2.4 Absorption of Overheads

Objectives of the Session : 

Objectives of the Session To explain the various overhead absorption rates To understand the methods of absorption of manufacturing overheads To explain the concept of under-absorption and over-absorption

Absorption of Overheads : 

Absorption of Overheads The process of applying overheads to the cost units is known as levy or recovery of overheads Absorption involves the distribution of overhead relating to a particular department among the units produced in that department during the relevant time period

Overhead Absorption Rates : 

Overhead Absorption Rates The overhead rate and the overhead amount is to be absorbed by a product can be calculated as follows: Overhead Rate = Overhead Expenses/Total Quantum of Basis (quantity or value) Overhead absorbed in a product = Overhead rate x Units of base per product These units of base can be units of products, direct labour hours, machine hours, etc.

Overhead Absorption Rates : 

Overhead Absorption Rates Actual Rate Predetermined Rate Moving Average Rate Blanket Rate Multiple Overhead Rate Supplementary Overhead Rate Frequency of Rate Revision

Actual Rate : 

Actual Rate This rate is computed by dividing the actual overhead expenses incurred during a period of time by the actual quantum (quantity or value) of the base selected for that period Overhead Rate = Actual Overheads/Actual Basis (No. of hours or units or direct wages etc.)

Actual Rate : 

Actual Rate Limitations of actual rate are as follows: Actual rate cannot be determined unless the accounting period is over. This delays the determination of the cost of products The actual rate is likely to witness wide seasonal and cyclical fluctuations. This makes the cost comparison difficult Actual costs are useful only when compared with the established norms or standards

Predetermined Rate : 

Predetermined Rate Predetermined rate is computed by dividing the budgeted overhead expenses for the period by the number of units of base for budget period. Predetermined rate helps in cost control, quick preparation of cost estimates and fixing price in cost plus contracts. The only limitation of this rate is that it may give rise to over and under absorption of expenses.

Moving Average Rate : 

Moving Average Rate This rate compromise between the actual rate and predetermined rate. It is computed by dividing the average of the past twelve months or six months actual overhead cost by the estimated base for the months.

Blanket Rate : 

Blanket Rate When a single overhead rate is computed for the factory as a whole it is known as single or blanket rate. It is calculated as follows: Overhead Rate = Overhead cost of entire factory ------------------------------------ Total quantum of the base selected

Multiple Overhead Rate : 

Multiple Overhead Rate When different rates are computed for each producing department, service department cost center, product or product line, each production factor, and for fixed overhead and variable overhead, then they are known as multiple rates. It is calculated as follows: Overhead Rate = Overhead cost allocated to each cost center/Corresponding base

Supplementary Overhead Rates : 

Supplementary Overhead Rates These rates are used for adjusting the under or over-absorption of overheads. These are used in addition to the original rates for ascertaining the true profit. That is why these are called as supplementary overhead rates. It is calculated as follows: Overhead Rate = (Actual Overhead - Absorbed Overhead)/Basis (No. of hours or units or direct wages etc.)

Frequency of Rate Revision : 

Frequency of Rate Revision The frequency of revision of the overhead rates varies from concern to concern. In case of seasonal factories annual rate normalizes the costs. In case of frequent changes in the pattern of the overhead expenses and the base to which rate is related, the revision of overhead rates at shorter intervals is favoured.

Methods of Absorption of Manufacturing Overheads : 

Methods of Absorption of Manufacturing Overheads The main methods of absorption of overheads are as follows: Rate per unit of production Direct material cost method Direct labour cost or Direct wages method Direct labour hour or Production hour method Prime cost method

Rate per Unit of Production : 

Rate per Unit of Production Under this method, overhead rate is calculated by dividing the budgeted overhead expenses by the budgeted production. This method is simple and suitable for extractive industries. Overhead Expenses Overhead Rate = ------------------------- Budgeted Production Illustration-1

Direct Material Cost Method : 

Direct Material Cost Method Under this method, percentage of factory expenses to the value of direct material consumed in production is calculated to absorb the manufacturing overheads. Overhead Expenses Overhead Rate = ------------------------- Direct Material Cost This method is simple and can be used where output is uniform, where the prices of materials are stable, where the proportion of overhead to the total cost is significant.

Direct Labour Cost or Direct Wages Method : 

Direct Labour Cost or Direct Wages Method Under this method, overhead rate for a particular job is determined as a percentage of direct wages. This percentage is arrived at by dividing the overhead expenses by direct wages and multiplying the result by hundred. Overhead Expenses Overhead Rate = ------------------------- Direct Labour Cost This method is suitable where labour cost constitutes a major proportion of the total cost of production.

Direct Labour Hour or Production Hour Method : 

Direct Labour Hour or Production Hour Method Under this method, overhead rate is calculated by dividing the overhead expenses by the total productive hours of direct labour. Overhead Expenses Overhead Rate = ------------------------- Direct Labour Hours For example, if in a particular period the overhead expenses are Rs.1,00,000 and direct labour hours are 1,00,000 then overhead rate per direct labour hour will be Re.1. (Illustration-2)

Prime Cost Method : 

Prime Cost Method The recovery rate under this method is calculated by dividing the budgeted overhead expenses by the prime cost incurred by cost center. Overhead Expenses Overhead Rate = ------------------------- Prime Cost (Illustration-3)

Underabsorption and Overabsorption : 

Underabsorption and Overabsorption Overhead costs are fully recovered from production, when actual rate method of absorption is adopted. But if a predetermined rate is used, the actual expenses may be different from the charged or budgeted overhead expenses. If the overheads absorbed are less than the overheads incurred, it is Underabsorption of overheads. If the amount of overheads absorbed is more than the actual overheads incurred it is Overabsorption of overheads.

Causes of Underabsorption or Overabsorption of Overheads : 

Causes of Underabsorption or Overabsorption of Overheads Error in estimating the overhead. The anticipated output may be different from the actual worked. The hours anticipated may be more or less than the actual hours worked. Due to fluctuations in the prices of material or wage rates, the basis upon which the factory overhead is recovered from production may not be correct. If overheads are not charged to work-in-progress proportionately. Non-recurring expenditure incurred due to unexpected changes in the methods of production. Seasonal fluctuations in the overhead expenses. Illustration-4

Summary of the Session : 

Summary of the Session At the end of the session, we are able to understand the: various overhead absorption rates. methods of absorption of manufacturing overheads. concept of under-absorption and over-absorption.