Indirect Costs

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The Bridgeton case introduced a relatively simple costing system: DM, DL, and one pool of indirect, support, or overhead costs. The one and only "cost pool" containing all overhead (OH) costs was allocated on the basis of DL$. In this case, the direct costs seem to be largely variable (i.e., they vary proportionally with production volume), whereas some of the indirect costs are relatively variable and others are largely fixed. Case in point: Not all INDIRECT costs are necessarily FIXED. To figure out which indirect costs are fixed or variable, one may want to use a combination of common sense and some analytical procedure applied to a time series of data across the various indirect cost accounts. There is no GAAP-rule spelling out which method to use; this is MANAGEMENT accounting! One approach is to compute the burden rate (OH/DL$) for each OH-account line item. If the ratio is relatively constant over time, the corresponding OH cost is largely variable. Alternatively, one could do a regression analysis, ideally on a large(r) time series of data. Interviewing plant managers about how costs behave usually provides good insights too. In this case, the "burden rate," "OH rate" or "allocation rate" is easy to compute: Total OH$ divided by total DL$. However, the burden rate may vary slightly from year to year because slight variations in production volume can be carried out with basically the same level of OH costs. Hence, the denominator of the burden rate tends to vary slightly (i.e., 5% growth in sales) whereas the numerator is largely constant under "normal" conditions. However, when we deviate from the "normal" operating conditions, i.e., when a "discontinuity" in the production process occurs (e.g., because of discontinuing a product or product line), we may want to think of "fixed" vs. "variable" costs in terms of "avoidable" vs. "unavoidable" costs. Variable costs are avoidable, but some fixed costs are more unavoidable than others. Again, when presented...
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