Page 182 - Accounting Best Practices

c09.qxd 7/31/03 3:08 PM Page 171
171
9–4 Eliminate Labor Variance Reporting
assign overhead costs to a product based on the amount of labor cost used to build
it. The trouble is that labor is an increasingly small component of total labor costs,
resulting in large overhead amounts being allocated based on tiny labor costs. The
ratio of overhead to labor costs can reach absurd levels, such as $10 for every $1
of labor. When there are large differences between the proportion of overhead to
the allocation base, even a slight change in the allocation base will result in a large
swing in the overhead costs. Thus, minute month-to-month differences in the allo-
cation base can falsely alter product costs by significant amounts.
The best practice that resolves this problem is to find new allocation bases
that are not so highly leveraged. By doing so, there is less chance of having
unusual cost swings based on small alterations in the allocation base. A good rule
of thumb is to keep the ratio of allocation base to overhead cost no higher than
one to one and preferably much less. This way, small changes in the allocation
base will result in similarly small changes in the overhead cost. If the allocation
base is not monetary, use an allocation base that is so large that any large changes
are unlikely. For example, if square footage is used as the allocation base, the
chance that the amount of square footage will suddenly change by an inordinate
amount is quite small. In either case, the goal of reducing wide swings in over-
head costs has been achieved.
This is a simple best practice to implement, usually requiring a modest
investment in investigation time in order to find new allocation bases to replace
the existing ones, as well as a few days of work to set up the allocation formulas.
Since there is little or no programming required, and the approval of other depart-
ments is unnecessary, there is no reason why this implementation cannot succeed
in short order.
This best practice addresses the problem of keeping overhead costs from
changing significantly. Another best practice reviews the problem from a different
angle, which is linking overhead costs to specific activities as tightly as possible,
resulting in a more informed allocation of costs to those activities that drive the costs.
For more information on this approach to overhead allocation, see the ‘‘Implement
Activity-Based Costing” section later in this chapter.

Cost: Installation time:

9–4 ELIMINATE LABOR VARIANCE REPORTING

The cost components of work-in-process and inventory goods will inevitably include
some labor. However, the proportion of labor in the total cost mix has dropped
markedly over the years, with material and overhead costs now predominating.
Nonetheless, the costing reports the accounting staff has traditionally generated are
mostly concerned with labor. Examples of these reports are those detailing over-
time, comparing actual to standard labor rates or usage, and labor efficiency. By
comparison, the reports concerned with the materials expense typically cover only