Under primary distribution overhead expenses are distributed among the production and service departments. Again, under secondary distribution service department costs are re-apportioned among production departments. The product passes through the production department.
Now the overhead cost of production departments (own share + share obtained from service department) will be charged to product units passing through these departments. The process of charging overhead expenses to product units is shortly known as Absorption.
Absorption is a process by which the overhead of the company is charged to the jobs on the basis of the resources which are consumed in the cost centre.
Absorption of overhead expenses or recovery of overhead expenses, for absorption of overhead expenses overhead rate will be calculated. That overhead rate may be calculated by taking different bases.
In other words the process of charging the overhead cost of the production department to the cost unit is called Absorption. It is otherwise known as Levy, Recovery or Application of Overhead.
So we have different methods of absorption. They are:-
A.Direct Material Cost Method.
B.Direct Labour Cost Method.
C.Prime Cost Method.
D.Direct Labour Hour Method.
E.Machine Hour Rate Method.
METHOD OF ABSORPTION
1.Percentage on Direct Material Cost Method :
Under this method absorption rate is computed by dividing manufacturing overhead by the direct material cost and the result is multiplied by the 100.
Overhead =Production Overhead ÷ Direct Material Cost ×100
➢It is suitable when identical articles are produced.
➢It is suitable when prices of material are stable.
➢It is suitable when the quantity of material required for all units is the same.
2.Percentage of Direct Labor Cost Method:-
Under this method absorption rate is calculated by dividing the production overhead by the direct labour cost and the result is multiplied by 100.
Overhead = Production Overhead ÷ Direct Labour Cost ×100
➢It is suitable when production is uniform.
➢It is suitable when rate of wages don’t fluctuate,
➢It is suitable when the ratio of skill and unskilled labour is constant.
3.Percentage of Prime Cost Method :-
Under this method the absorption rate is calculated by dividing the production overhead by prime cost and the result is multiplied by 100.
Overhead = Production Overhead ÷ Prime Cost ×100
The method is suitable when equal importance is given to both material and labour.
4.Production Unit Method :
Under this method absorption rate is determined by dividing total overhead of the production department by the number of units produced.
Overhead =Production Overhead ÷ No. of unit produce × 100
This method is suitable when the cost of unit production is identical.
5.Sale Price Method :-
Under this method absorption is calculated by dividing production overhead by the sale
Overhead =Production Overhead ÷ Sale price of the unit produced ×100
This method is suitable for apportioning of administration,selling,distribution,development and design cost to cost of product. ?
6.Direct Labour Hour Rate Method :-
Under this method, the absorption rate is calculated by dividing production overhead by the total direct labour during a period.
➢This method is suitable when the work is done manually.
➢The method is suitable where production is not uniform.
➢The method is suitable when the percentage method fails to give accurate results.
Overhead = Production Overhead ÷ Direct Labour hour during a period × 100
7.Machine Hour Rate :
Machine hour rate means the cost of running a machine for one hour.
Under this method, the absorption rate is calculated by dividing the factory overhead of a machine by the number of hours the machine has worked.
Machine hour rate= Factory overhead relating to machine ÷ Effective machine hour during a given period
STEPS IN CALCULATION OF MACHINE HOUR RATE :
Step – 1:–
The expenses relating to a machine can be divided into two parts. That is
Standing charges or fixed charges
Machine expenses or variable expenses
Standing charges include rent, rate, taxes, insurance, consumable stores, cost of supervision etc.
Machine expenses include power, repair and maintenance, depreciation etc.
Step – II :-
Standing charges are calculated by adding all the standing expenses of a particular period. Standing charges per hour is calculated by dividing total standing charges with the normal working hour of a machine.
Step – III:-
For machine expenses an hourly rate is calculated for each item separately by dividing the expenses by the normal working hour.
Step – IV:-
Total standing charges rate and the machine expenses rate is added to find out the machine hour rate.
When machine operator wages are also added to the simple machine hour rate it becomes a comprehensive machine hour rate.
ADVANTAGES OF MACHINE HOUR RATE :
(i)It helps in comparing the cost of operating different machines.
(ii)It is the most accurate method of calculating manufacturing overhead.
(iii)It provides useful data for calculating cost of production.
(iv) It helps in preparing a cost report.
(I)It is difficult to find out the total working hours of a machine when the production program is not available in advance.
(ii)It is a costly method because it involves additional work for calculating the working hour of a machine.
(iii)It doesn’t take into account the expenses which are not proportionate to the working hours of the machine.
Machine Hour Rate
(I)It is ascertained by dividing the overhead expenses by the number of hours the machine.
Overhead expenses ÷Machine hour
(iii) It is suitable where machines are treated as a major factor of production.
(iv) It is difficult to calculate the total working hours of a machine.
Labour Hour Rate
(I)It is ascertained by dividing the total overhead expenses by the total labour hour of the direct worker.
Overhead expenses ÷ Direct Labour hour
(iii) It is suitable where manual labour are the major factor of product.
(iv)It is easy to calculate labour hour.