- 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 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.
So who will pay for these overhead 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 costs.
The question is, how to assign a specific amount
of overhead costs to a specific product.
Imagine you're inside
the wood furniture manufacturing building.
Workers are working on the 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 these jobs.
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 costs to individual products
is the hard part of product costing.
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
right here 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.
Which one of these two projects
is going to consume more overhead costs?
It seems reasonable to think that the big project
with 10 workers will consume more overhead costs
than the small project with 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 cost in proportion
to the use of some important resource.
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 costs,
we don't know how to intelligently set our prices.
And if we don't know how to set our prices intelligently,
but our competitor down the street does know how to estimate
their costs appropriately, then in the long run,
our competitors going to beat us.
Cost flows and product costing.
Remember, there are three kinds of costs
in a production setting.
Direct materials and direct labor are relatively easy
to trace to specific products or processes.
More analysis is needed in assigning overhead costs
to products and processes.
That's where the art is involved.
We can have an entire course, a series of courses,
a year long seminar on just this one thing,
overhead allocation and you can see why
this is a crucial issue.