Different methods of absorption discussed below are used to determine the overhead absorption rate for production overhead: 1. Percentage on Direct Material Cost 2. Direct Labour Cost Percentage Rate 3. Prime Cost Percentage Rate 4. Labour Hour Rate 5. Machine Hour Rate 6. Rate Per Unit of Output 7. Standard Rate.
Method # 1. Percentage on Direct Material Cost:
Under this method, the amount of overheads to be absorbed by cost unit is determined by the cost of direct materials consumed in producing it. This rate is ascertained by dividing the total overheads by the total cost of direct materials consumed in the department and multiplied by 100.
Thus –
Example – Production Overheads – Rs. 1,00,000
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D. Materials Consumed – Rs. 5,00,000
Thus, if the direct material cost of a job is Rs. 30,000 the overhead to be absorbed by it will be (30,000 x 20)/100 = Rs. 6,000.
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This method is suitable under the following situations:
1. Where only one variety of the product is manufactured.
2. Where the materials used are common for different jobs or process or products.
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3. Where the prices of the raw materials remain stable.
4. Where material costs constitute highest proportion to total cost.
Advantages:
Following are the advantages of this method:
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1. This method is simple and easy to operate because cost of direct materials is readily available and no additional records are required to be maintained for this purpose.
2. This method gives fairly accurate rates where material prices do not fluctuate widely and where output is uniform.
Following are the main drawbacks of this method:
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1. Most of the factory overheads are not directly related to direct materials cost. So the method is not logically correct and hence gives misleading results.
2. This method fails to take into account the jobs performed by skilled and unskilled workers. A job which is performed by unskilled workers requires more amount of overheads. This method also fails to distinguish the jobs done by manual labour and machines.
3. This method does not take time factor into account. Most of the overheads are related to time element. A job which requires a longer period to complete may need more of overheads than a job which is completed in a shorter period of time.
4. This method is quite illogical and inaccurate because overheads are in no way related to the cost of materials consumed. The amount of overheads does not change because the work is being done on copper instead of iron. Both metals are quite different in prices and by applying the same percentage for both will be obviously incorrect.
Method # 2. Direct Labour Cost Percentage Rate:
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This is the oldest method of overhead absorption and still it is more popularly used. Under this method, the overhead to be absorbed is divided by direct labour cost and the quotient is expressed in the form of percentage.
It is calculated with the help of following formula:
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Production Overhead = Rs. 36,000
Direct Labour Cost = Rs. 1,20,000
Overhead Rate = (36,000/1,20,000) × 100 = 30%
Thus, a job for which direct wages are Rs. 1,800 will absorb production overheads of Rs. 540 (1,800 × 30)/100
This method is suitable under the following situations:
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1. Where labour cost forms a high proportion to total cost of production.
2. Where skill of labour does not differ widely.
3. Where the wage rate does not fluctuate widely.
Advantages:
The main advantages of this method are:
1. The method is simple to understand and easy to operate.
2. It gives stable results as labour rates are more constant than material prices.
3. Under this method special consideration is given to time factor, as higher the charge to a job for wages, the longer will have been the time spent on that job.
4. This method can be adopted with advantage where rates of workers are same, where workers are more or less of equal skill and where uniform types of works are performed.
Following are the main drawbacks of this method:
1. This method is not suitable, where machines are used at a great extent.
2. As it ignores time factor, this method is not suitable in those industries where piece rate system of wage payment is adopted.
3. Where the work is done by both skilled and unskilled workers, the method is not suitable. If works are done by unskilled workers overheads incurred will be more.
4. No distinction is made between work done by skilled and unskilled workers.
5. It also does not distinguish between production of hand workers and that of machine workers. Machines give rise to certain overheads like depreciation, power etc. which should be charged only to the work done on machines.
Method # 3. Prime Cost Percentage Rate:
This method is based on the assumption that both materials and labour give rise to factory overheads and thus total of the two i.e., material and labours should be taken as the base for absorption of factory overheads. In other words, this method is a combination of the material cost and labour cost methods.
Under this method overhead rate is calculated by dividing the production overheads by Prime Cost.
Production overhead = Rs. 60,000
Prime Cost (Material + Labour) = Rs. 3,00,000
∴ Overhead Rate = 60,000/3,00,000 × 100 = 20%
Thus, if prime cost of a job is Rs. 1,500, production overhead to be absorbed by that job should be Rs. 300 i.e., (1,500 × 20)/100.
Suitability:
This method is suitable where direct material cost and direct labour cost are equally important and overheads are related to both.
Advantages:
Following are the advantages of the method:
1. It is simple to understand and easy to operate.
2. Information regarding materials and wages are readily available and there is no need to keep separate account for them.
3. This method gives satisfactory result because it takes into account direct material cost and direct labour cost.
Disadvantages:
Following are the drawbacks of this method:
1. Under this method, equal importance is given to both material cost and labour cost, though most of the overheads are closely related to labour cost.
2. Where material cost is predominant element of cost, the method ignores time factor.
Method # 4. Labour Hour Rate:
Under this method, overheads are absorbed on the basis of direct labour hours worked. The overhead rate is obtained by dividing the overheads to be absorbed by the number of direct labour hours.
The following formula can be used for its calculation:‘
Example:
Production overhead = Rs. 60,000
Direct Labour hours = 75,000 hours
∴ Overhead Rate = 60,000/75,000 = 80 paise p.h.
Thus, if a job takes 15 hours for production, Rs. 12 (i.e. 15 hours @ 80 paise p.h.) will be charged to that job for production overhead.
Suitability:
This method is most suitable where manual labour is engaged in the factory.
Advantages:
This method has the following advantages:
1. This method gives full consideration to time factor.
2. This is not affected by the methods of wage payment (i.e., time rate or piece rate method)
3. This method gives accurate results.
Disadvantages:
Following are the main drawbacks of this method:
1. This method requires additional clerical work and separate records are necessary for recording direct labour hours.
2. This method is not desirable where machines are used to a great extent.
Method # 5. Machine Hour Rate:
This method refers to the overheads incurred for running a machine for one hour. This rate is ascertained by dividing the amount of factory overhead apportioned to a machine by the number of machine hours for the concerned period.
Expressed in the form of a formula:
Production overhead for Machine No. 1 = Rs. 30,000
No. of machine hours = 3,000 hours
∴ Machine hour rate = 30,000/3,000 = Rs. 10 p.h.
Thus, if the machine No. 1 is used for 20 hours for a job, overhead to be absorbed by that job will amount to Rs. 200 (i.e. 20 hours x Rs. 10 p. h.)
Suitability:
This method is most suited where machines are used predominantly for production purpose.
Advantages:
Following are the advantages of this method:
1. This is most scientific, accurate and logical method of overhead absorption.
2. It helps in knowing the existence and extent of idle time of machines.
3. This method takes into account time factor and hence gives accurate results.
4. It helps in comparing the efficiency and cost of operating different machines.
5. It helps management in choosing between manual labour and machines.
Disadvantages:
This method has the following drawbacks:
1. This method is not suitable in manual labour based factories.
2. It involves maintenance of additional records for noting down the machines hours operated.
Method # 6. Rate Per Unit of Output:
Under this method, the overheads are absorbed on the basis of number of units produced. The overhead absorption rate is obtained by dividing the overheads to be absorbed by the number of units produced.
It is expressed in the form of formula as follows:
Production Overheads = Rs. 52,000
No. of units produced = 1,000 units
∴ Overhead rate = 52,000/1,000 = 52 per unit
Thus, each unit produce will absorb Rs. 52 for production overhead.
Suitability:
This method is suitable where the finished goods are identical in nature.
Advantages:
It is the simplest method among all the methods.
Disadvantages:
The main drawbacks are:
1. This method is not suitable where different varieties of finished products are manufactured.
2. If historical overhead rate of recovery is adopted it involves considerable delay in computing the overhead rate as one has to wait for the completion of production for the given period.
Method # 7. Standard Rate:
This method is adopted by those industries which adopt standard Costing technique. The standard overheads and standard base is set on the basis of past experience and necessary adjustments are made based on the factors which affect it. The standard overhead is divided by a standard base, gives a standard rate of overhead absorption.
The following formula is used for the purpose:
