Under this method, machine hours are used as a basis for determining overhead absorption rate. It is the cost of operating the machine for one hour.
This method is suitable for industries where major portion of the production is performed by the machines. It is not desirable to compute machine hour rate of the whole industry since all the machines may not be uniform in every respect.
Hence separate rate is computed for each machine or for a group of identical machines. Machine hour rate is determined by dividing the amount of overheads concerning the machine by the number of effective machine hours.
Computation of Machine Hour Rate
Computation of Machine Hour Rate in different from all the above mentioned methods. Under this method, the machine is treated as a small department or cost center to apportion various expenses to the machines just as the expenses charged to bigger departments.
While computing machine hour rate, the fixed and variable expenses need to be segregated to yield a better result. Even if the machine is idle, it does not have any impact on the fixed overheads, whereas it has a significant effect on the variable expenses. Because of these reasons we need to compute Machine Hour Rate in a systematic manner.
Steps for Computation of Machine Hour Rate
Step-1: Each machine or group of machines should be treated as a separate cost center.
Step-2: Overheads are classified into two groups such as standing charges and machine expenses. Standing charges are fixed expenses which do not vary with the use of machine. Examples of standing charges are rent, rates, lighting, insurance, etc.
Machine expenses are variable expenses which vary with running of machines, such as depreciation, repairs, power, maintenance, etc. Some accountants treat depreciation as a standing charge.
Infect depreciation can be treated as fixed or variable expenses depending upon the method followed for its calculation. However for all practical purposes we have treated depreciation as a machine expense for computation of machine hour rate.
Step-3: The effective machine hours of each machine for a given period need to be calculated as shown below:
Step-4: The standing charges are estimated for a given period (year, month or week) for every machine and the total sanding charges are divided by the total number of effective working hours of the machine to arrive at the hourly rate of standing charges.
Step-5: The machine expenses of each machine are treated separately in order to compute the hourly rate. Each machine expense of a machine is calculated either by allocation or by apportionment.
Step-6: The aggregate of the standing charges per hour and hourly rate of all the individual machine expenses is calculated to arrive at the simple Machine Hour Rate. When the machine operator's wages added to the simple machine hour rate, it is known as Comprehensive Machine Hour Rate.
Comprehensive M.H.R. = Simple M.H.R. + Machine operator's wages
While computing machine hour rate some of the overheads may require to be apportioned for the desired machine cost center. This apportionment is made just like the apportionment of overheads dealt in the previous chapter. However the bases of apportionment of such overheads are mentioned below: