Direct Material Cost Method

In this method the cost of direct materials consumed in the manufacture of a product is used as the basis for allocation of factory overheads. The overhead rate is, therefore, calculated on the basis of the following formula:



This method may give satisfactory results in the following circumstances:
    
(i) Where the amount of overheads is insignificant in relation to cost of materials and wages and, therefore, a simple method of allocation is desired.
    
(ii) Where output is uniform, i.e. one kind of article is produced.
    
(iii) Where the prices or materials do not fluctuate quite widely and frequently.

The method will not give satisfactory results except in the above cases on account of the following reasons:
    
(a) Except a few items, factory overheads do not vary with variations in the value of material. Normal wastage of materials or coal or other sundry small stores used in manufacture naturally varies with the value of materials used, otherwise other important items such as works manager’s salary, factory rent, sales, insurance, lighting etc. do not vary with every change in the value of materials. Value of materials depends upon its price which is constantly fluctuating but certain factory expenses, as stated above, are fixed and, therefore, are not affected in any way with a change in price of materials. Overhead rate based on value of materials may, therefore, give misleading results. Consider the following example:

The following were constituents of cost of product A in 1994:



The factory overhead rate based on materials comes to:

(15,000/50,000) × 100 = 30%
    
(b) This method will result in greater recovery of factory overheads from those cost units which use superior quality of materials in comparison to those which use materials of inferior quality. This seems very illogical because actually reverse should have been the case.

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