C.

Absorption of Overheads

C. Absorption of Overheads
The most important step in the overhead accounting is Absorption of overheads. In simple words, absorption means charging equitable share of overhead expenses to the products. As the overhead expenses are indirect expenses, the absorption is to be made on some suitable basis. The basis is the absorption rate which is calculated by dividing the overhead expenses by the base selected 2

C. Absorption of Overheads
A base selected may be any one of the basis given below: I. Direct Material Cost II. Direct Labor Cost III. Prime Cost IV.Production Unit V. Direct Labor Hour VI.Machine Hour VII.Selling Price 3

C. Absorption of Overheads
The formula used for deciding the rate is as follows: Overhead Absorption Rate = Overhead Expenses/ Units of the base selected.

C. Absorption of Overheads
The methods used for absorption are as follows. I. Direct Material Cost Method II. Direct Labor Cost Method III. Prime Cost Method IV.Production Unit Method V. Direct Labor Hour Method VI.Machine Hour Method VII.Selling Price Method
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I. Direct Material Cost Method

Under this method, the overheads are absorbed on the basis of percentage of direct material cost. The following formula is used for working out the overhead absorption percentage: Overhead Absorption Percentage = (Budgeted or Actual Overhead Cost/ Direct Material Cost) * 100 This method is suitable in those organizations where material is a dominant factor in the total cost structure. 6

Illustration: 1
If the overhead expenses are Rs. 2,00,000 and Direct Material Cost is Rs. 4,00,000 the percentage of overheads to direct material cost will be, 2,00,000/4,00,000 X 100 = 50%. Thus, overheads will be absorbed on the basis of percentage of 50% to material costs.

Illustration: 2
A firm produces two products, A and B. Direct material costs for A are Rs. 2,50,000 and for B, Rs. 1,50,000. The overheads will be charged to these products as shown in the followingstatement, assuming the rate of absorption as 50% as shown above.

Illustration: 2

II. Direct Labor Cost Method

This method is used in those organizations where labor is a dominant factor in the total cost. Under this method, the following formula is used for calculating the overhead absorption rate. Overhead Absorption Rate = (Budgeted or Actual Overheads/ Direct Labor Cost) X 100

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Illustration: 3
If the overheads are Rs. 3,00,000 and Direct Labor Cost is Rs. 4,00,000 the % of absorption will be 3,00,000/4,00,000 100 = 75%. Overheads will be charged to each product as 75% of labor cost.

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III. Prime Cost Method

This method is an improvement over the first two methods. Under this method, the Prime Cost is taken as the base for calculating the percentage of absorption of overheads by using the following formula. Overhead Absorption Rate = (Budgeted or Actual Overheads/ Prime Cost)* 100

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Illustration 4
A manufacturing firm produces two products, A and B. The direct material cost for A is Rs. 5,00,000 and for B Rs. 3,00,000, direct labor cost is Rs. 3,00,000 and Rs. 2,00,000 respectively for A and B, direct expenses are Rs. 1,00,000 and Rs. 2,00,000 respectively for A and B. The overhead expenses are Rs. 9,60,000. The statement of cost will appear as follows.
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Illustration 4

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IV. Production Unit Method

This method is used when all production units are similar to each other in all respects. Total overhead expenses are divided by total production units for computing the rate per unit of overheads and overheads are absorbed in the product units. The formula of absorption of overheads is as follows. Overhead absorption rate = Budgeted or Actual Overheads/Production Units
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Illustration 5

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Illustration 5

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V. Direct Labor Hour Method

Under this method, the rate of absorption is calculated by dividing the overhead expenses by the direct labor hours. The formula is as follows. Overhead absorption rate = Budgeted or Actual Overhead Expenses/Direct Labor Hours This method takes into account the time spent by the labor in production of each unit where the production units are not uniform or identical.
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Illustration 6
If the overheads are Rs. 3,00,000 and Direct Labor Hours are 40, 000 the rate of absorption will be 3,00,000/ 40, 000 = Rs. 7.5/ labor hour. Overheads will be charged to each product as Rs. 7.5/ labor hour.

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VI. Machine Hour Rate

Where machines are more dominant than labor, machine hour rate method is used. Machine hour rate is calculated by dividing the overhead cost by a number of hours for which a machine or machines are operated. The formula for calculating the machine hour rate is: Overhead absorption rate = Budgeted or Actual Overhead Expenses/ Machine Hours Actual or Budgeted
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Illustration 7
If the overheads are Rs. 3,00,000 and Machine Hours are 2,00, 000 the rate of absorption will be 3,00,000/ 2,00, 000 = Rs. 1.5/ machine hour. Overheads will be charged to each product as Rs. 1.5/ machine hour.

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VII. Selling Price Method

In this method, selling price of the products is used as a basis for absorbing the overheads. The logic used is that if the selling price is high, the product should bear higher overhead cost. Ratio of selling price is worked out and the overheads are absorbed.

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Illustration 8
If the overheads are Rs. 3,00,000 and selling price is of Product A & B are Rs. 6 / per unit and Rs. 3/ unit. Overhead would be distributed in the ratio of selling price. Total overhead absorbed in product A = Rs. 3,00,000*(6/9)=2,00,000 Total overhead absorbed in product B = Rs. 3,00,000*(3/9)=1,00,000
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Under/Over Absorption of Overheads

In overhead absorption the rate of absorption may be either predetermined or historical. The main advantage of the historical rate is that there is no possibility of under/over absorption of overheads. If predetermined rate is used, there is every possibility of under or over absorption of overheads. The following illustration will clarify the point.

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Illustration 9
A manufacturing company uses direct material cost as the basis for absorption of overheads. The absorption rate is worked out as follows: (Budgeted Overheads Rs. 50,000/ Budgeted Material Cost Rs. 1,00,000)*100 i.e. 50%

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Illustration 9
Now if the actual overheads are Rs. 70,000 and the actual direct material cost is Rs. 1,20,000, the overheads absorbed will be Rs. 60,000 i.e. 50% of the direct material cost and there will be under absorption of Rs. 10,000 as the actual overheads incurred are Rs. 70,000. Thus it can be seen that there is a possibility of over/under absorption of overheads if predetermined rates are used for absorption.
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Under/Over Absorption of Overheads

Once the under/over absorption is noticed, the following corrective steps are to be taken to rectify the same. a. Use of supplementary Rate b. Carrying forward to future period c. Writing off to Profit and Loss A/c

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Under/Over Absorption of Overheads

a. Use of supplementary Rate :- The under/over absorption can be rectified by using the supplementary rate. This rate is calculated by dividing the under/over absorbed amount of overheads by the units of the base. The rate so arrived is known to be supplementary rate.

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Under/Over Absorption of Overheads

b. Carrying forward to future period :- If the amount of under/over absorption of overheads is small, it may be carried forward to the future period hoping that it will be rectified in the future. c. Writing off to Profit and Loss A/c :- Amount of under/over absorption can be written off to Costing Profit and Loss Account and thus not reflected in the total costs.
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