There are various methods of absorption of factory overhead. Some of the methods are briefly explained below.
1. Production Unit or Cost Unit Method
This method is followed under historical costing. The rate is calculated by dividing the overhead by the number of units produced. The following formula is used to calculate the rate.
OH Rate = Budgeted or Actual Overhead / No. of units budgeted or produced
Advantages of Production Unit or Cost Unit Method
1. This method is suitable for the department which produces only one product or homogeneous products or products measured in terms of a common yardstick.
2. It is applicable to the company where the manufacturing methods are simple.
3. This method is simple to understand and easy to apply.
2. Percentage of Direct Material or Direct Material Cost Method
Under this method, the rate is calculated by expressing the overhead cost as a percentage of direct materials for the same period. The following formula is used to calculate the rate.
OH Rate = Budgeted or Actual Overhead / Budgeted or Actual Direct Material Cost x 100
Advantages of Direct Material Cost Method
1. This method is very simple to understand and easy to apply.
2. This method is suitable to the cost unit or cost centre where materials are formed as major part of the finished product.
3. This method is useful if grades of materials and prices of materials do not widely fluctuate.
Disadvantages of Material Cost Method
1. There is no logical relationship between the items of overhead and material cost.
2. Time factor item of overhead is not considered under this method. For example: Rent.
3. This method is not suitable if some materials passes through all processes and some materials passes through few processes.
4. The price fluctuation of material will not be accompanied by similar fluctuations in overhead.
5. Time spent on the completion of product is ignored in this method. For example cheap raw materials or inferior quality material requires more time than quality raw material. If so, cheap raw materials absorb high overhead and quality raw material absorb less overhead. This is undesirable.
3. Percentage of Direct Wages Method (or) Direct Labour Cost Method
Under this method, the rate is calculated by expressing the overhead cost as a percentage of cost of direct labour for the same period. The following formula is used to calculate the rate.
OH Rate = Budgeted OR Actual Overhead / Budgeted OR Actual Direct Labour Cost x 100
Advantages of Direct Labour Cost Method
1. This method is used where labour cost forms a major portion of the total cost.
2. If different grades of labourers are employed to produce a product, this method is fair.
5. There is a direct relationship between time factor and direct wages. If more time is required to finish a product, there must be a payment of high amount of wages.
6. Comparison of direct wages from one period to another is more dependable.
Disadvantages of Direct Labour Cost Method
1. This method is not suitable if the workers are paid on piece rate basis. The reason is that overhead depends upon the time instead of output.
2. Sometimes, workers are employed with costly equipment and hand tools. If costly equipment is used, the overhead is high and vice versa in the case of using hand tools. But, overhead absorbed on direct wages basis is equal. This is not acceptable.
3. If skilled workers perform a job, the wages is high. If unskilled worker performs the same job, the wages is low. These practices lead to absorption of overhead in different rate. This is unfair.
4. Percentage of Prime Cost Method
This method is the combination of both percentage of direct material cost method and percentage of direct labour cost method. The following formula is used to calculate the rate.
OH Rate = Budgeted OR Actual Overhead / Budgeted Prime Cost x 100
Advantages of Percentage of Prime Cost Method
1. This method is very simple to understand and easy to apply.
2. It gives equal importance to direct material and direct labour.
3. It recognizes time factor.
Disadvantages of Percentage of Prime Cost Method
1. This method suffers from the limitation of both percentage of direct material cost method and percentage of direct labour cost method.
2. If the portion of direct material cost is more than direct labour cost, giving equal importance is not acceptable.
3. If the portion of direct labour cost is more than direct material cost, insufficient allowance is given for the time factor.
Suitability of Percentage of Prime Cost Method
This method is suitable if the following conditions are satisfied.
1. A standard product is produced.
2. A standard quantity of materials at standard rate is consumed.
3. A standard number of labour hours at standard rate is required for production.
5. Direct Labour Hour Rate Method:
Generally, time is the key factor, which determines the amount of indirect expenses. Hence, any recovery rate calculated on the basis of the hours of work shall give accurate result. In a manufacturing process, if handwork is the rule, the rate of overhead per direct labour hour is worked out and applied suitably. The following formula is used to calculate the rate.
OH Rate = Budgeted OR Actual Overhead / Budgeted OR Actual Direct Labour Hour
A direct labour hour rate may be calculated for each department or for each group of workers.
Advantages of Direct Labour Hour Rate Method
1. If the production units are heterogeneous, the time spent by the labour is considered in the calculation of overhead rate.
2. This method can be easily adopted if proper records of time booking are maintained.
Disadvantages of Direct Labour Hour Rate Method
1. If mechanical production is followed, this method is not suitable.
2. The maintenance of direct labor hours are required for overhead rate calculation. This is very difficult.
3. There is no difference between the time spent by the skilled labour and unskilled labour.
Suitability of Direct Labour Hour Rate Method
This method is highly suitable if the following conditions are satisfied.
1. Labour is very important in production process.
2. Output is not uniform.
3. Any percentage method fails to suit the condition.
6. Machine Hour Rate Method
If automatic and semi-automatic machines are used in the manufacturing process, machine hour rate is applied in the case of overhead absorption.
CIMA defines machine hour rate as an
actual or pre-determined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost to be apportioned or absorbed by a number of hours for which a machine or machines are operated or expected to be operated.
Now a day, machine, production is getting importance and, therefore, the overhead may be absorbed on the basis of machine hour rate.
Types of Machine Hour Rate
The following are the important types of machine hour rate.
A. Ordinary Machine Hour Rate
It is calculated by taking into account of all the indirect expenses, which are relating to the running of a machine. All these indirect expenses are classified into two categories. They are
Expenses incurred proportionately according to the running of the machine and
Expenses incurred in no way connected with the running of the machine.
The expenses like power, repairs and maintenance and depreciation are incurred directly proportionate to the running of the machine. These are known as machine expenses or variable expenses. Moreover, expenses like insurance, taxes, lubricants etc. are incurred but not in proportion to the running of the machine included in the machine hour rate. All these expenses are totaled which is divided by machine hours to determine the machine hour rate.
B. Composite Machine Hour Rate
Under this method, both variable expenses and fixed expenses are taken into account to calculate machine hour rate. The fixed expenses like supervision, rent, lighting, heating etc. are included along with the variable expenses to calculate the machine hour rate.
These fixed expenses are known as standing charges. The standing charges of each machine are divided by the working hours of that machine to determine the machine hour rate for standing charges. To calculate the composite machine hour rate, ordinary machine hour rate is added with the machine hour rate for standing charges.
C. Group Machine Hour Rate
Under this method, a machine hour rate is prepared for a group of machines. Such group of machines is treated as a cost centre. This method is followed if identical machines are used in a factory. All direct expenses are allocated to the cost centre. All the indirect expenses are apportioned on a suitable basis.
Consideration for the Computation of Machine Hour Rate
The following points are considered while computing machine hour rate
1. Group of machines should be treated as single cost centre.
2. The estimated overhead expenses for the period should be determined for group of machines.
3. All the expenses should be classified into two categories. They are standing charges and machine expenses.
4. Both direct and indirect expenses are combined to obtain total overhead expenses to operate the machine during the period. The total overhead expenses are divided by the number of hours to be operated for the specific period to obtain machine hour rate.
5. The wages of operator should be included in the direct wages and should not be included in machine expenses. If so, misleading machine hour rate is calculated. Hence, accountants prefer to include such wages into the machine expenses for computing actual machine hour rate.
Advantages of Machine Hour Rate
The followings are the advantages of machine hour rate.
1. If machine work is predominant in any production, the machine hour rate ensures equitable charge.
2. An operator operates many machines or many operators operate single machine, machine hour rate becomes the best method of recovery.
3. Only productive time is taken into consideration for the calculation of machine hour rate. Hence, it is a logical method.
4. It is very easy to calculate machine hour rate well in advance.
5. The idle time of the machine is disclosed through analyzing under absorption of overhead.
6. It helps the allocation of indirect expenses to each job.
7. The share of expense of a job is determined with high degree of accuracy by using job specification sheets and route sheets.
8. If this method is followed, the price for the job is accurately fixed.
Disadvantages of Machine Hour Rate
The followings are the disadvantages of machine hour rate.
1. The calculation requires more clerical work.
2. Indirect expenses are apportioned on suitable basis. If suitable basis is not followed, the calculation of machine from rate is misleading.
3. This method is not useful if one single rate for the factory is to be used.
4. If most of the work is done manually, this method has limited application.
7. Sales Price Method:
Under this method, sales value is taken into consideration for the calculation of machine hour rate. The budgeted or actual overhead is divided by sales realized or to be realized. This method is rarely used by many organizations. The reason is that there is no relationship between the overhead absorption and sales value realized. Hence, it leads to inequitable absorption of overhead to a job or a product.