Cost Hierarchy: Evidence and Implications

Dhinu Srinivasan

doi:10.34257/gjmbrdvol21is2pg1

Abstract

Empirical evidence on the association between overhead costs and non-volume related cost drivers is mixed. Anderson and Sedatole (2013) offer possible explanations for the lack of evidence and find that the cost hierarchy is descriptive of the association between resource consumption and production activity. In this paper, we provide evidence on the presence of the cost hierarchy by studying the behavior of indirect production labor costs using daily data for five years from seven production departments of an industrial equipment manufacturer. We find that in addition to direct labor costs, the number of setups and number of distinct parts are also significantly associated with indirect production costs in at least six out of the seven production departments. Interestingly, despite our evidence for the existence of the cost hierarchy, the simple method of estimating these indirect costs as a proportion of only direct labor costs performs remarkably well in predicting costs.

Highlights

Introduction companyIndirect production labor activities compriseCost accounting textbooks and extant studies claim that indirect manufacturing costs vary not just with volume-related cost drivers such as direct labor cost, and with batch and productrelated cost drivers (e.g. Lanen et al, 2013)
If non-volume related activities are a key driver of indirect production costs, managerial decisions based on the traditional product cost information are believed to be suboptimal, as the measured product costs are likely to be distorted (Hilton and Platt, 2014)
1 Direct Labor Cost (DLCOST) is highly correlated to direct labor hours (DLHOURS), and the results reported here do not change appreciably when this alternative unit-level cost driver is employed in our analysis

Summary

Introduction

Introduction companyIndirect production labor activities compriseCost accounting textbooks and extant studies claim that indirect manufacturing costs vary not just with volume-related cost drivers such as direct labor cost, and with batch and productrelated cost drivers (e.g. Lanen et al, 2013). We provide detailed evidence on the presence of the cost hierarchy by studying the behavior of daily indirect production labor costs in multiple departments of an industrial equipment manufacturer. The short cycle times (0.05 to 0.14 day, on average) in the production departments at our research site imply a tight matching between indirect labor costs incurred each day in production departments and the daily activity measures that drive these costs. This tight association between daily indirect production labor costs and production activity presents an excellent opportunity to examine the time-series behavior of these variables using daily data

Methods

Results

Conclusion