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ACCA Applied Skills · Performance Management · Activity-based costing

A company absorbs production overheads using a single plant-wide rate based on direct labour hours. Production is increasingly automated, and direct labour is now a small share of total cost. What is the main resulting weakness of this method?

The weakness is that overheads are spread using labour hours, which no longer cause the overhead in an automated environment. Product costs are therefore distorted, with high-activity or complex products often under-costed and simple high-volume products over-costed.

  1. AOverheads are allocated to products on a basis that no longer reflects what causes them, distorting product costsCorrect
  2. BDirect labour costs can no longer be traced to products
  3. CFixed overheads can no longer be separated from variable overheads
  4. DTotal overheads absorbed will always exceed the overheads incurred

Explanation

With automation, overhead is driven by machine use, set-ups and similar activities rather than labour hours. A labour-hour rate therefore spreads costs on an inappropriate basis, misstating product costs. Direct labour can still be traced, and total absorption is not systematically too high.

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