What are the various methods of absorption of Overheads?

The various methods of absorption of overheads include the following:

Rate per unit of production

Under this method, the units of production are taken as the basis for overhead’ absorption rate. This is the simplest method of all.

The overhead rate can be determined by dividing the overheads of the cost center or job by the number of units produce’ this method is suitable where the output is uniform in size and quality.

The rate is calculated as follows:

Amount of overheads

Overhead Rate

Number of units produced

Advantages: (a) It is simple to understand and easy to calculate.

(b) It is suitable when the output is uniform. Disadvantages: (a) It does not consider time factor.

(b) The distinction between skilled and unskilled worker is ignored

(c)It also ignores the distinction between the manual labour and job done by machine.

Percentage on Direct Material Cost

Under this method, the direct material cost is taken as the basis of overhead absorption rate. This method is suitable where (i) prices of materials do not flux (ii) the product is uniform in all respects, and (iii) material cost constitutes a signifies: proportion of the total cost.

Usually amount of factory overhead and value of direct materials are determined from the past experience and the overhead rate is computed in advance. This overhead rate is applied to determine the amount of overhead to be charged to a job.

Practical Example: Factory overhead and Direct Material cost as per past experience amount to Rs.10, 000 and Rs.50, 000 respectively. A particular job (Job No A-ll) requires direct material cost of Rs.6, 000. Now we need to know how much overheads are to be charged to the job.

Advantages

1. This method is simple to understand and easy to calculate.

2. This method is suitable when the prices of material do not fluctuate widely.

3. This is suitable when the products are uniform. Disadvantages

1. This method ignores the time factor.

2. This method is not suitable when the material costs fluctuate widely.

3. It ignores the distinction between jobs done manually and jobs done by machine.

Percentage on Direct Labour Cost

Under this method, the direct labour cost forms the basis of overhead absorption rate. This method is suitable when:

(i) The Direct labour cost constitutes a major proportion of the total cost.

(ii) The labour rates do not fluctuate widely.

(iii) The workers are of same efficiency level, and

(iv) The production is uniform.

A factory overhead as per past information is Rs.16, 000 and Direct Labour Cos is Rs. 1, 00,000. In job A-15 the requirement of direct labour cost is Rs. 10,000.

(i) In the first step we need to find the overhead absorption rate.

(ii) In the second step the overhead to be charged to job A-15 is calculated as 16% of Rs. 10,000 i.e. Rs. 1,600.

Advantages:

1. This method is simple to understand and easy to calculate.

2. This method is suitable when the labour rates do not fluctuate widely.

3. This method is suitable when the labour is a major factor of production. Disadvantages:

1. It does not give satisfactory result when the piece rate system is followed.

2. It ignores the distinction between skilled and unskilled workers.

3. It is not suitable when the labour rates fluctuate widely.

Percentage on Prime Cost

Under this method, prime cost is used as the basis for determining overhead absorption rate. We know that both direct material and direct labour determine the overheads. The prime cost comprising of direct material, direct labour and direct expenses, is quite significant is every type of organisation.

This method is suitable when:

(i) The products are uniform.

(ii) Both the quantities of direct material and direct labour are constant.

Practical Example: Factory overhead is Rs. 10,000. Prime cost is Rs. 1, 00,000. Jab no A-17 requires prime cost of Rs.20, 000.

(ii) Overhead to be absorbed to Job A-17 = 10% of Rs.20, 000 = Rs.2, 000. Advantages:

This method is simple to understand and easy to operate.

It considers both direct material and direct labour to determine the overhead. Because the aggregate of both is quite significant and constitute major portion of the total cost.

Disadvantages:

1. In common with the previous two systems, this method does not distinguish between jobs done by skilled and unskilled workers.

2. This method ignores the distinction between jobs done manually and jobs done by machine.

Direct Labour Hour Rate

Under this method, direct labour hours are considered for determining the overhead absorption rate. This rate is obtained by dividing the overheads by the total productive hours of workers. This method is suitable for labour intensive industries where manual labour is a dominant factor of production.

Practical Example:

Factory overhead is Rs.20, 000 and Direct Labour Hours is 10,000. The job no- A16 requires 1,500 direct labour hours.

Advantages

(i) It is simple to understand and easy to calculate

(ii) It considers time factor.

(iii) It is suitable when manual labour is a dominant factor of production.

Disadvantages

(i) It ignores job done by skilled and unskilled workers.

(ii) It ignores the distinction between jobs done manually and those done by machines.