Absorption of Overheads
The most important step in the overhead accounting is ‘Absorption’ of overheads. CIMA defines absorption as, ‘the process of absorbing all overhead costs allocated or apportioned over a particular cost center or production department by the units produced.’ 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. A base selected may be any one of the basis given below. The formula used for deciding the rate is as follows,
Overhead Absorption Rate = Overhead Expenses/ Units of the base selected.
The methods used for absorption are as follows:
a. Direct Material Cost: 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: Budgeted or Actual Overhead Cost/ Direct Material Cost X 100
b. 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: Budgeted or Actual Overheads/ Direct Labor Cost X 100
c. 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: Budgeted or Actual Overheads/ Prime Cost X 100
d. 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. If a firm produces more than one products and if they are not uniform to each other, equivalent units are calculated to find out the rate of overheads per unit. The formula of absorption of overheads is as follows: Overhead absorption rate = Budgeted or Actual Overheads/Production Units
e. 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. Budgeted or Actual Overhead Expenses/Direct Labor Hours
f. Machine Hour Rate: Where machines are more dominant than labor, machine hour rate method is used. CIMA defines machine hour rate as ‘actual or predetermined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost to be appropriated or absorbed by a number of hours for which a machine or machines are operated or expected to be operated’. In other words, machine hour rate is the cost of operating a machine on per hour basis. The formula for calculating the machine hour rate is, Budgeted or Actual Overhead Expenses/ Machine Hours
g. 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.
Overhead expenses are usually applied to production on the basis of predetermined rates. The pre-determined rate may present estimated or actual cost. The actual overhead cost incurred and overhead applied to the production will seldom be the same. But due to certain reasons the difference between two may arise.
Over absorptions: If the amount applied exceeds, the actual overhead, it is said to be an over absorption of overheads.
Under absorption: If the amount applied is short fall of the actual overhead in production it is said to be the under absorption of overheads. The over or under absorption of overheads may be termed as overhead variance.
Reason of over or under-absorption of overheads: The under or over-absorption of overhead arises due to following reasons:
a) Errors in estimating overheads.
b) Overhead may change due to change in method of production.
c) The seasonal fluctuation in overhead cost in some industries.
d) Under utilization of available capacity, unexpected change in the volume of out put.
e) Valuation of work in progress in wrong process.
Treatment of under and 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: 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.
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.