Direct Labour and Overheads

1
Direct Labour and Overheads

• Refers to method of determining indirect costs as
  fractions of the direct labour cost (overheads)
• Commonly, product cost made up of
• Prime Cost
• direct labour direct materials
• Overheads
• shop overhead
• company overhead

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
2
Direct Labour and Overheads

• Overheads are often a very high proportion of
  total costs, so lumping many sources together
  conceals true sources of costs
• Even an operators cost has high overhead content
  (can be gt50)
• Can be as many indirect staff in a workshop as
  direct!
• Adding buildings, plant, tooling and power can
  lead to 400 shop overhead

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
3
Prime Costs Overheads

• Sometimes, overheads are calculated as
  percentages of the prime costs
• Suitable where there is a significant direct
  material content cost, e.g. garment industry
  where capital equipment costs are not very high,
  management structure tends to be flat so there is
  little supervision and there is not an
  expensive design section

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
4
Costing

• Other breakdown of costs can be used depending on
  the product cost structure
• direct material can range from few percent to
  more than 50
• direct labour is typically 10 - 20, but in
  service industries can be 70 or more
• production shop overheads 100 - 500
• company overheads few percent to gt30
• profit 10

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
5
Standard Costs

• Costs PREDICTED for each identified element in
  total product cost
• costs can be divided between direct labour,
  direct materials and overheads
• can be more refined (essential for relatively
  large capital investment)
• all direct components need to be detailed
• must be continually reviewed

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
6
Standard Costs

• Direct labour costs depend on wages paid and the
  efficiency of the worker
• easy to determine if Paying by Results
• can use methods studies
• or time studies for existing operations
• Direct material costs depend on amount of
  material used, cost of materials (incl. volume
  discounts), amount of material wasted or scrapped

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
7
Cost Management

• Having standard costs allows actual costs to be
  monitored and compared
• this leads to variances
• Allows Management by Exception
• reduces administrative control effort
• Variances can be used for overheads, but overruns
  difficult to attribute to causes
• Variances of gross margins and output also used

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
8
Cost Management System

• Comprehensive system which recognises that
  traditional cost accounting (on which pricing is
  based) does not adequately trace costs and does
  not support the justification of new investments
  in advanced manufacturing technology and fails to
  monitor benefits.
• Often requires a change in accounting procedures

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
9
Cost Management System

• Based on a number of principles, a few of which
  are
• Use activity-based cost accumulation and
  reporting
• Costs should be consistent with the requirement
  to support life-cycle management
• Technology costs should be assigned directly to
  products

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
10
Pricing

• A number of approaches used in practice
• Two common rational methods are
• use of standard costs
• use of hourly rates and material costs
• Use of Cost Management Systems is a modern
  approach

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering
11
Pricing

• Pricing may be modified due to inter alia
• changes in demand,
• competition,
• company policy regarding market presence and
  share,
• expectations, and
• need to retain important customers

Dr Alan J. R. Smith Mechanical and Manufacturing
Engineering