Percentage on Direct Material Cost

Percentage on Direct Material Cost Absorption Costing Manufacturing Overhead Cost Units Financial Accounting Managerial Accounting
A basis used in absorption costing for absorbing the manufacturing overhead into the cost units produced. The formula used is: Overhead Absorption Rate = (Total Overhead / Total Direct Material Cost) * 100.
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Definition

In accounting, the term “Percentage on Direct Material Cost” refers to a specific method used in absorption costing to allocate manufacturing overhead costs to the cost units produced. This method calculates the overhead absorption rate by dividing the total overhead by the total direct material cost and then multiplying by 100 to convert it to a percentage. This percentage is then applied to the direct material cost of each unit to determine its share of overhead costs.

Examples

  1. Example 1: Suppose a manufacturing company has a total manufacturing overhead of $50,000 and a total direct material cost of $200,000. The overhead absorption rate would be calculated as follows:

    \[ \text{Overhead Absorption Rate} = \left(\frac{$50,000}{$200,000}\right) \times 100 = 25% \]

    Thus, for every dollar spent on direct materials, $0.25 of overhead costs are added.

  2. Example 2: Assume a factory produces multiple units, and the total manufacturing overhead is $75,000 with a total direct material cost of $250,000. The overhead absorption rate would be:

    \[ \text{Overhead Absorption Rate} = \left(\frac{$75,000}{$250,000}\right) \times 100 = 30% \]

    Each unit’s direct material cost would include an additional 30% for overhead.

Frequently Asked Questions (FAQs)

Q1: Why use the percentage on direct material cost method?
A1: This method is used because it provides a systematic way to allocate overhead costs proportionally based on the direct material costs incurred, ensuring that products consuming more materials bear a fair share of overhead.

Q2: Is this method suitable for all types of manufacturing?
A2: It is most suitable for manufacturing processes where direct material costs constitute a significant portion of the total production cost and where material consumption correlates with overhead usage.

Q3: How does this method affect product pricing?
A3: By accurately allocating overhead costs, it ensures that product costs are fully accounted for, which is essential for setting profitable pricing strategies.

Q4: Can this method be used alongside other cost allocation methods?
A4: Yes, it can be used in conjunction with other methods, such as labor-hour rate or machine-hour rate, depending on the company’s cost structure and production dynamics.

  • Absorption Costing: A costing method that includes all manufacturing costs - direct materials, direct labor, and overhead - in the cost of a product.
  • Manufacturing Overhead: Indirect factory-related costs that are incurred when a product is manufactured.
  • Direct Material Cost: The cost of raw materials that are consumed directly in the production of goods.

Online Resources

  1. Investopedia: Absorption Costing
  2. AccountingTools: Overhead Rate
  3. Coursera: Fundamentals of Accounting

Suggested Books for Further Studies

  1. “Accounting Made Simple: Accounting Explained in 100 Pages or Less” by Mike Piper.
  2. “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
  3. “Financial and Managerial Accounting” by John J. Wild and Ken W. Shaw.
  4. “Management and Cost Accounting” by Colin Drury.

Accounting Basics: “Percentage on Direct Material Cost” Fundamentals Quiz

### How is the overhead absorption rate calculated using the percentage on direct material cost method? - [ ] Total Overhead Cost / Total Direct Labor Cost - [ ] Total Direct Material Cost / Total Overhead Cost - [x] (Total Overhead / Total Direct Material Cost) * 100 - [ ] Total Overhead / Total Direct Labor Hours > **Explanation:** The overhead absorption rate using the percentage on direct material cost method is calculated by dividing the total overhead by the total direct material cost and then multiplying by 100. ### If the total overhead is $50,000 and the total direct material cost is $200,000, what is the overhead absorption rate? - [ ] 15% - [x] 25% - [ ] 40% - [ ] 10% > **Explanation:** The overhead absorption rate is calculated as (50,000 / 200,000) * 100 = 25%. ### For a unit with a direct material cost of $100 and an overhead absorption rate of 30%, what is the overhead cost allocated per unit? - [ ] $20 - [ ] $50 - [x] $30 - [ ] $10 > **Explanation:** The overhead cost allocated per unit would be 30% of $100, which is $30. ### What type of manufacturing process is this method most suitable for? - [ ] Service-oriented processes - [ ] High-tech industries - [x] Processes with significant direct material costs - [ ] Labor-intensive processes > **Explanation:** This method is most suitable for manufacturing processes where direct material costs constitute a significant portion of the total production cost. ### Can this method be used in addition to other overhead allocation methods? - [x] Yes - [ ] No - [ ] Only if approved by financial auditors - [ ] Only in small-scale businesses > **Explanation:** This method can be used alongside other methods, such as labor-hour rate or machine-hour rate, depending on the company's cost structure. ### Why is accurate overhead allocation important for product pricing? - [x] It ensures profitable pricing strategies. - [ ] It has no impact on pricing. - [ ] It reduces labor costs. - [ ] It increases production efficiency. > **Explanation:** Accurate allocation ensures that all costs are considered in product pricing, contributing to setting profitable prices. ### What is included in manufacturing overhead? - [ ] Only direct labor - [x] Indirect factory-related costs - [ ] Only raw material costs - [ ] Marketing expenses > **Explanation:** Manufacturing overhead includes all indirect factory-related costs that are incurred when a product is manufactured. ### Which of the following is an example of direct material cost? - [ ] Factory utility bills - [ ] Supervisor salaries - [ ] Factory rent - [x] Cost of raw materials used in production > **Explanation:** The cost of raw materials used directly in the production of goods is considered direct material cost. ### What happens if overhead costs are not properly allocated? - [ ] Cost units may be overpriced. - [x] Cost units may be wrongly priced. - [ ] Prices remain unaffected. - [ ] Profit margins increase. > **Explanation:** If overhead costs are not properly allocated, cost units may be wrongly priced, leading to loss-making or impractically priced products. ### Which statement is true regarding absorption costing? - [ ] It only includes direct materials and labor. - [ ] It excludes overhead costs. - [x] It includes all manufacturing costs. - [ ] It's only used for external reporting. > **Explanation:** Absorption costing includes all manufacturing costs - direct materials, direct labor, and overhead - in the cost of a product.

Thank you for exploring the detailed concept of “Percentage on Direct Material Cost” and engaging with our comprehensive quiz. Keep enhancing your financial acumen!

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Tuesday, August 6, 2024
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