In this article we will discuss about the meaning and methods of overhead absorption.
Meaning of Overhead Absorption:
CIMA defines Absorption of Overheads as “the process of absorb, overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”.
Absorption of overheads refers to charging of overheads to individual products or jobs. It is a process of distribution of overheads allotted to a particular department or cost centre over the units produced. The absorption of overhead is done by applying overhead absorption rates. The overheads allocated or apportioned over different cost centres or cost units are again absorbed into unit cost on some equitable basis.
Overheads absorption is a process of charging of overheads to cost units by means of rates separately calculated for each cost centre. In most cases the rates are predetermined. The overhead to be absorbed by a particular cost unit will be calculated by dividing the producing cost centre overhead for a period by the cost units produced by that centre in the period.
When a cost centre produces dissimilar units e.g., jobs to customer order, the volume of production must be expressed in a common measurement e.g., direct labour hours, machine hours etc. When a cost unit passes through several centres, the overhead absorbed should be separately for each centre.
The overhead absorption rate is calculated as follows:
Methods of Overhead Absorption:
The important methods used in absorption of overhead are discussed below:
i. Production Unit Method:
Under this method, overhead absorption rate is calculated by dividing the overhead cost by number of units produced or expected to be produced as shown below:
For example, the budgeted overhead is Rs. 2,00,000 p.a. and the budgeted production is 50,000 units p.a.
(a) Where the manufacturing methods are simple and the company makes only one product, this method can be used.
(b) It is simple to understand and easy to apply.
(c) This method is suitable if production consists of products that are more or less identical and which take approximately the same time to produce.
ii. Percentage of Direct Material Cost Method:
Under this method overhead is absorbed based on the actual or predetermined absorption rate calculated by expressing the overhead cost as percentage of direct materials for the same period.
The absorption rate is calculated as follows:
For example, budgeted overhead is Rs. 1,00,000 and the budgeted direct material cost is Rs. 4,00,000, then overhead absorption rate is:
(a) This method is useful if materials are a major part of the cost of units made in the cost centre.
(b) This method is simple to understand and easy to apply.
(1) The cost of materials is often subject to considerable fluctuations which will not be accompanied by similar fluctuations in overhead.
(2) Most of the overheads are attributable to time spent on the job or cost unit and this factor is completely ignored in this method.
For example, cheap raw material may take longer time for process than expensive quality material. The unit with cheap raw material should absorb higher overhead cost than the unit processed with high quality raw material.
iii. Percentage of Direct Labour Cost Method:
Under this method, overhead absorption rate is calculated by expressing the overhead expense to be absorbed as a percentage of cost of direct labour for the same period, as shown below:
For example, the budgeted overhead is Rs. 1,00,000 and the budgeted direct labour cost is Rs. 5,00,000.
The absorption rate is calculated as shown below:
(a) This method is used where labour cost is an important part of total unit cost.
(b) This method is fair in situation where more than one product is made, and each product requires different amounts of various grades of labour, which are paid at different rates.
(c) It is simple to understand and easy to apply.
(d) This method is better than percentage of direct material cost, since labour rates fluctuate less frequently than the rate of materials.
(1) It ignores time taken for completion of the job or unit, as job performed by a skilled worker takes lesser time than an unskilled worker.
(2) It ignores the work performed by machine where the labour is a mere attendant.
(3) If a job undertaken by a skilled worker may have a higher labour cost than one undertaken by an unskilled worker, but if the two jobs take equal amounts of time to complete, it might be unfair to charge different amounts of overhead to them.
iv. Percentage of Prime Cost Method:
This method is a combination of both direct material cost and direct labour cost method. The overhead absorption is calculated as follows:
For example, the budgeted overhead is Rs. 2,00,000 and the budgeted prime cost is Rs. 8,00,000.
(1) This method suffers from the disadvantages of both the methods.
(2) It gives equal weightage to both material and labour.
(3) Where the cost of material is predominating item of prime cost, insufficient allowance is given for the time factor.
v. Direct Labour Hour Rate Method:
Under this method, overhead absorption rate is calculated by dividing the overhead with the number of direct labour hours.
For example, the budgeted overhead of production centre is Rs. 2,00,000 and the budgeted direct labour hours for the period is 40,000.
(a) This method takes into account the time spent by the labour in production of each unit where the production units are not uniform or identical.
(b) It is more appropriate in a labour intensive cost centre where proper records are maintained for time booking.
(c) It is adopted where labour is the limiting factor.
(1) It is not suitable in mechanized and capital intensive production.
(2) Maintenance of labour time records is difficult.
(3) No distinction of hours spent by skilled worker and unskilled worker.
vi. Machine Hour Rate Method:
CIMA defines Machine Hour Rate as an “actual or predetermined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost to be apportioned or absorbed by a number of hours for which a machine or machines are operated or expected to be operated.”
In a manufacturing environment where automatic and semi-automatic capital intensive machinery used, machine hour rate is applied in absorption of overheads. This is the most scientific method of absorption of factory overheads, the budgeted overhead cost to be absorbed is divided by the budgeted hours for which the machine or machines will work.
The machine hour rate is calculated as follows:
For example, the budgeted production overhead is Rs. 3,00,000 and estimated machine hours is 15,000.
Then machine hour rate is:
1. It is used in mechanized production environment where machine time is vital and limiting factor.
2. Machine hour rate will be able to account for varying lengths of time taken by products or jobs as they are worked on by the various machines in the department.
3. It is more realistic because machine hour rate is applied only when the machine is used in production of the job or cost unit.
4. Machine hour rate can be computed for the entire plant (called composite machine hour rate) or machine hour rate for individual machines (simple machine hour rate).
(1) In labour intensive industries machine hour rate is not suitable.
(2) It is difficult to maintain detailed record of machine usage.
(3) Ascertainment of machine hour rate requires skill and detailed working knowledge.
Compute the machine hour rate from the following data:
Only actual hours run on production i.e., 1800 hours is taken into consideration for computation of machine hour rate, treating hours spent for setting and adjusting as non-productive.
In a machine shop, the machine hour rate, worked out at the beginning of a year on the basis of 13 week period which is equal to 3 calendar months.
The following estimates for operating a machine are relevant:
Power consumed @ 15 units per hour @ 40 paise per unit. Power required for productive hours only. Setting up time is part of productive time but no power is required for setting up jobs.
The operator and supervisors are permanent. Repairs and maintenance and consumable stores are variable.
You are required to:
(a) Work out the machine hour rate.
(b) Work out the rate for quoting to the outside party for utilizing the idle capacity in the machine shop assuming a profit of 20% above variable cost.