Although general overhead costs are not associated with a specific product, we still need to incorporate them into product costs in a rational way. To do this, we look for some way to allocate these costs to a product; that is, we try to determine a way to divide the overhead costs to each product we’re making in some way that is a fair representation of the proportion of the overhead costs each product “caused”.
Suppose you ran a sporting goods manufacturing plant which makes both tennis balls and golf balls. To understand the true cost of making each product, you would want to make sure that you accurately represent its share of the plant’s electricity bill. You produce an equal number of each product, but since the golf balls are more energy intensive to produce, they account for 90% of the power consumption at your plant. Logically, we would want to attribute 90% of the electricity cost to the golf ball product, and only 10% to the tennis balls. This is an example of how we can assign overhead costs using a cost driver.
A cost driver is a factor that allows overhead costs to be reasonably assigned to a cost object. The cost driver must either be the cause of the overhead costs, or at least reasonably associated. If you were estimating the cost of a road trip, the length of the trip might be an appropriate cost driver to use. Although the actual cost would vary depending on the fuel efficiency of your vehicle, the traffic conditions, your driving habits, and if the price of gas, you could roughly say that if your vehicle uses 12 litres per 100 km on the highway, and gas costs about $1 per litre, that you will spend 12 cents per kilometer for your trip. This cost driver allows you to easily estimate the cost for a trip from Saskatoon to Whitehorse (2500km -> $300), or Vancouver to Halifax (6000km -> $720), or any other trip with a simple calculation.
For a manufacturing situation like our sporting goods factory, we might use the common cost driver of machine-hours to estimate power consumption. The more hours the golf ball machines operate to produce each ball, the greater the cost assigned to the product. While this may not produce a perfect estimate (suppose the golf ball machines consume slightly more power each hour compared to the tennis ball machines), it is clear that this cost driver is still closely related to the overhead cost in question, and should produce some kind of reasonable estimate.
Let’s look at an example which will combine what we have learned about direct and indirect costs:
The Not-Flat-Earth Telescope Company has a production plant which manufactures several different models of telescopes to fill orders for stores around the province. Two of its most popular models are the Myopiscope and the Hyperscope. The material and manufacturing costs associated with making one telescope of each model are shown below. The plant is a large facility for which overhead costs include its lease, utilities, machine maintenance, and general administration. To ensure that the revenue from telescope sales covers these costs, management assigns overhead to each model of telescope based on three separate cost drivers. For each machine-hour used, it assigns $10 to cover utilities (e.g. heat, electricity) and machine maintenance. It also charges an additional 5% of the materials cost to account for their indirect raw material procurement costs (e.g. shipping and receiving department), and 25% of the labour cost to cover the salaries of support staff (e.g. sales, human resources). Not-Flat-Earth also pays an average wage of $18/hour for its direct labour costs.
This morning, Not-Flat-Earth sold an order of 30 Myopiscopes and 12 Hyperscopes to the Sell-O-Scope Astronomy Shop. How much should they have charged for this order?
Step 1: Calculate the direct cost for a single telescope of each model, based on materials and labour.
DC = Optical Tube + Lenses + Mount + (labour hours x hourly wage)
Step 2: Calculate the additional overhead costs for a single telescope of each model.
OH = (Machine Hours x Hourly rate) + (material Cost x %rate) + (Labour Cost x %rate)
OHHyperscope = $17.28
Step 3: Find the total cost of each telescope by combining its direct and overhead costs, and then multiply to get the total cost for the order.
Cost = DC + OH
CostMyopiscope = $40.00 + $10.60 = $50.60
CostHyperscope = $81.50 + $17.28 = $98.78
Order Cost = (30 x $50.60) + (12 x $98.78) = $2703.36
So, we find that Not-Flat-Earth should have charged Sell-O-Scope $2703.36 for the order.