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The assumption underlying the traditional method of costing is that overhead expenditure is connected to the volume of production activity.
§ This assumption was probably valid many years ago, when production system were based on labour-intensive or machine-intensive mass production of fairly standard items. Overhead costs were also fairly small relative to direct materials and direct labour costs; therefore any inaccuracy in the charging of overheads to products costs was not significant.
§ The assumption is not valid in a complex manufacturing environment, where production is based on smaller customised batches of products, indirect costs are high in relation to direct costs, and a high proportion of overhead activities – such as production scheduling, order handling and quality control – are not related to production volume.
