Overhead Allocation Debate
Direct Labor Hours vs Machine Hours -which one is best overhead allocation base? Answer may vary based on situations. Let us see. Can we really draw a conclusion to this debate? Is direct labor suitable allocation base at all situations?
Overhead Allocation is always a controversial element in cost accounting. Neither of Direct Labor Hours and Machine Hours is reliable and defects free allocation basis. It depends on various circumstances and management acceptance.
Direct Labor Hours Basis of Overhead Allocation:
Computation of Rate per DLH (Direct Labor Hours) rate is as follows:
Estimated Factory Overhead/ Estimated Direct Labor Hours=Rate per DLH
If estimated factory overhead is $300,000 and total direct labor hours are estimated to be 200,000 hours, an overhead rate based on direct labor hours would be $1.50 per hour of direct labor ($300,000 / 200,000 hours).
A job that required 400 direct labor hours would be charged with $600 (400 hours X $1.50) for factory overhead. The use of this method requires accumulation of direct labor hours by Job or product. Timekeeping routines with their forms and records must be organized to provide the additional data. The use of the direct labor hours basis requires first -a-direct relationship between labor hours and factory overhead and, second, a difference in the rates of hour for like work, caused by seniority rather than increased output.
As long as labor operations are the chief factor in production processes, the direct labor hours method is acceptable as the most equitable basis for applying overhead. However, if shop or factory departments use machines extensively, the direct labor hours method might lead to an inaccurate costing. This disadvantage is overcome through the use of the machine hours method.
Machine Hours Basis of Overhead Allocation:
This method is based on time required by machine or group of machines performing identical operations. Machine hours expected to be used are estimated and a machine hour rate determined as follows :
Estimated Machine Hours/Estimated Factory Overhead= Rate per Machine Hour
If factory overhead is estimated to be $300,000 and assuming that 300,000 machine hours will be used, the machine hour rate is $1 per machine hour ($300,000 / 300,000 machine hours). Work that required 120 machine hours would be charged with $120(120 hours X $l)for factory overhead.
This method of Overhead Allocation requires additional clerical work. Shop men, foremen, or timekeepers will have to collect machine hour data needed to charge overhead to jobs or products. In many instances, the machine hours method is considered the most accurate method of applying overhead. A system must be designed to assure correct accumulation of all required data for proper overhead accounting.
Another application of overhead rates is their use for estimating purposes. When materials and labor costs have been estimated, knowledge of the overhead allocation or distribution base quantity needed can be translated easily and efficiently into a factory overhead cost to arrive at total estimated cost.
Selection of the correct basis for applying overhead is of utmost importance if a cost system is to provide proper and accurate costs and if management is to receive meaningful and valuable data. Overhead Allocation between Direct Labor Hours Vs Machine Hours depends mostly on business decisions and circumstances.