The object of absorption of overheads is to charge an equitable proportion of the total factory overheads to each unit of production. The total factory overheads are distributed to the production cost centres (a) by allocating departmental expenses, (b) by apportioning common costs along with service department expenses, and (c) by redistributing service department cost to the production cost centres. The total overhead of each production cost centre will be absorbed or recovered by the output of the department concerned. For this, a suitable base, such as, production unit, direct labour hour, machine hour, direct wages, etc. is to be determined, and the total departmental overheads are to be divided by the base to arrive at recovery or absorption rate at which the expenses are to be applied to the production units. The rate may be actual or predetermined. Again, the rate may be a single or blanket rate to the entire factory or separate rates for each production departments or cost centres.
Actual vs. Pre-determined Rate
Actual overhead recovery rate is computed by dividing actual overheads cost by actual base in a particular period. It is obvious that one has to wait till the close of the accounting period for calculating actual rate.
Predetermined overhead recovery rate, on the other hand, is determined before the commencement of the period during which the same will be used. The rate is computed with reference to the budgeted overhead cost for the year and a predetermined quantity of the base (say, labour hour) for the year, which will be used as a denominator.
When historical cost ascertainment is the sole objective, actual overhead rate may lead to desired result. Otherwise, considerable delay will occur in arriving at the production using actual overhead rate. Even if the actual rate is calculated on a monthly basis, it will not serve the purpose due to the following reasons:
a) Some of the expenses are not evenly incurred throughout the year. Examples are repairs and maintenance, lighting and heating, etc.
b) Production volume fluctuates month to month due to more or less working days in a month or seasonal nature of product. As a result monthly overhead rates will fluctuate and consequently, production cost will vary from month to month, when such fluctuating rates will be applied to products in busy seasons, the cost will be low, while in slack season, the cost will be higher.
Predetermined overhead absorption rates, on the other hand, have the following advantages:
a) Product cost can be worked out promptly.
b) Product cost can be estimated prior to commencement of production and can help the management in price quotation and fixing selling price well in advance.
c ) Product costs are not affected unnecessarily due to the vagaries of the calendar or seasonal fluctuations.
d) Use of predetermined rate will provide data available for cost control as well as decision making.
e) By using normal capacity as base while determining rate, losses due to idle capacity is highlighted and real cost of production is reflected.
In the light of above discussion, the method of predetermined overheads absorption rate appears to be more useful.
Blanket vs. Multiple Rate
Overheads recovery rate may be one for the entire factory, or different rates for each production department. When a single rate is used for the entire factory, it is known as single or blanket rate. In a small firm or where only a single product is manufactured or all products are identical and pass through all the cost centres uniformly, blanket rate may be applied. But where disproportionate costs are incurred in different departments producing different products, through widely different processes, a blanket rate will lead to disastrous result. In all such cases, departmental or multiple recover rates are used. A product passing through each department will be charged with the overhead rate of that department. The following example will clarify the difference:
Illustration :
Cost Machine Overheads Overhead recovery rate
centre hour Rs. Rs./machine hour
Leaf processing 2000 200000 100 Cigarette making 8000 400000 50 Cigarette packing 10000 300000 30
Total 20000 900000
Instead of the departmental recovery rates, a blanket rate of Rs. 45 per machine hour can be computed as Rs. 900000 divided by 20000 = Rs. 45. But what will be the effect? Cigarettes vary in tobacco blends (which require different processing time), size and brands (medium, magnum & king size) and packing (shell & slide, pouch & hinge lid}. As a result, each brand and pack of cigarette takes different time for processing, making and packing, and total overheads applicable will vary considerably. Again, consider the price : Cigarettes sell @ Rs. 2 per 10’s to Rs. 50 per 20’s. If blanket rate is applied, it will be too much load on cheap cigarettes, and too little on the expensive ones, although expensive cigarettes require more time for blending and packing. Consequently, cheap cigarettes will not be able to cover its overheads, while expensive cigarettes will have high margins.
Overheads
Other disadvantages in using blanket rates are that the performance of individual cost centres cannot be evaluated, and work in progress valuation may be incorrect. Hence, multiple rates should be used wherever difference in product, process and expense of the departments exists.