From the course: Accounting Foundations

Product costing: Overhead

From the course: Accounting Foundations

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Product costing: Overhead

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- Back to the process of estimating the cost to produce the custom ordered oak table. The estimated direct materials cost, the oak, is $1,000. The estimated cost of the direct labor, the skilled craftspeople, is $900, composed of 30 hours at $30 per hour. Is that it? No, you need infrastructure, overhead, we call it. You've got to have a roof over your head. You need electricity. You must have supervisors. You need maintenance people. You need quality control inspectors. You have to pay property taxes and insurance. Who will pay for these costs? Well, the owner can pay for them, but then the business won't last very long. In a sustainable situation, the customers must pay for the overhead cost. The question is how to assign a specific amount of overhead cost to a specific product. Imagine that you're inside the wood furniture manufacturing building. Workers are working on this oak table right here, a children's desk over there, some bookcases in the corner, and a China cabinet over there. There is one factory supervisor overseeing all of these jobs. Now, how much of that supervisor salary should be assigned to the oak table? How much of the property taxes on this building should be assigned to the oak table? How much of the wages of the maintenance people? You see, assigning overhead cost to individual products is the hard part of product costing. Remember, somebody has to pay for this overhead cost. Who? Well, there are two choices. Either I build the overhead cost into the total production cost and bill the customer for it, or I the owner have to pay those overhead costs myself. Let's consider how to reasonably assign overhead costs to individual projects. Let's consider two projects. I'm working on this big fancy oak dining room table, and I've got 10 workers gathered around doing various things. At the same time, two workers are working on a little child's desk project on the other side of the factory. Now, which one of these two projects is going to consume more overhead costs? Well, it seems reasonable to think that the big project with 10 workers will consume more overhead costs than the small project with only two workers, more supervisor time, more electricity, more mess for maintenance people to clean up and so forth. So a traditional way of assigning overhead costs is in proportion to the number of direct labor worker hours spent on a specific product or process. Now, there are other more sophisticated approaches, but they're all based on this idea of assigning overhead costs in proportion to the use of some important resource, like worker hours, machine hours, product complexity, and so forth. So at what price should we sell the oak table? If we don't understand our cost, we don't know how to intelligently set our price. And if we don't know how to set our prices intelligently, but our competitor down the street does know how to estimate their cost appropriately, then in the long run, our competitor is going to beat us. Cost flows and product costing. There are three kinds of costs in a production setting, direct materials and direct labor, they're relatively easy to trace to specific products or processes. More analysis is needed to assign overhead costs to products and process. That's where the art is involved. Identifying and assigning materials and labor costs, that's easy. Accurately allocating overhead, now that's the hard part. But even though it's hard, you have to get it right. If you don't and your competitor does, they win and you lose.

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