INDIRECT LABOR COSTS AND IMPLICATIONS FOR OVERHEAD ALLOCATION

Cost accounting typically allocates indirect labor cost to cost object based on direct labor hours. The allocation process implicitly assumes that indirect labor costs vary proportionally with direct labor hours. The assumption of a linear relationship between indirect and direct labor is particularly suspicious at low production volume levels because there tends to be a fixed component in indirect labor. The linearity assumption is also challenged by recent increasing complexity of indirect labor tasks. As automation technology replaces some work of the of traditional labor, the cost of non-production workers becomes an important element of manufacturing overhead and it may not be related to labor hours in a simple linear manner. A model is derived to show the relationship between indirect labor overhead and direct labor hours under different conditions. The implication for the allocation of indirect labor overhead is also discussed.