80 Deliveries

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• indirect costs (5)
• direct labor cost (3)
• direct labor hours method (2)
• cost drivers (2)
• direct labor hours (2)
• single unit (2)

1.Allocating Overhead Expenses[Original Blog]

One of the challenges of calculating the cost of a single unit of output or service is how to account for the indirect costs, also known as overhead expenses. Indirect costs are the costs that are not directly traceable to a specific product or service, but are necessary for the overall operation of the business. Examples of indirect costs include rent, utilities, depreciation, insurance, salaries of administrative staff, etc. These costs are usually fixed or semi-variable, meaning they do not change proportionally with the level of output or activity. Therefore, allocating indirect costs to each unit of output or service can be difficult and subjective. Different methods of allocation can result in different costs per unit and affect the profitability and pricing decisions of the business. In this section, we will discuss some of the common methods of allocating indirect costs and their advantages and disadvantages.

Some of the methods of allocating indirect costs are:

1. Direct labor hours method: This method allocates indirect costs based on the number of direct labor hours used for each product or service. For example, if the total indirect costs for a month are $100,000 and the total direct labor hours are 10,000, then the indirect cost rate per direct labor hour is $10. If product A uses 100 direct labor hours and product B uses 200 direct labor hours, then the indirect costs allocated to product A are $1,000 and to product B are $2,000. This method is simple and easy to apply, but it assumes that indirect costs are driven by direct labor hours, which may not be true in some cases. For example, if some products or services are more complex or require more machinery than others, they may incur more indirect costs than the direct labor hours suggest.

2. Direct labor cost method: This method allocates indirect costs based on the direct labor cost of each product or service. For example, if the total indirect costs for a month are $100,000 and the total direct labor cost is $200,000, then the indirect cost rate per direct labor dollar is 0.5. If product A has a direct labor cost of $2,000 and product B has a direct labor cost of $4,000, then the indirect costs allocated to product A are $1,000 and to product B are $2,000. This method is similar to the direct labor hours method, but it takes into account the different wage rates of different workers. However, it still assumes that indirect costs are driven by direct labor cost, which may not be accurate in some situations.

3. Machine hours method: This method allocates indirect costs based on the number of machine hours used for each product or service. For example, if the total indirect costs for a month are $100,000 and the total machine hours are 5,000, then the indirect cost rate per machine hour is $20. If product A uses 50 machine hours and product B uses 100 machine hours, then the indirect costs allocated to product A are $1,000 and to product B are $2,000. This method is more appropriate for businesses that use a lot of machinery and equipment in their production process, as it reflects the consumption of indirect resources by each product or service. However, it may not capture the differences in the complexity or quality of the products or services that may affect the indirect costs.

4. activity-based costing (ABC) method: This method allocates indirect costs based on the activities that cause them, rather than the output or input measures. For example, if the total indirect costs for a month are $100,000 and there are four activities that generate them: ordering materials, setting up machines, inspecting products, and delivering products. The indirect costs of each activity are estimated and then divided by the number of cost drivers, such as number of orders, number of setups, number of inspections, and number of deliveries. Then, the indirect costs of each activity are allocated to each product or service based on the number of cost drivers they use. For example, if product A requires 10 orders, 20 setups, 30 inspections, and 40 deliveries, and product B requires 20 orders, 40 setups, 60 inspections, and 80 deliveries, then the indirect costs allocated to product A and product B are calculated as follows:

| Activity | indirect cost | Cost Driver | Cost Rate | Product A | Product B |

| Ordering materials | $20,000 | Number of orders | $200 per order | $2,000 | $4,000 |

| Setting up machines | $30,000 | Number of setups | $300 per setup | $6,000 | $12,000 |

| Inspecting products | $40,000 | Number of inspections | $400 per inspection | $12,000 | $24,000 |

| Delivering products | $10,000 | Number of deliveries | $100 per delivery | $4,000 | $8,000 |

| Total | $100,000 | | | $24,000 | $48,000 |

This method is more accurate and realistic, as it identifies the cost drivers of each activity and allocates indirect costs accordingly. However, it is also more complex and costly to implement, as it requires more data collection and analysis.