Selecting a base or denominator is the next important step towards absorption of overheads. The cost accountant should consider, while selecting the base, various factors such as the nature of the products which pass through the cost centres, factors which mainly cause incurrence of overheads and variations in time spent by various products. Lastly, the base which is most economical should be selected. The following bases are used for overhead absorption:
(a) Production unit method
The absorption rate, which could be actual or predetermined, is calculated by dividing the cost to be absorbed by the number of cost units produced or expected to be produced. Rate per unit is also calculated by dividing ‘estimated overheads for the Budget period’ by the ‘estimated units of production at normal capacity’. This is the simplest and the most direct method of applying factory overheads to production units. However, its usefulness is limited to those situations where there is only one product or if there are two or more products, all of them can be reduced to an equivalent production unit.
Problem :
Products manufactured X Y Z
Normal capacity units 2000 1000 3000 Unit weight kgs. 2 3 5
Solution :
Factory overheads for the period Rs. 2,20,000
X Y Z
Estimated total weight kgs 2 × 2000 3 × 1000 5 × 3000 = 4000 + 3000 + 15000 = 22000Kgs.
Absorption rate will be Rs. 220000 divided by 22000 Kgs. = Rs. 10 per Kg. Applying the rate to the products, the absorption rates will be:
X = Rs. 10 × 2 = Rs. 20 per unit Y = Rs. 10 × 3 = Rs. 30 per unit Z = Rs. 10 × 5 = Rs. 50 per unit
(b) Percentage on direct wages method
When direct labour cost is used as a basis for absorbing overheads, the rate is expressed as a percentage of direct wages as follows:
(Estimated or budgeted overheads for the period/Estimated or budgeted direct wages for normal output) × 100
The advantages of the method are as follows :–
i) The method is simple and easy to apply.
ii) It is suitable where production is uniform, and labour-oriented, and all the workers earn more or less the same hourly rate.
iii) It recognises the fact that a large proportion of overhead expenses vary with time, and longer a job takes to complete, the higher it absorbs the overheads.
iv) Labour rates fluctuate less frequently than material cost.
However, this method suffers from the following disadvantages :
i) It ignores the difference in the rates of pay for different types of workers. An experienced and skilled worker is paid at a higher rate, and at the same time, his output may be higher than others. He takes less time to complete which means less incurrence of overhead, but the absorption on the basis of high wages will be higher than is applicable.
ii) Overtime payments create further anomaly because many of the overheads do not increase with overtime work.
iii) It does not make any distinction between manual and machine production, as well as using expensive and cheap machines. Expensive automatic machines use power, costly lubricants, maintenance besides high depreciation, but if absorption is made on the basis of attendant’s wages, the recovery of overheads will be inequitable.
(c) Percentage on direct material cost
This method is similar to the previous one except that the material cost is taken as base for calculating absorption rate. This method is seldom used because it is very difficult to establish relationship between direct material costs and factory overheads. The method suffers from the following weaknesses :–
(a) Material prices are subject to constant fluctuations, and this will lead to charging high or low overheads even though there may be no change in overhead expense.
(b) Most of the overhead expense items vary with time, such as, rent, rates, taxes, insurance premium, supervisory and managerial salaries, etc. but this method completely ignores the fact.
Overheads (d) Percentage on prime cost method
The method is also very simple, but is subject to the same weaknesses as those mentioned in case of direct wages and direct materials. The only circumstances in which this rate could be used, would be when a standard product is made, material prices are stable, labour rates are steady and machine and equipments remain unchanged.
(e) Direct labour hour rate
The direct labour hour rate is computed by dividing ‘estimated overhead expenses to be absorbed’ by ‘estimated direct labour hours available for production’. The terminology defines direct labour hour rate as: “A rate calculated by dividing the budgeted or estimated overhead cost attributable to a cost centre by the appropriate number of direct labour hours. Hours may be either the number of hours expected to be worked, or the number of hours which would relate to working at normal capacity”. The rate may be computed for each group of workers or each department. This method is superior to any of the earlier methods discussed because the majority of overhead expenses vary with time, and this method relates overhead absorption rates with time. This rate is most appropriate for cost centres where manual operation are predominant. Obviously, the method is not suitable for cost centres where operations are mostly mechanised.
(f) Machine hour rate
In factories or departments, where production is largely by machinery, this method gives greater accuracy than any of the other methods discussed earlier. The terminology defines a machine hour rate as “a rate calculated by dividing the budgeted or estimated overhead or labour and overhead cost attributable to a machine or group of similar machines by the appropriate number of machine hours. The hours may be the number of hours for which the machine or group is expected to be operated, the number of hours which would relate to normal working for the factory, or full capacity”. In a highly mechanised cost centre, majority of the overhead expenses are incurred on account of using the machine, such as, depreciation, power, repairs and maintenance, insurance, etc. Machine hour rate, therefore, provides the most equitable basis for absorption of overheads in machine intensive cost centres.
Computation of Machine Hour rate
The overhead expenses are to be departmentalised first. Then, each machine or a group of machines within the department shall be treated as a cost centre, and all the items of expenses are allocated to the machine cost centres on some suitable basis. A machine hour rate is then computed by dividing the total overhead for the machine cost centre by the anticipated machine hours. For example, in the cigarette making department, there are twenty machines of which eight machines manufacture filter cigarettes, five machines plain medium cigarettes, and seven machines produce magnum size cigarettes. In such a situation, three different machine hour rates are to be computed for three groups of machines.
Machine hour rate can be bifurcated into variable or running expenses and standing or fixed expenses in order to differentiate between expenses being incurred while running the machine compared to when it remains idle. For example, power, oil, grease and cotton waste, repairs and maintenance expenses are running or variable, while depreciation, rent and taxes, lighting and heating, insurance and supervision are included under standing or fixed charges.
Lastly, a machine hour rate may include the wages of the machine operator and attendance, if they become part of the complements. For example, in cigarette making machine, the operator and two catchers become part of the machine, because as long as the machine operates, they have to attend the machine and gain the same speed, say 2000 cigarettes per minute, as the machine produces. Such rate is called comprehensive machine hour rate. Needless to mention that operators wages shall be included as variable overhead expenses.
Illustration : From the following details, compute a comprehensive machine hour rate: 1. Cost of the machine - Rs. 4 lakhs, having a scrap value of Rs. 40000 at the end of 10
years of life.
2. Machine will run in two shifts of 7 hours duration for 33 working days ; 200 hours will be lost for repairs, maintenance and idle time.
3. Other details :
(a) Wages of two operators @ Rs. 4000 for each.
(b) Rent and rates of the machine shop accommodating four identical machine – Rs. 2400 per year.
(c) General lighting charges of the department – Rs. 300 per month. (d) Insurance premium for the machine – Rs. 200 per quarter.
(e) Cost of repairs and maintenance per machine per month – Rs. 2500 (f) Supervisor’s salary – Rs. 6000 per month.
(g) Power consumption – 20 units per hour @ rate Rs. 1.75 per unit. (h) Other factory overheads – Rs. 13200 p.a.
There are four machines in the department and the supervisor devotes one-fifth of his time for each machine.
Computation of Machine Hour Rate
Department : Machine No.
Machine description : Effective life: 10 years Estimated working hours (300 × 7 × 2) – 200 = 4000 Hrs.
1. Running Expenses : Per year Per hour
Wages (4000 × 2 × 12) 96000 24.00
Power 20 Units @ 1.75 140000 35.00
Repairs & maintenance (2500 × 12) 30000 7.50
Overheads 2. Fixed expenses :
Depreciation(Rs.400000/40000) divide by10) 36000 Rent & rates 2400 divide by 4 600 General lighting (300 divide by 4) × 12 900
Insurance Rs. 200 × 4 800
Supervisor’s salary (6000 × 12) / 5 14400 Other overheads 13200 divided by 4 300
Subtotal 56000 14.00
TOTAL 322000 80.50
Comprehensive machine hour rate = Rs. 80.50 per machine hour. 6.4 OVER– AND UNDER– ABSORPTION OF OVERHEADS
When predetermined rate is used for absorption of overheads, there is likely to arise a difference between overheads absorbed and actual overheads incurred during the period. This may happen due to one or more of the following reasons:
(a) Any error or omission at the time of computation of predetermined rates in estimating expenses or adopting the basis of recovery.
(b) Actual overhead expenses are more or less than the estimates. (c) Actual hours or output differs from the budget or estimated figures.
Overabsorption of overhead arises when more overhead expenses are applied to products compared to actuals incurred. Under absorption of overhead arises under reverse condition. For example,
Recovered by applying
Production Administration Selling & Dist. Overhead Overhead Overhead
Rs. Rs. Rs.
Predetermined rates 20000 10000 10000 Actual overhead expenses incurred 19000 12000 9500
Overabsorbed 1000 – 500
Underabsorbed – 2000 –
The various reasons of over- and under- absorption may be analysed. Apart from the causes mentioned earlier, the difference may be caused by seasonal fluctuations, changes in the production methods affecting overheads, all expenses not properly accounted for, etc.
Treatment of Under- or Over- Absorbed Overheads
i) Write off to costing profit and loss account. ii) Carry forward to next accounting period. iii) Use of supplementary rate.
i) Write off to costing profit and loss Account. Under-absorbed and over-absorbed overheads are first collected in a control account and then the net balance is debited or credited to the costing profit and loss account. This method is applicable when the amount of under- or over-absorbed overhead is not significant in relation to the total overheads. A typical overhead adjustment account is illustrated below:
Overhead Adjustment A/c (figures in Rs.)
Rs. Rs.
To Administration By Production overheads control a/c
overheads control a/c (Overabsorbed) 1000 (Underabsorbed) 2000 By Selling and Distrn. ovds. control a/c
(Overabsorbed) 500 By Costing profit & loss a/c transfer 500 2000 2000
ii) Carry forward to next accounting period. Under this method, under or over-absorbed overhead is transferred to a suspense or reserve account, and is carried over to the next accounting period as deferred charges or deferred credit on the assumption that it has occurred due to seasonal fluctuations and business cycle which extends over more than a year, and shall be evened out in the subsequent accounting period. This may also happen during the earlier part of a new project.
iii) Use of supplementary rates. If the under- or over-absorbed overheads are significant and has arisen due to error at the time of computation of rate, a supplementary rate has to be developed and applied to the cost of sales, finished stock and work-in-progress. The supplementary rate may be computed either as rates per hour or as a percentage of overheads already absorbed.
Illustration : Solution : Rs. Overhead incurred 2,50,000 Overhead recovered 2,00,000 Cost of sales 30,00,000
Closing finished stock 12,00,000
Closing work-in-progress 8,00,000
Total value of cost of sales,
Finished stock and work-in-progress = Rs. 50,00,000 Overhead underapplied = Rs. 50,000
Overheads
Accounts will be debited as under:
Cost of sales a/c Rs. 3000000 × 0.01 = Rs. 30,000 Finished stock a/c Rs. 1200000 × 0.01 = Rs. 12,000 Work-in-process a/c Rs. 800000 × 0.01 = Rs. 8.000
Total Rs. 50.000
As a result of the above adjustment, profit for the period will be reduced by Rs. 30,000, while profit of the subsequent period will be affected by Rs. 20000, when finished stock and work- in-process will be used.
6.5 CAPACITY COSTS
In computing a predetermined overhead rate regard must be had to determination of level of activity. Such a predetermined rate will vary according to different capacities, e.g., maximum, practical, normal. Thus if the estimated expenditure be Rs. 1,000 and maximum and practical capacities be 500 and 400 labour hours respectively, the predetermined rates are: .
1. Rate based on maximum capacity = Rs.1000/500 = Rs. 2.00 per labour-hour. 2. Rate based on practical capacity = Rs.1000/400 = Rs. 2.50 per labour-hour. (1) Maximum capacity:
Maximum capacity is the maximum productive capacity of a plant or department. Some losses are bound to occur in actual practice, but as such losses are not considered in determining maximum capacity, it is also called ideal or theoretical capacity. It is equal to the rated capacity specified by the manufacturers that may be achieved provided no operating time is lost. This maximum capacity is thus rarely achieved and is seldom used.
(2) Practical capacity:
Practical or operating capacity is the maximum capacity less inevitable interruption, such as, time lost for breakdown, repairs, set up, normal delays, sundays and holidays, inventory taking etc. Practical capacity does not consider the external factors, such as, lack of orders from customers, unbalanced capacity, etc. Although the nature and extent of inevitable interruptions would depend on the type of plant, nature of product and other circumstances, practical capacity may be taken as 80 to 90% of the maximum capacity. Predetermined overhead rate is sometimes based on practical capacity. Determination of overhead rates based on practical capacity has the following advantages:
(i) Practical capacity can be assessed accurately and overhead rates based on practical capacity relatively accurate.
(ii) Idle capacity cost is indicated in the form of under-absorption of fixed overhead. This assists in the control of volume variance.
(iv) Costs are not disturbed by variation in sales volume, stocks are correctly valued, and profits are accurately calculated.
(3) Capacity based on sales expectancy:
This is the capacity based on expected sales and is determined after a careful study of the market conditions. In most cases this capacity is less than the operating capacity because of lack of orders from customers. Predetermined overhead rate is sometimes computed based on sales expectancy. Determination of overhead rate on the basis of capacity at sales expectancy has the following advantages:
(i) The amount of fixed overhead charged to the cost of production bears the same ratio to the total fixed overhead as the actual capacity bears the capacity based on expected sales. (ii) Overhead is recovered in production in full.
(iii) The units cost becomes a basis for taking decision on price fixation and for integration in the budgetary plan.
(4) Actual capacity:
This is the volume of production achieved in a particular period. Actual capacity depends on various factors prevailing is the organisation and may be below or above the practical capacity and capacity based on sales expectancy.
(5) Normal capacity:
Normal capacity is generally the long term average capacity based on sales expectancy. But opinions differ as to what should be regarded as the normal capacity and accordingly normal capacity may be the practical or operating capacity and in rare cases the maximum capacity. In determining the normal capacity, the rated capacity of a plant and the sales potential are not so important as its physical capacity and long-term average sales expectancy. While determining normal capacity, machinery and equipment purchased should be excluded.
The advantages and consequently the objectives of establishing normal capacity are –
(i) Establishment of budgets by determining the normal plant capacity.
(ii) Computation of overhead rates based on normal capacity so as to remove under-or over-absorption to a great extent. It is extensively used in seasonal factories.
(iii) Establishment of sales prices.
(iv) Setting up of standards for materials, labour and overhead and reporting the variances. (v) Control as well as reduction of costs.
(vi) Basis for scheduling production and fixation of operating schedule. (vii) Valuation of inventory.
Overheads 6.6 OVERHEAD RATES BASED ON NORMAL CAPACITY
As already mentioned normal capacity may represent capacity based on expected sales or maximum and practical operation capacity. The determination of normal capacity is very difficult and opinions may vary among the technical persons while fixing normal capacity. Some may give more emphasis on expected sales volume. Others may give emphasis on practical capacity attained while in extreme cases maximum capacity may be the normal capacity. The choice of normal capacity thus vary according to the different circumstances prevailing in an organisation. The overhead rate will differ accordingly and the amount of under- or over-absorption will differ if actual capacity differs from the normal capacity. This will be evident from the following illustration.
Illustration 15 :
From the following data calculate overhead rates based on –
(a) Maximum capacity, (b) Practical capacity, and
(c) Capacity based on expected sales.
Maximum Practical Capacity on
capacity capacity expected sales
(100%) (80%) (75%)
Direct labour hours 20,000 16,000 15,000
Fixed overhead (Rs.) 60,000 60,000 60,000 Variable overhead (Rs.) 40,000 32,000 30,000
(d) If the actual capacity utilised be 14,000 labour-hours, calculate amount of under-or over-recovery of fixed overhead on the basis of each of above capacities.
Solution : Computation of overhead rates based on –
(a) Maximum (b) Practical (c) Capacity on
capacity capacity expected sales
(100%) (80%) (75%)
(a) (b) (c)
(i) Direct labour-hours 20,000 16,000 15,000
(ii) Variable overhead (Rs.) 40,000 32,000 30,000 (iii) Fixed overhead (Rs.) 60,000 60,000 60,000 Variable overhead rate (ii)/(i) Rs. 2.00 Rs. 2.00 Rs. 2.00 Fixed overhead rate (iii)/(i) Rs. 3.00 Rs. 3.75 Rs. 4.00
Thus variable overhead rate remains constant at all levels and fixed overhead rate varies and depends on the particular capacity selected.
(d) If the actual capacity utilised be 14,000 labour-hours, the amount of under-absorption will be as follows :
Normal capacity Fixed overhead Overhead Under-absorption
based on – rate per absorbed on of overhead (Rs.
labour-hour as actual capacity 60,000 - absorbed
shown earlier (14,000 labour-hrs.) amount)
Rs. Rs. Rs.
(a) Maximum capacity 3.00 42,000 18,000
(b) Practical capacity 3.75 52,500 7,500
(c) Expected sales capacity 4.00 56,000 4,000
Comments :
(1) Under-absorption in (a) represent idle capacity cost inclusive of all interruption. (2) Under-absorption in (b) represents the cost of capacity utilised due to lack of sales provided that no amount of the under-absorbed amount is attributable to other causes, e.g., change in expenditure, difference between predetermined and actual overhead rates are.