Methods of Factory Overhead Absorption
The common methods applied for absorbing factory overhead are as follows:
(1) Units of Output Method:
Under this method, absorption of factory overhead is made on the basis of the number of units manufactured. The overhead rate is obtained by dividing the amount of overhead expenses by the number of units of output.
Overhead Rate = Factory Overhead of the Department / Number of units of Output
For example, if the amount of factory overhead for department ‘A’ for a particular period is$10,000 and the number of units manufactured by the department during the period is 2,000, the overhead rate per unit will be $5 ($10,000 + 2,000 units) and each unit will bear $5 by way of overhead cost.
This method is a very simple and direct method of overhead absorption and can be applied in single output industries like collieries, brick-making, etc., where only one product or a few grades of the same product are manufactured. But this method cannot be applied in multi-product industries where a variety of products of different values are manufactured.
(2) Direct Material Cost Method (Percentage on Direct Material Cost):
The absorption of overhead, under this method, is made on the basis of direct
materials consumed. The overhead rate is expressed as a percentage of the
direct material cost and is calculated by dividing the factory overhead for
a particular period by the cost of direct materials used during the period and
multiplying it by 100.
Overhead rate = (Factory Overhead Cost of Direct Materials used) x 100
If, the amount or factory overhead for department ‘A’ for a month is $10,000 and the cost of direct material consumed is $25,000, the overhead rate will be 40% on direct material cost (10,000 / 25,000) x 100 and if on a job done by department direct material costing $200 has been used, the job will absorb $80 (40% of $200) by way of overhead. Rs. (40% 01′ Rs. 2()()) by way of overhead.
This method is very simple and equitable where the same type of material is used in all the articles manufactured and the price of such material is not subject to considerable fluctuations.
This method is not widely used on account of the following disadvantages:
(1) Cost of Materials is often subject to considerable fluctuations which will not be accompanied by similar fluctuations in factory overhead. This basis is, therefore, unstable.
(2) This method ignores the time factor involved in the production.
(3) The mere fact that a job consumes material of a very expensive nature is no justification for supposing that factory overhead chargeable to it would be proportionately higher.
(4) Factory expenses are affected not only by the materials cost but also by the type of workers employed to do a job. But under this method, no distinction is made between the jobs done by skilled workers and those done by unskilled workers.
(3) Direct Labour Cost Method (Percentage on Direct Wages):
Under this method, the absorption of overhead is made on the basis of the direct wages. The overhead rate is expressed as a percentage of direct wages and is obtained
by dividing the factory overhead for a particular period by the direct wages
paid during that period and multiplying it by 100. The overhead rate is obtained
by applying the following formula:
Overhead Rate = (Factory Overhead /Direct Wages) x 100
For example, if the factory overhead cost for department ‘A’ for a particular month is $10,000 and the total labor cost is $20,000, the overhead rate will be 50% on direct wages (10,000 / 20,000) x 100. And if a job done by the department ‘A’ involves a payment of $200 by way of direct wages, it will absorb $100 (50% of $200) by way of overhead.
This method is very simple and is widely practiced on account of the following advantages:
(1) Automatic consideration is given to the time factor as the wages are paid on the basis of time.
(2) Wages rates are more constant than material prices and hence this method provides a stable basis for the absorption of overhead.
(3) Factory expenses, to a great extent, depend on the number of workers employed and hence, this basis is more equitable.
But this method suffers from the following disadvantages:
(1) Variations in the wage rates of skilled and unskilled workers are not taken into account. It is notable that unskilled workers give rise to more factory expenses than skilled workers and hence the jobs done
by unskilled workers should bear a higher charge for overhead but the reverse is likely to happen under this method.
(2) No distinction is made between the work of hand workers and that of machine workers. It should be remembered that hand workers give rise to more factory expenses than machine workers.
(3) Time element may be ignored if the workers are paid on the basis of piece-work and not on the basis of time.
(4) Prime Cost Method (Percentage on Prime Cost):
Under this method, absorption of overhead is made on the basis of prime cost. This method assumes that both materials and labour give rise to overhead and, therefore, both should be into consideration. The overhead rate is expressed as a percentage of the prime cost and can be obtained by the following formula:
Overhead Rate = (Factory Overhead / Prime Cost) x 100
For example, if the factory overhead for department ‘A’ for a particular month is $10,000 and the prime cost is $40,000, the overhead rate will be 25% on prime cost (10,000 / 40,000) x 100 and if the prime cost of a job done by the department is $300, the job will absorb $ 75 (25% of $300) by way of overhead.
This method is simple to operate and combines the advantages of both direct materials cost and direct labour cost methods. But this method assigns equal weight to materials and labour, though factory overhead is more closely related to labour.
(5) Direct Labour Hour Rate Method:
Under this method, absorption of overhead is made on the basis of number of hours for which direct labour is employed. The direct labour hour rate of overhead is obtained by dividing the factory overhead for the department for a given period by the total number of direct labour hours for the period. Thus, overhead rate is:
Overhead Rate = Factory Overhead / Number of Direct Labour Hours
For example, if the factory expenses for department ‘A’ for a particular period amount of $10,000 and the total number of direct labour hours worked during the period is 5,000, the direct labour hour rate will be $2 ($10,000 / 5,000 hours). If a particular job done during the period involves 50 hours
work of direct labour, it will absorb $100 (50 hours x $2) by way of overhead.
Direct labour hour rate is basically a time rate and since most of the items of factory overhead vary with time, this method provides a satisfactory basis for overhead absorption. But this method assumes the pre-dominance of direct labour in production and ignores all other factors of production.
(6) Machine Hour Rate Method:
Under this method, overhead absorption is made on the basis of the cost of operating machinery. This method is applied in highly organized engineering works where most of the work is done by machines. The hourly cost of operating a machine represents the overhead rate and is known as machine hour rate. The machine hour rate is obtained by dividing the factory expenses connected with a machine for a given period by the number of hours worked by the machine during that period.
Thus overhead rate under the machine hour rate method is:
Overhead Rate = Factory Overhead (relating to a machine) Number of Machine Hours
For example, if the factory expenses relating to Machine No. 15 installed in department ‘A’ for a particular period amount to $5,000 and the total number of hours worked by the said machine during the period is 1,000, the machine hour rate will be $5 ($5,000 + 1,000 hours). If a particular job executed during the period has taken 30 hours of machine No. 15, it will absorb $150 (30 hours x $5) by way of factory overhead.
In highly mechanized factories where a considerable portion of the factory overhead is related to the running of the machines, machine hour rate method provides the most scientific basis for the absorption of overhead. But this method is a complicated one as it involves too much mathematical calculations. Moreover, it requires the maintenance of accurate records regarding the life of the machines and the cost of repairs and maintenance.
(7) Dual Hour Rate Method:
This is a combination of machine hour rate and direct labour hour rate. It is adopted in those departments where both manual and machine work are equally important. In such cases, overheads are classified into two groups, i.e., overheads which are related to manual work and secondly those related to machine work. The first kind of overheads are absorbed by means of a labour hour rate and the second category of overheads by a machine hour rate.
The following information relates to a Manufacturing Co., for the year ended 31st March 2019:
Materials Used $60,000; Direct Labour $30,000; Factory Overhead $18,000; Direct Labour Hours 12,000; Machine Hours 10,000.
The following information relates to Job No. 75:
Materials used$1,200; Direct Labour $650; Direct Labour Hours 265; Machine Hours 255.
Enumerate 4 different methods of absorbing Factory Overheads and prepare a statement showing total cost of Job No. 75 under each of the four methods referred to above.
The main four methods of absorbing factory overhead may be:
- A Percentage on Direct Materials.
- A Percentage on Direct Labour Cost.
- Direct Labour Hour Rate Method.
- Machine Hour Rate Method.
The overhead rate as a percentage on direct materials cost comes to 30%, calculated as follows:
= (18,000 / 60,000) x 100
The factory cost of the job will be as follows:
The overhead rate as a percentage on direct labour cost comes to 60% calculated as follows:
= (18,000 / 30,000) x 100
The factory cost of the Job will be as follows:
The direct labour hour rate of overhead comes to $1.50, calculated as follows:
= ($18,000 / 12,000 hours)
The Factory cost of the Job will be as follows:
The machine hour rate of overhead comes to $1.80, calculated as follows:
= $18,000 / 10,000 hours.
The factory cost of the job will be as follows:
Choice of Overhead Absorption Method:
At this stage, we know that there are a number of methods which can be used for absorbing factory overhead e.g., direct material cost method, direct labour cost method, direct labour hour rate method, machine hour rate method, etc.
The method selected for absorbing overhead must be most equitable and suitable failing which the costing results may be misleading. The following factors should be taken into account while selecting a method of factory overhead absorption:
(a) The type of industry — whether job order or continuous production.
(b) Nature of the manufacturing process — whether manual or mechanical.
(c) The main constituents of overhead and their nature — whether fixed or variable.
(d) The organizational set up of the undertaking into departments, cost centres.
(e) Capacity at which the factory is working — full capacity or under-capacity.
(f) Policy of the management.
Requisites of a Good Method of Absorption:
A good or satisfactory method of absorption of factory overhead should possess the following characteristics:
- It should be simple and convenient in its application and should not require the maintenance of unnecessary clerical records.
- It should be adequate ensuring the recovery of overhead which is more or less equal to the actual amount of overhead.
- It should give due consideration to the time factor involved in production.
- It would make proper distinction between the work done by skilled workers and that by unskilled workers.
- It should also make proper distinction between work done by manual labour and work done on machines.
- Multiple rates (determined with reference to the difference in nature of work done in different departments) should be preferred to blanket rate or overall overhead rate of the entire factory.