The incidence where the company assigns the cost of direct labor to the calculation of total cost poses no challenge. Initially, the company would assign the labor costs to the product cost through direct tracing. The difficulty arises when a direct actual observable labor input and output relationship does not exist between the direct labor cost and the complete product. Unlike other costs, this relationship is normally not available for the overheads. In this case, when the company assigns the overheads through direct tracing, it must rely on the labor input and, in some instances, may resort to allocation.
This means that labor costs are assigned to a functional unit to establish the plant and departmental cost pools before obtaining the predetermined overhead rates. The challenge associated with the usage of predetermined overhead rates is that the overheads are not uniform within the production year. The normal costing system becomes inaccurate because the information used does not portray the exact unit production cost required in the cost assignment within the same period of production. However, the budgeted labor overhead costs established may relate more accurately to the production of the following year. As a result, the estimates can be attuned to cater to variations expected within the next year.
When the overhead costs cover a large percentage of the total manufacturing costs, several distortions in the calculation of costs are encountered. If the proportion of non-labor-related overhead costs to the total overhead costs is large, an impairment of the effectiveness of plantwide and departmental overheads rates is imminent. Such a situation occurs because the usage of these rates assumes that the employment of labor in production correlates to the output produced. However, if the labor employed does not directly relate to the amount of output, then an anomaly arises. This commonly occurs when the products are in batches.
In this case, the setup costs of producing these batches do not vary with the number of units within each batch but increase with the number of batches produced. In addition, the output manufacturing costs may rely on the number of dissimilar work orders completed instead of the amount of output produced. In these cases, the labor costs cannot assign the costs accurately to the products, while the extent of the distortion of the costs relies on the proportion that the labor overhead costs correspond. The distortion of costs can be related to product diversity. This occurs when the production employs labor in varied proportions because of product complexity or variance in the product size, batch size, or setup time.
The consumption ratio varies with the proportion of labor consumed in the diversification of the output, and hence, causes the variation in the assignment of costs. The distortion of the costs can be detrimental to the company’s position in the market because the company will be reporting misleading cost information to the management. Therefore, there are chances of charging improper prices on its products. The high-volume products will be overcosted and concurrently overpriced in the market. On the other hand, the low-volume products will be undercosted, and their prices undercast. The company will make low sales of the high-volume production since their prices are set higher than the prices of their competitors. The market position of the company will fall while the competitors take over the market.
The distortion of the costs can be detrimental to the company’s position in the market because the company will be reporting misleading cost information to the management. Therefore, there are chances of charging improper prices on its products. The high-volume products will be overcosted and concurrently overpriced in the market. On the other hand, the low-volume products will be undercosted, and their prices undercast. The company will make low sales of the high-volume production since their prices are set higher than the prices of their competitors. The market position of the company will fall while the competitors take over the market.