Overhead absorption

What is Overhead Absorption?

Overhead absorption is defined as the allotment of overhead to cost units. When the amount of overheads has been determined on the pre-determined basis for each cost center, the next step is to charge it to production. This involves taking each cost center and to apply its overheads to all the products passing through that cost center. This application of overheads is called absorption which can be defined as charging of overheads to production.

As we know that all products, jobs or services pass through one or more producing cost centers and therefore it becomes necessary to charge overheads to the cost of products, jobs, processes according to certain well set norms and scientific reasoning so that the cost pertaining to a cost center must be absorbed as per the set norms. The process of such charging to or recovering the overheads in the cost of production is called overhead absorption.

Explanation

After the overheads have been allocated and apportioned to various production departments, the total overhead cost of a production department shall comprise of:

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(i). The expenses allocated to the production department e.g., salary of the departmental head, salary of departmental foremen, cost of indirect materials issued to the department, etc.

(ii). The share of the common expenses apportioned to it e.g., factory rent, salary of works manager, factory power, factory lighting, etc.

(iii). The share of the expenses of the personnel department, expenses of the stores department, expenses of time-keeping department, etc.

The total amount of overhead accumulated for a production department is ultimately to be charged to the various cost units of that department. The distribution of the accumulated overhead cost of a production department amongst its cost units is known as overhead absorption. Thus, the absorption of overhead is the function of apportioning the overhead costs to individual units, jobs, production lots, processes, work-orders or such other convenient cost units and is also known as “recovery” or “application” of overhead expenses to cost units.

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Steps to be taken in the Overhead Absorption

There are three essential steps for overhead absorption. These are:

  • Determination of absorption bases
  • Working out the overhead absorption rate
  • Application of overhead at this worked out rate to products.

Methods to calculate the overhead absorption rate

The following are the various methods to calculate overhead absorption with the help of which overheads are recovered or charged to or absorbed in the factory cost:

1. Rate Per Unit of Output:

This is the simplest method of overhead absorption. This refers to the application of overheads on the basis of number of units of output manufactured during the period. This is said to be a direct method pf overhead absorption and is the most convenient method. The overhead rate here is obtained by dividing the amount of overhead by the number of units (output) produced.

The overhead rate can be determined by dividing the total estimated overheads of cost center or job by the total estimated units of output. This method is suitable where the output is uniform in size and quality.

Formula

The overhead absorption rate is calculated as follows:

Overhead absorption rate per unit = Total estimated overheads / Total estimated units of output

Example

Say, if total unit produced are 3,000 and total production overhead on these units produced comes to $15,000; then

Rate per unit = Amount of production overhead / Number of units produced

Rate per unit = 15,000 / 3,000 = $5.00

Here, according to this method of overhead absorption, $5 per unit will then be taken as factory overhead.

2. Percentage on Direct Material Cost

Under this method, the total direct material cost for all production is taken as the basis of the overhead absorption rate. This method is suitable where:

(i) Prices of materials don’t fluctuate,
(ii) The product is uniform in all respects, and
(iii) Material cost constitutes a significant proportion of the total cost.

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

Formula

The rate is calculated as follows:

Overhead absorption rate = (Total estimated overheads / Total direct material cost for all production ) x 100

Example

Say, if the total production overhead is $15,000 and the cost of direct material is $60,000; then

Rate = (15,000 x 100) / 60,000 = 25%

Here, according to this method, the absorption rate will come to 25%. If for example, the direct materials cost of a product is $2,000; then the overhead of (2,000 x 25) / 100 = $500 per unit will be charged to factory cost. This is a good method. It is easy and simple. It gives reasonably accurate results in the case where grades and prices of raw materials do not differ widely. where the quantity and cost of materials in each product is uniform, and also where the processing is uniform.

3. Percentage on Direct Labor Cost

This method of overhead absorption refers to the application of overheads as a percentage of direct labour. this is one of the oldest methods of cost absorption and supposed to be one of the best. The percentage rate is obtained by dividing the overhead cost by the amount of direct labour. The overhead here is applied by multiplying to obtained percentage by the direct labour of cost of each product, job or process.

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

(i). The direct labor cost constitutes a major proportion of the total cost.
(ii). The labor rates don’t fluctuate widely.
(iii). The workers are of the same efficiency level.
(iv). The production is uniform.

Formula

The rate is calculated as follows:

Overhead absorption rate (%) = (Total estimated overhead / Total estimated direct wages) x 100

Example

Say, if production overhead is $15,000 and Direct Labour Cost is $30,000, then:

Rate (%) = (15,000 x 100) / 30,000 = 50%

If a job has incurred direct wages of $1,000, overheads to be absorbed in this case shall be $500, i.e. 50% of $1,000. This method is applied in cases where labour is the major factor of production and the grade and skill, gender, etc. of labour do not widely differ.

This is a good, easy, simple and economical method of overhead absorption. Salary, Rent, Insurance, taxes are some of the overheads which are related to the time factor as well as wages. Therefore, this method for these items of overheads gives satisfactory results. It is again good because of the simple fact that labour rate as compared to other rates in the elements of cost are more stable. Hence, it gives a better result.

4. Percentage on Prime Cost

Under this method, the prime cost is used as the basis for determining the overhead absorption rate. We know that both direct material and direct labor determine the overheads. The prime cost comprising of direct material, direct labor, and direct expenses is quite significant in every type of organization. This method is suitable when:

(i). The products are uniform,
(ii). Both the quantities of direct material and direct labor are constant.

Formula

The rate is calculated as follows:

Overhead absorption rate (%) = (Total estimated overhead / Estimated prime cost) x100

Example

Say, if the production overhead is $1,000 and the prime cost is $4,000, the rate will be:

Rate (%) = (1,000 x 100) / 4,000 = 25%

If the prime cost of a unit is $200, that the absorption rate per unit will be $50, i.e. ($200 x 25) / 100, that is $50.

This is a simple and easy method. no additional record is required for its calculation. It takes into account all direct costs, i.e. materials, labour and expenses. It is best suited to those units of production where overheads are dependent on both direct material as well as direct labour.

5. Direct Labor Hour Rate

Under this method, total direct labor hours are considered for determining the overhead absorption rate. This method is suitable for labor-intensive industries where manual labor is a dominant factor in production.

Formula

The rate is calculated as follows:

Overhead absorption rate per direct labor hour = Total estimated overheads / Total estimated direct labor hours for all production

Example

Say, if the overheads amount to $4,000 and labour spent comes to 20,000 hours, then:

Rate = 4,000 / 20,000 = $0.2 per hour

If on a job 25 hours are spent then the absorption on the hob will be of $0.2 x 25 hours, i.e. $5. This method should be applied where the labour is the predominant factor of production.

6. Machine Hour Rate

Under this method, total machine hours are considered for detemining the overhead absorption rate. This is a very good method of absorption of overhead cost in the industry where all work is done with help of machines.

Formula

The rate is calculated as follows:

Overhead rate per machine hour = Total estimated overhead / Total estimated machine hours for all production

Example

Say, if a factory uses 10 machines and each machine runs for 20 hour per day and total production overhead comes to $20,000 then the machine hour rate

Machine hour rate = 20,000 / (10 x 20) = $200

But machine hour rate is always calculated for a machine and not for all the machines. Therefore, the formula and computation will be as given below:

Machine Hour Rate = Production overhead of one machine / machine hour of one machine

=(20,000 / 10) / 20

= $2,000 / 20 = $10 per hour per machine.

Application of Overhead absorption Rates

For the application of pre-determined absorption rates, the actual (i.e., the actual number of units or other actual base data e.g., direct labour hours, machine hours etc.,) is multiplied by the predetermined rate. The resultant amount will give the amount of overhead to be applied (or charged) to production for the period.

It is seldom applied overheads agree with the actual overheads. There will always be a difference between the actual overheads and applied overheads. If the absorbed amount exceeds actual overhead, the difference would be called as “overapplied overhead”. If however, it falls short of actual overhead, the difference would be called ‘Under applied overhead”.

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