A method of overhead absorption in cost accounting is a method of allocating expenses and gains to cost centres within a business.
Benefits of Overhead Absorption
Overhead absorption is useful for accounting purposes because it allows managers to assign a dollar value to the cost of services or products provided by each department or cost centre.
It is an important concept in business decision making because it provides a way for managers to allocate overhead to different activities within the organization.
For example, the manager may decide to charge the sales department with the costs associated with training and marketing new products and charge the maintenance department with the costs of the physical plant associated with those products.
Methods of Absorbing Overheads
Before we describe various methods, it would be better to know how to judge whether an approach will give good results or not. The technique selected for charging overhead to products or jobs should be such will ensure:
- That the total amount charged (or recovered) in a period does not differ materially from the actual expenses incurred in the period. In other words, there should not be any significant over or under-recovery of overhead; and
- That the amount charged to specific jobs or products is desirable. In the case of factory overhead, the means.
- The time spent on completion of each job should be taken into consideration;
- That the distinction should be made between jobs done by skilled workers and those done by unskilled workers. Usually, the latter class or workers need more supervision, cause more significant wear and tear of machines and tools and waste a more substantial quality of materials. Hence jobs done by such workers should beat a correspondingly higher burden for overheads; and
- Those jobs done by manual labour and those done by machines should be distinguished. It stands to reason that no machine expenses should be changed to jobs done by manual labour.
In addition, the methods should
- Be capable of being used conveniently; and
- Yield uniform results from period to period as far as possible; any change that is apparent should reflect a change in the underlying situation such as the substitution of human labour by machines.
Several methods are commonly employed either individually or jointly for computing the appropriate overhead rate to be employed. The more common of these are:
- Percentage of direct materials.
- Percentage of prime cost.
- Percentage of direct labour cost.
- Labour hour rate.
- Machine hour rate.
Percentage of direct materials and prime cost
Suppose for a given period; actual figures are estimated as follows:
Direct materials 2, 00,000
Direct labour 1,00,000
Factory overheads 90,000
The percentage of factory overhead to direct materials will be 45%, prime cost 30%, and direct labour 90%. If, on jobs, material cost is Rs. 10,000 and direct labour is Rs. 7,000, the cost, after absorbing factory overhead, will be as follows:
- 17,000+45% Rs.10,000 or Rs. 21,5000
- 17,000+30% Rs.17,000 or Rs. 22,100, and
- 17, 000+90% Rs7, 000 or Rs. 23,300.
With a different method, one can see how the cost of the work comes out to be different. Of these methods, the first and second are generally considered to be unsuitable on account of the following reasons:
- Manufacturing overhead expenses are mostly a function of time I,e., time is the determining factor for the incurrence and application of manufacturing overhead expenses. They are so would be clear if we recall that overhead expenses, especially manufacturing expenses, can in the ultimate analysis be regarded as expenditure incurred in providing the necessary facilities and service to workers and employed in the production process.
The question of facilities and service made available to workers naturally is dependent on the length of time during which workers make use of the facilities. It may, therefore, be said that the job or product on which more time has been spent would entail larger manufacturing expenses than the job requiring less time. The factor is ignored altogether by the first method and largely by the second method.
- Overhead are neither related to the prime cost not to direct material cost except to a very small extent. Thus, if the percentage of material cost is used when there are two jobs requiring the same operation time but using materials having varying prices, their manufacturing overhead cost would be different whereas this should not normally be so.
The method of absorbing overhead costs based on prime cost also does not consider the time factor. The fact that the amount includes labour cost in addition to material cost does not render the prime cost to be more suitable; in fact, the result is liable to be more misleading because of the cumulative error of using both the labour and material cost as the basis of allocation of overhead expenses, on neither of which they are already dependent.
- Since material prices are prone to frequent and wide fluctuations, the manufacturing overheads, if based on material cost or prime cost, also would fluctuate violently from period to period.
- The skill of the workers involved and whether machines were used or not are ignored when these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of absorbing materials handling and store overheads,
Percentage of direct labour cost
This method also fails to give full recognition to the element of the time which is of prime importance for the accounting for, and treatment of manufacturing overhead expenses expect I so far as a number of wages are a product of the rate factor multiplied by the time factor. Thus, the time factor is taken into consideration only indirectly.
Partially in the computation of the overhead percentage rate. This method, therefore, cannot be depended upon to produce very accurate results, skilled and unskilled, with varying rates of pay. Also, no distinction is made between jobs done by manual labour and those done by machines.
In spite of the inaccuracies, which may arise under this method, it is widely used in actual practice because it is simple and does not involve much calculation. On the other hand, a more scientific method is employed, e.g., the direct labour hour rate or the machine hour rate, more complexities in the overhead accounting procedure would be introduced. However, the selected method will give proper allowance to the time element.
Thus, the advantage of eliminating a small error in practice involves a heavy price on account of the introduction of complexities.
- The method is simple and economical to apply.
- The time factor is given recognition, even if indirectly.
- Total expenses recovered will not differ much; the estimated figure since total wages paid are not likely to fluctuate much.
- It gives rise to certain inaccuracies due to the time factor not being given full importance.
- Where machinery is used to some extent in the process of manufacture, an allowance for such a factor is not made.
- It does not provide for varying skills of workers.
Labour hour rate
This method improves the percentage of direct wage basis, as it fully recognises the significance of the element of time in the incurring and absorption of manufacturing overhead expenses.
This method is admirably suited to operations that do not involve any extensive use of machinery. To calculate the labour hour rate, the factory overhead is divided by the total number of direct labour hours.
Suppose factory overheads are estimated at Rs.90.000 and labour hours at 1,50.000. The overhead absorption rate will be Re.060. If 795 direct labour hours are spent on a job, Rs. 477 will be absorbed as overhead. It can be calculated for each category or worker.
Machine hour rate
By the machine hour rate method, manufacturing overhead expenses are charged to production based on a number of hours machines are
By the machine hour rate method, manufacturing overhead expenses are charged to production on the basis of the number of hours machines are used on jobs or works orders. There is a basis of similarity between the machine our and the direct labour method insofar as both are based on the time factor. The choice of or the other method is conditioned b the actual circumstance of the individual case.
Regarding departments or operations in which machines predominate and the operators perform relatively a passive part, the machine hour rate is more appropriate. This is generally the case for operations or processes performed by costly machines, which are automatic or semi-automatic and where operators are essential merely for feeding them rather than for regulating the quantity of the output. In such a case, the machine hour rate method alone can be depended on to correctly absorb the manufacturing overhead expenses to different items of production.
What is needed for computing the machine hour rate is to divide overhead expenses for a specific machine or group of machines for a period of the operating hours of the machine or the group of the machine for the period.
Usually, the computation is made on the basis of the estimated expenses or the normal expenses for the coming period. Thus the machine hour rate usually is a predetermined rate. It is desirable to work out a rate for each individual machine; where a number of simple machines are working in a group; there may be a single rate for the whole group. There are two methods of computing the machine hour rate.
According to the first method, only the expenses directly or immediately connected with the operation of the machine are taken into account, e.g., power, depreciation, repairs and maintenance, insurance, etc. The rate is calculated by dividing the estimated total of these expenses for a period by the estimated number of operational hours of the machines during the period.
It will be obvious, however, that addition to the expenses stated above there may still be other manufacturing expenses such as supervision charges, shop cleaning and lighting, consumable storage and shop supplies, shop general labour, rent and rates, etc. incurred by the department as a whole and, hence, not charged to any particular machine or group of machines.
To see that such expenses are not left out of production cost, one should include a portion of such expenses to compute the machine hour rate. Alternatively, the overheads not directly related to machines may be absorbed on the basis of productive labour hour rate method or any other suitable method.