Overhead Absorption: Rate, Examples, Formula and Methods

The following are the various methods and techniques of absorbing manufacturing overhead: 1. Direct Material Cost Method 2. Direct Labour Cost (or Direct Wages) Method 3. Prime Cost Percentage Method 4. Direct Labour Hour Method 5. Machine Hour Rate Method 6. Rate per Unit of Production Method 7. Sale Price Method.

Overhead Absorption: Rate, Examples, Formula and Methods

Method # 1. Direct Material Cost Method:

Under this method direct material is the basis for absorption. Direct material percentage rate is calculated by dividing the predetermined production overhead by direct material.

The formula is given below:

Suitability:

This method is suitable:

(1) When material cost forms the major part of total cost;

(2) When the price of material does not fluctuate;

(3) When the quantity of material used is uniform for all units of output;

(4) Where only one kind of article is produced.

Advantages:

(1) It is simple to calculate

(2) The information is readily available to calculate the rate.

(3) Overhead cost items in the form of upkeep and handling of material can be fairly absorbed only be this method.

Disadvantages:

(1) Fluctuations in material prices may affect the overhead absorbed. Overhead may be stable but absorption rate may not be appropriate as the basis is not suitable, when the raw material prices fluctuate.

(2) The time factor is not taken into account in this method which is very important for absorbing overhead cost.

(3) Expensive materials may result in less overhead expenses than cheap materials. Thus, overhead cost has nothing to do with direct material cost of a product.

(4) Variable expenses vary with volume of production, whereas fixed expenses remain constant. This is totally ignored in this method.

Method # 2. Direct Labour Cost (or Direct Wages) Method:

Actual or predetermined direct labour cost method is calculated by dividing the overhead cost apportioned by the wages paid or expected to be paid and expressed as a percentage.

The formula for calculating the percentage rate is:

Suitability:

(1) When wages form the major part of the total cost.

(2) When there is little variation in wage rates payable to different categories of employees.

(3) When there is uniform efficiency and productivity among work force.

(4) When output is uniform.

Merits:

(1) It is simple to calculate and easy to understand.

(2) The information is readily available for calculations.

(3) If wages are paid on time basis, this method takes time factor into account.

(4) Labour rates are more stable than material prices.

Demerits:

(1) If wages are paid on piece rate basis, the time factor is totally ignored.

(2) Differences in output of skilled and unskilled workers and difference in rates of pay may make the method inaccurate.

(3) Distinction between fixed and variable expenses is ignored.

(4) No distinction is made between the production of hand workers and that of machine workers.

(5) When labour is not the major cost of production this method of absorption will not be suitable.

Method # 3. Prime Cost Percentage Method:

Under this method the overhead is divided by the aggregate of direct material and direct labour cost of the department.

Merits:

(1) This method is simple to calculate and apply.

(2) The rationale behind this method is that both material and labour costs cause the overhead to be incurred and therefore it is appropriate to use the aggregate of both as basis for absorption.

(3) This method is suitable when a standard article is produced requiring constant quantity of raw material and number of hours spent upon its production.

Demerits:

(1) When material forms major part of total cost, time factor is ignored.

(2) No consideration is given for fixed and variable cost.

(3) It combines the shortcomings of both direct material and direct labour percentage methods.

Method # 4. Direct Labour Hour Method:

Direct labour hour rate is computed by dividing the factory overhead by direct labour hours.

The formula is:

Suitability:

(1) This method is suitable when production is carried on manually.

(2) It is suitable even when the production is not uniform.

Merits:

(1) This method is simple and easy to calculate since labour hours are readily available from time sheets, job cards, etc.

(2) It is a scientific method since time factor is duly considered.

(3) The rate is not affected by wage rates, different kinds of incentive systems, etc.

Demerits:

(1) This method cannot be used when machines are extensively used for production.

(2) This method fails to take into account the expenses which are not incurred according to labour hours, such as power, depreciation, fuel, insurance, etc.

(3) When piece rate systems are used for payment, labour working hours may not be available in records.

Method # 5. Machine Hour Rate Method:

Machine hour rate method of absorption is used in those industries where machines are extensively used for production and manual labour is negligible or plays very minor role. The I.C.M.A., London, defines machine hour rate as “an actual or predetermined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost apportioned or absorbed by the number of hours for which a machine is operated or expected to be operated”. It is not desirable to calculate a blanket rate or one single rate for the entire factory, since the cost, horse power, capacity of machines differ. It is appropriate to calculate multiple rates.

Machine hour rate is calculated by dividing the factory overhead by machine hours.

Computation of Machine Hour Rate:

The machine hour rate may be calculated for a specific machine or group of machines.

The particulars required for computing machine hour rate are:

(1) Expenses chargeable to each machine.

(2) The total hours worked by each machine or group of machines.

The following is the procedure for computing machine hour rate:

(1) Each machine or group of machines are treated as a cost centre to identify the overhead cost.

(2) The overhead expenses of machines are classified under two heads i.e.-

(i) Fixed or standing charges, which remain constant irrespective of use of the machine.

Examples of fixed expenses are:

Supervision

Rent

Insurance

Lighting and heating

Consumable stores, etc.

(ii) Machine Expenses:

These expenses vary with use of the machine. Examples are power, depreciation and repair expenses.

(3) Fixed expenses being period costs are accumulated for the period and divided by the number of machine hours during the period to obtain the fixed charges per hour.

(4) The machine expenses are estimated separately and then divided by the number of working hours to give hourly rate for each item.

(5) The total of standing charges per hour and machine expenses per hour is the ordinary machine hour rate.

Comprehensive Machine Hour Rate:

If machine operator’s wages are also added to the ordinary machine hour rate it is called comprehensive machine hour rate. Generally machine operator’s wages area part of direct wages. But to provide a ‘comprehensive’ idea of the cost of operating machines, some experts on costing include the operators wages also in the computation of machine hour rate and call it ‘Comprehensive machine hour rate’. But other costing experts object to such a procedure because, it makes a direct cost into an overhead item.

The bases used for apportionment of different expenses for the computation of machine hour rate, are as under:

Suitability:

Machine hour rate method is suitable when machines are extensively used in production.

Merits:   

(1) It is a scientific method of absorption, since time factor is taken into account.

(2) Cost of operating different machines is computed and efficiency of different machines is compared.

(3) The difference between machine work and manual work, cost wise and quality wise can be ascertained.

(4) Machine hour rate reveals idle time.

Demerits:   

(1) It involves additional cost in ascertaining working hours of machines.

(2) Expenses not connected to machine operation are ignored.

(3) It is inaccurate when manual labour plays equally important role in production.

Method # 6. Rate per Unit of Production Method:

Per unit method of absorption of overhead is used when the output is measured in physical units like number, weight, etc.

The rate per unit is calculated as given below:

This method is suitable when only one type of product is produced and all the units of output are uniform in all respects. If different products are produced of the units of output are of different size, grade, quality, etc., this method is not suitable.

Method # 7. Sale Price Method:

Under this method budgeted overheads are divided by the sale price of units of production.

The formula is:

Sales price method is inequitable for absorbing production overhead because production overhead has no specific relationship with sale price of products.