Basis (Methods) for Calculating Overhead Absorption Rate:
The production overheads calculated for each production department after going through apportionment and allotment are used to calculate overhead absorption rate. There are six basis (methods) to calculate an overhead cost absorption rate.
General formula for calculating overhead absorption rate is as follows:
On 31 December 2016 the following estimates relate to ABC Ltd for the year ending 30 June 2017.
Use the above data to calculate overheads to be absorbed to calculate total cost of the job by using six basis (methods) for overhead absorption.
(1) Raw Material Cost Basis:
When the historical records of a company reveal that in the past, there was a correlation between raw material costs and factory overheads then they may use a rate as a percentage of raw material cost to absorb production overhead costs into the product or cost unit.
Overhead absorption rate and total overheads to be absorbed for the job may be calculated as:
The material cost base normally has a limited use as fluctuations in price of materials are not accompanied by similar fluctuation in overheads; moreover cheap quality material has a low material cost but has more overheads and opposite is true for better quality material. There are instances that one product using high priced material and another is made from low priced material but go through the same manufacturing process and as a result incur approximately same amount of factory overheads. In this case by using direct material cost base the product using expensive material will be charged more overheads than its share.
(2) Direct Labor Cost Basis:
This is frequently used rate in practice and is easy to apply as amount of direct wages is readily available. This is recommended as unlike material prices; labor rates are relatively stable moreover there is direct relationship between direct labor cost and factory overheads on the basis that both are related to time.
Certain objections are raised for using this method as no distinction is made between skilled and non-skilled workers and differences of their pay scale. It may also ignore time factor as when workers are paid on piece rate basis or when business makes higher overtime payments whereas overheads do not increase at the same rate.
(3) Prime Cost Basis:
This is applied by using both direct material and direct labor cost in the calculation, which is given below:
This method is usually recommended as it combines the weaknesses of both direct material cost and direct labor cost base.
(4) Units of Production Basis:
This method is simple and easy to use when company manufactures only one type of product and all units produced are similar in terms of size, time spent being worked on by the cost center etc. This is calculated as follows:
(5) Direct Labor Hours Basis:
This method is more appropriate in a labor intensive cost center where there is insignificant role of machines involving low machine related expenses and relatively high labor costs. This is considered as a better method for overhead absorption than direct labor cost method as is only based on time factor and is not distorted by factors like varying wage rates, overtime or bonus payments.
The use of this method requires a record of the direct labor hours expended on each job, product or cost unit in order to determine the share of overhead, it should bear.
(6) Machine Hour Basis:
This method is more appropriate in a capital intensive cost center where use of machines is the most significant factor in production. In such a cost center most of the production overheads are related to the machinery (power, repairs, depreciation, etc.), so a machine hour rate should reflect fairly the incidence of overheads. This is used as follows:
This method is in frequent use as it gives consideration to time factor, moreover in contrast to different efficiency and skill levels of workers the machines normally give equal output. However this method has a drawback as it is quite difficult to estimate machine hours in advance.
Which Method is better for Calculating Overhead Absorption Rate?
There is general acceptance that the time based methods (direct labor hours, machine hours and to some extent direct labor cost) are more likely to reflect the load on a cost center as production overheads also tend to be incurred on a time basis so even in exams students should use these methods unless questions requires to use some other methods.
In respect of capital intensive operations or machine related departments, machine hours’ base is more appropriate since most of the overheads in these departments would be closely related to machine hours. However, for labor intensive operations direct labor hours base is the most appropriate method.