Evaluating Suppliers’ Overhead Allocations

INTRODUCTION Knowing the cost of a particular product, a manufacturing process, or any business operation is vital to efficient management. The functional business area concerned with collecting and interpreting cost data is cost accounting. However, determining the cost of anything (i.e., purchase requirements) is not as simple as it might first appear, since the term cost has many meanings and different kinds of costs are useful for different purposes. Supply managers should understand cost accounting and its underlying theories, since suppliers' direct costs and their allocation of overhead costs are integral elements in determining their products' selling prices.|1^ Consequently, supply professionals typically utilize the principles of cost theory to analyze each cost element contained in a supplier's proposal to determine the appropriateness of the proposal.|2^ Historically, cost theory developed as specialty within the field of accounting to help manage and control the costs of direct materials, direct labor, and overhead. Direct materials and direct labor are materials and labor that can easily be traced to the production of individual products. All other manufacturing costs, including indirect materials, indirect labor (i.e., engineering, supervision, marketing, maintenance, etc.), and facility operations, are classified as overhead costs (sometimes called indirect costs). Individual direct costs are generally subject to close managerial control, whereas overhead costs tend to be controlled less directly as a group. Since direct materials and direct labor can be clearly identified with specific products, these costs can easily be assigned with a high degree of accuracy. Overhead costs, on the other hand, are usually assigned to the various products somewhat arbitrarily.|3^ Assigning overhead costs to specific products is a significant problem for all manufacturers, because they typically produce a number of different types of products for numerous customers. Rather than attempting to trace these costs directly to products, overhead costs are allocated among the products being produced on some logical empirical basis. In cost theory, indirect costs are generally accumulated into cost pools (e.g., manufacturing overhead, engineering overhead, general and administrative expenses, and so on) and then allocated to a specific product on a basis reflecting the proportion of the indirect cost incurred during its production. The methods of assigning indirect costs to individual products differ widely among firms; however, most firms tend to use direct labor as the basis for allocating manufacturing overhead costs, and to use total manufacturing costs (direct costs plus manufacturing overhead costs) as the basis for allocating general and administrative expenses.|4^ Thus, a seller's direct labor cost has a multiplying effect on its product pricing structure because it is the basis for allocating manufacturing overhead and general and administrative expenses (and in some cases, profit).|5^ Figure 1 illustrates the relationship of various cost elements and the resulting price that may be offered by a supplier. Increased competition during the 1980s stimulated many manufacturers to focus their efforts on methods to increase productivity. The use of various types of numerically and computer controlled machines, along with industrial robots, was designed to decrease input requirements and expand output--thus improving productivity.|6^ Some firms embraced the concepts of just-in-time, total quality management, group technology, and flexible manufacturing systems, resulting in improved product quality, reduced scrap, smaller inventories, and in many cases, significantly reduced amounts of direct labor used by a manufacturer.|7^ These production advancements suggest that direct labor or direct labor costs may have become less important as a driver for the incurrence of indirect costs--and, consequently, may no longer be an appropriate basis for the allocation of indirect costs to specific products. …