Absorption of Overheads: Definition, Bases and Methods

In this article we will discuss about the Absorption of Overhead:- 1. Definition Absorption of Overhead 2. Bases of Absorption 3. Method of Absorption of Overheads—Choice of Method.

Definition Absorption of Overhead:

Overhead absorption is a process by which overheads are included in the total cost of a product. According to Terminology of Cost Accountancy overhead absorption is defined as “the charging overheads to cost units by means of rates separately calculated for each cost centre. In most cases the rates are pre-determined”.

When dissimilar products are made which require different production processes or for jobs using identical facilities, overhead absorption becomes very much essential.

The overhead to be absorbed by a cost unit is computed with reference to two factors:

(i) The overheads attributable to a given cost centre; and

(ii) The number of units of the absorption base i.e. labour hours, machine hours etc.

So, Overhead Absorption Rate:

Bases of Absorption:

The objective of overhead absorption process is to include in the total cost of a product an appropriate share of a firm’s total overheads. Various bases to absorb overheads have been developed.

These bases are:

(i) Direct labour hour overheads absorption rate (OAR) .

Total overheads ÷ Direct labour hours.

(ii) Direct wages OAR = Total overheads ÷ Direct wages x 100.

(iii) Direct Materials OAR = Total overheads ÷ Direct Materials used.

(iv) Prime Cost OAR = Total overheads ÷ Prime Cost x 100.

(v) Machine hour OAR = Total overheads ÷ Total Machine Hours.

Selection of Base:

Certain factors are considered for choosing a particular and appropriate base for absorption of overheads, but final choice is a matter of judgement arid common sense. Let us discuss them one by one.

1. Direct labour hour basis:

This method of absorbing overhead is most appropriate in a labour intensive cost centre. Moreover, it is easy to use. Nowadays, most production methods involve substantial use of machinery and so the labour hour method may become increasingly inappropriate.

2. Machine hour rate:

This method is most appropriate, in a mechanised cost centre, i.e. where production is mainly carried on mechanically. In such a cost centre, many of the overheads are related to the machinery, this method of absorption of overheads reflects more accurately the incidence of overheads in the total cost.

So, where a large part of the overhead is incurred by the use of machinery, the use of machine hour rates can be suggested.

3. Direct Material:

This method of overhead absorption is not commendable since its use leads to some absurd anomalies.

Though this method is simple and easy to understand and apply, it suffers from the following disadvantages:

(i) There is no logical relationship between direct materials cost of a product and factory overhead.

(ii) Nowadays, in every economy, material prices fluctuate substantially. This change in price leads to high or low overhead costs, even though overhead costs remain unchanged.

(iii) Most of the overhead expenses vary with time, they accrue on time basis and not on materials consumed. The use of direct materials cost as the basis of absorption totally ignores the time factor which is considered as an important factor in allocation of overhead.

(iv) This method is not rational when part of the materials passes through all processes and part through only some processes.

4. Direct Wages:

This method is frequently used in practice. This is computed in the following way:

This method is simple to operate and understand. It considers the time factor and so it is a rational method for the absorption of factory overheads. Under this method, labour cost is computed by multiplying number of hours spent on work by an hourly labour rate. This signifies that the more hours worked, the higher the labour cost and greater the charge for factory overheads.

This method is beneficial where production is uniform. The following are the demerits of this method:

(i) It does not consider the share of other factors of production other than direct labour. In many concerns, machinery is considered the major factor of produc­tion but not the labour. In such case, machine hour is recommended as the base of absorption.

(ii) It does not take into account the variations in the rates of wages for different personnel. Where wage rates vary and different incentive schemes are in existence, correlation between wages paid and time elapsed does not exist.

If there is only one rate of wage per hour paid throughout a cost centre and no form of incentive scheme exists then the Direct Wages system would be more appropriate to use. But such a situation is a distant possibility.

5. Prime Cost:

This method combines the total of direct materials cost and direct labour cost.

The formula is: 

Advantages:

This method is simple to operate as the prime cost data is easily available.

Disadvantages:

(i) It ignores time factor in absorbing factory overhead.

(ii) Since the method is a combination of direct materials and direct wages, it suffers from the shortcomings of both the methods.

(iii) Where the cost of materials forms a larger part of prime cost, the time factor will be ignored.

(iv) Additional costs which arise due to the use of costlier machines are ignored and thus, this method is likely to result in an inequitable allotment of overheads.

Method of Absorption of Overheads—Choice of Method:

It is really a difficult task to choose the proper method of absorption of overhead. Out of the methods discussed previously the direct labour hour method is usually the best method because most of the factory overheads are period costs as they relate to time and not to the production.

If all the workers in a department or in a Cost Centre are paid wages at the same rate, direct labour hour method is to be followed. If the workers are paid at different rates, direct wages percentage rate is to be adopted.

Circumstances:

1. If the cost centre is labour intensive and the workers are paid at the same rate of wages

2. If the cost centre is labour intensive and the workers are paid at different rates of wages

3. If the cost centre is machine intensive

4. If the cost of materials is predominant

5. If the prime cost is predominant

Method to be followed:

1. Direct labour method

2. Direct wages percentage rate

3. Machine hour rate

4. Direct materials cost percentage

5. Prime cost percentage rate.

Source Documents:

The following are some of the primary documents from which overhead expenses can be collected:

1. Store requisitions – Indirect, materials

2. Job cards or tickets – Indirect labour

3. Purchase vouchers – Indirect materials

4. Salary or Pay Bills – Indirect labour

5. Subsidiary records – Indirect expenses Cash vouchers, Cash Book

6. Plant Register – Depreciation

7. Lease Deed – Rent

8. Local government assessment – Rates.