part of the cost of a product.
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Direct Labour Cost: The total cost of all employees who work directly on the manufacturing of products.
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Production Overheads: Indirect costs associated with the manufacturing process, such as utilities, depreciation of equipment, and factory rent.
Online References
- Investopedia: Absorption Costing
- The Balance: Introduction to Cost Allocation
- Accounting Tools: Percentage Method of Cost Allocation
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- “Managerial Accounting for Dummies” by Mark P. Holtzman
- “Accounting for Decision Making and Control” by Jerold Zimmerman
- “Introduction to Managerial Accounting” by Peter C. Brewer, Ray H. Garrison, and Eric Noreen
Accounting Basics: “Percentage on Direct Labour Cost” Fundamentals Quiz
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