Tracking Overhead
Jack would have a many task at hand if he tried to daily trace all such items of overhead. For example:
x How difficult it would become to track the "indirect material"? How many wire nuts are used on the billboard? How much inches of electrical tape were used? What was the price of the items?
x What about not direct labour? Donnie spent two hours on job-related management and travel issues for the six hours of direct labour time on the 14th. Should the cost of 2 hours be spent over three jobs equally, pro-rata based on the hours, or any other basis? On the 15th, Donnie might spend the entire day on the residential wiring job and have less administrative and travel time. How does this affect the cost per hour of output on the 15th versus the 14th? What about time spent by Jack's? He is heading 4 electricians. Should the cost of his time be owed 1/4 to each, or based on any other formula?
x Then, one should think about the cost of rent, trucks, equipment, and so on Donnie needed a ladder to scale the billboard. A ladder will in due course of time wear out -- but what amount is the "ladder cost" for one trip up and down the billboard? Now, repeat the same question for every item of cost incurred in running Castle Electric.
Tracking overhead is kind of tricky. One way this is done is by using the fixed overhead rate. Suppose Jack sat down at the starting of the year with his accountant. Together they carefully took all of the production overhead which was anticipated during the year -- the cost of Jack's time, the rent, the cost of vehicles, taxes, utilities, insurance, indirect l insurance, abort, indirect materials, depreciation of long-lived possessions, and so forth. The expected over all came to about $150,000. Jack figures that his four electricians will work a whole of about 7,500 direct labour hours throughout the year. By comparing the two numbers ($150,000 and 7,500 hours), it is now possible to "model" the overhead is $20 per direct labour hour. The "transparency application rate" is hence determined.
Now, two things should be made very clear. First, overhead application is random. Jack decided to apply the overhead based on the direct labour hours; this is a general choice, but not only option. Some other methodical and rational approach could have been developed. Normally, one would try to establish some correlation between the request base and overall cost incurrence. For example, feet of wire used (instead of direct labour hours) could have been selected as application base; but, feet of wire would be difficult to defend since two of Donnie's three jobs did not take use of any wire and would not be assigned any of business overhead! The point is that some logical method requires to be used to attach overhead costs to the output, but no single choice is absolute. Cost allocation necessarily includes some degree of arbitrary methodology; this is neither advantageous nor disadvantageous, it is the reality. In some ways, costing is more of the "art" than the "science" -- despite its outward appearance of mathematical accuracy.
Second, excluding differences between the actual overhead and the amount applied to the production. For example, Jack will likely discover that the original overhead is more or less than $150,000. Jack will also find out that his electricians will possibly work more or less than the anticipated 7,500 hours. When all is said and done, Jack will be required to deal with the actual cost. The difference between the amounts of overhead applied to the production which is direct labour hours X the $20 per hour rate and the actual amount spent should be accounted for! We will see how to deal with this afterwards in the chapter.