This method has only limited use because in most cases no logical relationship exists between the direct materials cost of a product and factory overhead used in its production. One product might be made from high priced materials, while another requires less expensive materials.However, both products might require the same manufacturing process and thus incur approximately the same amount of factory overhead.If the materials cost basis for Overhead Allocation is used, the product using expensive materials will in this case be charged with more than its share.
Then which basis for overhead allocation should be selected?To overcome this unfairness, two overhead rates might be calculated: : one for items that are materials oriented, such as purchasing, receiving, inspecting, handling, and storage; the remaining overhead costs would be charged to production using a different base.
Direct Labor Cost Basis For Overhead Allocation : The direct labor cost basis is the most widely used method of applying overhead to jobs or products. Estimated factory overhead is divided by estimated direct labor cost to compute a percentage
Estimated Factory Overhead/ Estimated Direct Labor Cost x 100=Percentage of Direct Labor Cost
If estimated factory overhead is $300,000 and total direct labor cost for next period is also estimated at $300,000, the overhead rate would be 100 percent. A job or product with a direct labor cost of $3,000 would be charged with $3,000 ($3,000 X 100%) for factory overhead.
Analysis of direct labor cost basis of applying factory overhead indicates that it is a step in the direction of charging overhead equitably to products manufactured. Factory overhead items such as supplies, overtime .and power are used over a period of time. Any method of applying factory overhead must take this time factor into consideration. The direct labor cost basis does so in that labor cost is computed by multiplying number of hours spent on work by an hourly wage rate ; the more hours worked, the higher the labor cost and the greater the use and therefore the charge for factory overhead.
The direct labor cost basis for Overhead Allocation is relatively easy to use since information needed to apply overhead is readily available. Its use is particularly favored when (1) a direct relationship between direct labor cost and factory overhead exists and (2) the rates of pay per hour for similar work are comparable.
The weekly payroll provides the direct labor cost without any additional record keeping. As long as economy in securing underlying information remains a main prerequisite, the direct labor cost basis can be accepted as the best and quickest of the available methods for applying overhead.
