Describe the various Methods of Absorption of Factory Overhead.

List of the Methods of Factory Overheads Absorption:

There are many methods by which absorption of factory overheads rate can be computed. The difference lie between them only on the base selected the numerator in all the methods is the total overheads for the department and denominator is base selected.

The Six Key Methods of Factory Overhead Absorption are:

Production Units Method:

It is the simplest method. Here the number of units produced is taken as base. The overhead rate is ascertained in terms of per unit of a product.

Also read | Collection of Overheads in Overhead Distribution.

It is suitable for those industries where the output can be measured in terms of physical units like mining, brick making and foundries. This method is suited best where the units are uniform in size and are of good quality and standard.

For example, if the production overheads are Rs. 75,000 and the number of units produced are 1,500 the overhead rate will be:

Overhead rate = Amount of Production Overhead / No of Units Produced in that Department.

= 75,500 / 1,000 = Rs.50 per unit.

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Direct Material Cost Method:

The base in this method is direct material cost. The overhead absorption rate is computed as a percentage of direct material cost.

For example, If production overheads are Rs.1,00,000 and the direct material cost is Rs. 2,00,000 the overhead rate will be 50% of material cost calculated as follows:

= Production overheads / Material Costs X 100

= 1,00,000 / 2,00,000 x 100 = 50%

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If the direct material cost of job is Rs. 3000, then the overhead to be absorbed by cost unit will be 50% of Rs. 3000 i.e. Rs. 1,500. The above method is best suited when:

  • Production units are uniform.
  • All units require same kind of material, in same quantity.
  • Where the material forms a major portion in the total cost.
  • Where overheads constitute large portion in cost related to materials like: purchasing, storing etc.

Limitations of this method are:

  • When there is fluctuation in the prices of material. Misleading results are obtained.
  • In cases where different materials are obtained for different jobs, it becomes tough to compare them. Hence give misleading results.
  • Time factor is ignored.
  • No difference between work done by skilled and unskilled labor is identified.

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Direct Wages Method:

Under this method, the absorption rate is ascertained by taking direct wages as the base and expressing it as a percentage of direct wages.

For example, production overheads are Rs. 1,60,000 and the direct labor cost is Rs. 2,00,000, the overhead rate will be 80% of direct wages calculated as follow:

Overhead Rate = Production Overheads / Prime Cost X 100

= 1,60,000 / 2,00,000 X 100 = 80%

Now, if the direct wages of job are Rs. 4,000, the absorption of production overheads by the job will be 80% Rs. 4,000 i.e. Rs. 3,200. It is particularly suited when:

Also read | The Advantages and Limitations of Cost Audit.

  • The rates of wages are the same,
  • Similar nature of work is done by the labor,
  • The workers are of same or equal efficiency, and
  • The use of machines is negligible.

Though this method is simple, easy to understand and duly recognizes the time factor, it suffers from the following limitations:

No distinction is made between skilled and unskilled workers. The work done by unskilled workers should bear a higher charge of factory overheads as they take more time and utilize factory facilities for longer period.

But under this method, more amount of factory overhead is charged to the work done by skilled workers, as the skilled workers are paid at a higher rate.

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The difference between the work done by machines and hand workers is not recognized. Certain machine expenses like depreciation, power etc. and should be charged only to the work done on machines.

But total factory overhead is absorbed by all the units whether done by machines job by hand workers.

The relationship between direct wages and overhead is less close. Despite the above limitations, it is most commonly used method for the absorption of factory overheads.

Prime Cost Method:

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Prime cost is the aggregate of direct materials and direct wages. In order to combine the advantages of both the methods, sometimes prime cost is taken as the basis for the overhead absorption rate.

Overhead Rate = Production Overheads / Prime Cost X 100

Production Overhead Rs. 80,000

Prime Cost Rs. 1,00,000

Overhead Rate = 80,000 / 1,00,000 X 100 = 80%

Machine Hour Method:

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This method is similar to labor hour method. But, instead of taking labor hours as the base, machine be ignored under this method, and this is the main limitation of this method.

Direct Labour Hour Method:

Under this method, the overhead absorption rate is calculated per labor hour. It is one by dividing the total overheads in the production department by the number of hours worked by labor in that department.

The overhead pertaining to a job or product is ascertained by multiplying the hourly rate with the number of labor hours spent for that job or product. This method tries to eliminate the defects of direct wage method.

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It take into consideration the time factor and the difference in wages rate does not affect its validity. It is suited to those concerns which are labor oriented.

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