Percentage on Direct Labour Cost

In absorption costing, percentage on direct labour cost serves as a crucial method for allocating production overheads to cost units, ensuring accurate accounting and cost management.

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.
  • 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.

  • Direct Labour Cost: The total cost of all employees who work directly on the manufacturing of products.

  • Production Overheads: Indirect costs associated with the manufacturing process, such as utilities, depreciation of equipment, and factory rent.

Online References

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

### What is the primary purpose of using the percentage on direct labour cost method? - [ ] To allocate direct materials - [ ] To measure employee efficiency - [x] To distribute production overheads - [ ] To calculate profit margins > **Explanation:** The primary purpose of using the percentage on direct labour cost method is to distribute production overheads to cost units based on the direct labour costs incurred. ### Which type of costing method primarily utilizes the percentage on direct labour cost? - [x] Absorption costing - [ ] Variable costing - [ ] Activity-based costing - [ ] Engineered costing > **Explanation:** Absorption costing is the method that primarily utilizes the percentage on direct labour cost to allocate overheads to the cost of production units. ### What is the percentage on direct labour cost if total production overheads are $60,000 and total direct labour cost is $240,000? - [ ] 15% - [ ] 20% - [x] 25% - [ ] 30% > **Explanation:** Using the formula \\( \left( \frac{60,000}{240,000} \right) \times 100 = 25\% \\), the percentage on direct labour cost is 25%. ### In what type of production environment is the percentage on direct labour cost method most relevant? - [ ] Capital intensive - [x] Labour intensive - [ ] Machine intensive - [ ] Technology intensive > **Explanation:** The percentage on direct labour cost method is most relevant in a labour-intensive production environment where direct labour costs are significant. ### Which costs are allocated using the percentage on direct labour cost method? - [ ] Direct materials - [ ] Selling and administrative costs - [x] Production overheads - [ ] Research and development costs > **Explanation:** Production overheads are the type of costs allocated using the percentage on direct labour cost method. ### Why might the percentage on direct labour cost method be less accurate in highly automated processes? - [x] Because overheads do not correlate well with labour costs - [ ] Because it is difficult to measure direct labour - [ ] Because it results in lower overhead allocation - [ ] Because it is time-consuming > **Explanation:** The percentage on direct labour cost method might be less accurate in highly automated processes because overheads do not correlate well with labour costs in such environments. ### What is the role of direct labour cost in the percentage on direct labour cost method? - [ ] A fixed allocation factor - [ ] A non-relevant cost - [x] A basis for overhead allocation - [ ] A form of variable costing > **Explanation:** In this method, direct labour cost acts as the basis for allocating production overheads, aligning distribution with labour consumption. ### How is the overhead absorption rate expressed in the percentage on direct labour cost method? - [ ] As a ratio - [ ] As a fraction - [x] As a percentage - [ ] As a coefficient > **Explanation:** The overhead absorption rate in this method is expressed as a percentage, reflecting the proportion of total overheads to direct labour cost. ### Which of the following is a critical component of the overhead absorption rate formula? - [ ] Total revenue - [x] Total production overheads - [ ] Total assets - [ ] Gross profit > **Explanation:** Total production overheads are a critical component of the overhead absorption rate formula, determining the numerator in the calculation. ### How can inaccuracies in overhead allocation be minimized using the percentage on direct labour cost method? - [ ] By increasing production volume - [ ] By reducing labour costs - [x] By ensuring precise recording of direct labour costs - [ ] By applying fixed rates regardless of production levels > **Explanation:** Ensuring precise recording of direct labour costs can help minimize inaccuracies in overhead allocation when using this method.

Thank you for deepening your understanding of accounting principles with our comprehensive exploration and challenging quiz on the “Percentage on Direct Labour Cost.” Continue building your expertise for future financial success!


$$$$
Tuesday, August 6, 2024

Accounting Terms Lexicon

Discover comprehensive accounting definitions and practical insights. Empowering students and professionals with clear and concise explanations for a better understanding of financial terms.