Question:
You have been asked for advice by the owner of a small business who has previously estimated overhead costs as a percentage of direct labour cost. This method has produced quite reasonable results because the products have all been of similar sales value and have required similar labour inputs. The business has now changed and will in future concentrate on two products. Product X is a high-volume item of relatively low sales value and requires relatively little labour input per item. It is largely produced by automatic processes. Product Y is a low-volume item of relatively high sales value and requires considerably more labour input by specially skilled workers. It is largely produced by manual craft processes. What advice would you give to the owner of the business about allocation of overhead costs comprising:
a. the owner's salary for administrative work;
b. rent paid on the production facilities; and
c. depreciation of production machinery?
Compare the effect of having one overhead recovery rate for all three costs in aggregate, and the effect of identifying the factors which ‘drive' each cost in relation to the production process.