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
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.
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.
Related Terms
- 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
Suggested Books for Further Studies
- “Accounting Made Simple: Accounting Explained in 100 Pages or Less” by Mike Piper.
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
- “Financial and Managerial Accounting” by John J. Wild and Ken W. Shaw.
- “Management and Cost Accounting” by Colin Drury.
Accounting Basics: “Percentage on Direct Material Cost” Fundamentals Quiz
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