Under the traditional method of costing, the predetermined overhead rate of $2 per direct labor hour was computed by dividing the estimated overhead by the estimated direct labor hours. For example, as shown in Figure 6.3, Musicality determined the direct costs and direct labor for their three products: Solo, Band, and Orchestra. ![]() Manufacturing overhead was not a large cost of the product, so an overhead allocation method based on labor or machine hours was logical. ![]() Historical Perspective on Determination of Manufacturing Overhead AllocationĪll products consist of material, labor, and overhead, and the major cost components have historically been materials and labor. Activity-based costing (ABC) is the process that assigns overhead to products based on the various activities that drive overhead costs. Making this change allows management to obtain more accurate product cost information, which leads to more informed decisions. This shift in costs gives companies the opportunity to stop using the traditional single predetermined overhead rate applied to all units of production and instead use an overhead allocation approach based on the actual activities that drive overhead. As technology changes the ratio between direct labor and overhead, more overhead costs are linked to drivers other than direct labor and machine hours.
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