Absorption of overheads
Meaning
Absorption of overhead
expenses refers to a systematic process of distributing the overheads among the
units produced by production departments. Overhead absorption is also called as
overhead recovery, levy of overhead, overhead
costing. eg charging the overhead cost to Mango Mastani just like dry fruit cost, milk cream cost, mixer dep, light bill, helper charges, cashier charges of Mastani house, Rent advertising charges
Definition
i) ICMA London, defines overhead absorption as “it is the allotment of
overhead to cost units”
ii) The Institute Of Cost And Works Accountant, India, defines Overhead Absorption
-“It is the allotment of overhead to cost units by mean of rates separately calculated for each cost center.”
Methods of Overhead Absorption
There are various
methods of overhead absorption
1) Production Unit
Method
2) Percentage Method
a)
Percentage of Direct Material
b)
Percentage of Direct Labour Cost
c)
Percentage of Prime Cost
3) Hourly Rate Method
a)
Direct Labour Hour Rate
b)
Machine Hour Rate
c)
Duel Hour Rate
1) Production Unit
Method – when the same type of products is manufactured the method can be used.
Production
unit rate = factory overhead
________________
No of unit
produced
2)
Percentage of Direct Material Cost -
the actual and predetermined overhead rate of production overhead is computed
by dividing the production overhead by the direct material cost and multiplying
by 100
Production Overhead
Percentage
of Direct Material = __________________ × 100
Direct
Material Cost
Suitability-
1.
When only one kind of article is produced
2.
When prices of material are stable.
3.
When the same quantity of material is used for all units.
4.
When material cost forms a greater part of the cost of production
Merits -
1.
It is simple to calculate.
2.
It is easy to understand.
Demerits –
1.
This method does not take into account the time factor
2.
Variable expenses vary with the volume of production whereas fixed expenses may
not do so. This distinction has been ignored.
3.
When the prices of material fluctuate this method is not suitable.
3.
Percentage of Direct Labour Cost -
the actual and predetermined overhead rate of production overhead is computed
by dividing the production overhead by the direct wages cost and multiplying by 100
Production Overhead
Percentage
of Direct Wages = __________________
× 100
Direct Wages Cost
Suitability-
1.
When production is uniform.
2.
When labor cost is a predominant part of the cost of production.
3.
When there is no variation in the wage rate.
4.
When the ratio of skilled and unskilled labor is constant.
Merits
–
1.
It is easy to calculate and easy to understand.
2.
Wages are paid on a time basis.
3.
This is a stable method as compared to the material because labor rates do not
fluctuate as material rates.
4.
There is very less possibility of under or over absorption of overhead as
labor rates do not fluctuate so much.
Demerits
–
1.
If a piece-rate system is adopted, the time factor is completely ignored.
2.
The method does not consider the difference between skilled workers and
unskilled workers.
3.
There is no distinction between the work of production of manual workers and
production of machine workers.
4) Percentage of Prime Cost-
This method is a combination of the direct material method and the direct wages method. The
actual and predetermined overhead rate of production overhead is computed by
dividing the production overhead by the prime cost and multiplying by 100
Production Overhead
Percentage
of Prime Cost = __________________ × 100
Prime Cost
As this method is the combination of the above
two methods it has all the merits and demerits of the above two methods.
5)
Direct Labour Hour Rate- this is
also known as Production Hour Rate. It
is a scientific method because overhead expenses are related to the time factor. In
this method, the overhead absorption rate is computed by dividing the production
overheads by the direct labor hours.
Production
overhead
Direct labor rate
=_____________________________
Direct labor
hours during the period
Suitability
1.
It is suitable when most of the work is done manually
2.
It is suitable when the production is not uniform.
3.
It is suitable when the percentage method fails to give accurate results.
Merits –
1.
It is easy to calculate because the labor hours are available from the time
sheets and job cards etc.
2.
It is a scientific method, as it gives more importance to the time factor.
Demerits-
1.
The method cannot be used where machines are used predominantly for production.
2.
This method does not take into account the expenses which are not related to
labor hours such as insurance power depreciation etc.
6)
Machine Hour Rate – The cost of
running a machine per hour can be called the machine hour rate. A separate rate
for each machine or group of machines can be established which can be related to
overhead costs of the production department. The actual or predetermined
overhead rate is computed by dividing production overhead costs by the machine
hours operated.
Direct
labour rate = Production
overhead
-----------------------------------
Direct Machine
hours during the period
Merits –
1.
It is a scientific method of recovering overhead.
2.
An equitable charge is made where work is predominantly done by machines.
3.
It helps to compare the relative efficiencies and cost of operating different
machines.
4.
Under absorption, if any reveals the extent of the ideal time of the machine.
5.
The time factor is taken into account.
Demerits –
1.
It is costly
2.
It requires more clerical work
3.
When manual labor is equally important, this method is not useful
4. blanket rate cannot be used.
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