Average Rate V. Machine Specific Rate

Nov 04, 2013

A manufacturing client of mine recently had one of their major customers demand more information regarding their manufacturing costs. As a result, my client is looking for additional details as to how rates are computed and individual unit costs are calculated. This manufacturer has been very successful and for years has computed their overhead application rate based on a direct labor hour. This is a capital intensive business with more and more of their annual investment going to high-tech automated equipment. This equipment allows for more of the operations to be machine controlled with a high level of productivity, and the diminishing requirement of labor in the control of the speed of the operation.

In the early years, this company had to rely on direct labor for virtually every one of its key processes. In fact, those processes that remain in effect today are labor controlled. However, some of the more automated processes are completely automated with only quality and material handling requiring labor to maintain the speed and accuracy of the process. For all of these years, this client has used an average overhead rate which we computed annually based on direct labor hours.

man-vs-machineNow due to the pressures from their customer and a number of other reasons, they have asked to specifically identify their overhead to their manufacturing processes and perhaps change the application method from direct labor hours to a machine rate.

Because of the automated nature of many of those processes, this idea seemed logical to me so we quickly changed our method of computing overhead and direct labor to a machine method. However, with several of the manual process still requiring direct labor, we continued to apply overhead with the direct labor method. As an overall check, we computed an average by specific machine and were comforted to find that using this method our average rates were very similar to what we had previously computed. Although, using this new method our actual overhead rates varied widely among machines with actual changes ranging several hundred percent from the low rate to the high rate. Of course this will dramatically change the price per part being produced with this equipment, but from my perspective this is a far more accurate presentation of what products actually cost.

We will continue to use this method in the future, or my client will be dependent on the outcome of the negotiations that prompted this recalculation to begin with. This more current method should result in far more accurate product costing. I am confident that this client will find surprises related to their product costs that were unanticipated prior to this re-computation of the rate of applying overhead.

Categories: Cost Accounting