Page 183 - DCOM202_COST_ACCOUNTING_I

Unit 9: Absorption of Overheads

The following are the main methods of absorbing factory overheads: Notes
1. Percentage on Direct Material Cost: Under this method, the percentage of factory expenses
to material is calculated on the basis of past records and the factory expenses in the current
year are charged to the factory on the jobs according to that percentage. For example, the
factory expenses in the previous year are ` 12,000 on a material of ` 48000. That means the
percentage of factory overhead to direct material is 25%. Therefore, even in the current
year, same percentage will be calculated.
2. Percentage on Direct Wages: Sometimes, on the basis of estimates, the percentage of factory
expenses to direct wages is calculated and jobs are charged according to this percentage.
This method of absorption can be adopted under the following circumstances:
(a) Where production is uniform.
(b) Where labour employed and type of work performed are uniform.
(c) Where, the ratio of skilled and unskilled labour is constant.

(d) Where there are no variations in the rates of pay.
3. Percentage on Prime Cost: It is argued that both materials and labour give rise to overhead
expenses and therefore, both should be taken into consideration in determining the factory
expenses.
4. Direct Labour Rate: This is a scientific method as most of the overhead expenses are related
to the time factor. This method can be applied in those departments or factories where
manual labour is predominant.
The direct labour hour rate is obtained by dividing the total overhead of the department
for a particular period by the total number of direct labour hours of that department for the
same period. Each job is changed at this rate for the number of direct hours spent thereon.
A serious defect of this method is that it fails to take into consideration expenses that are
not dependent on labour hours such as power, depreciation, fire insurance, etc.
5. Machine Hour Rate: Machine hour rate is the cost of running a machine per hour. It is one
of the methods of absorbing factory expenses to production. There are two methods of
computing the machine hour rate. viz.
(a) The ordinary machine hour rate, and
(b) Composite machine hour rate.

Dual Hour Rate: This is the combination of machine hour rate and direct labour rate. It is
adopted in those departments where both manual and machine works are equal.
6. Rate Per Unit of Output: This method is simple and adopted where products of the same
types are manufactured. The rate per unit is obtained by dividing the overheads by the
number of units produced. Each unit is exchanged at this rate for the recovery of overhead.

Notes Factors in Selecting Methods of Overhead Rate for a Factory
1. Adequacy: The overhead should be such that overheads should be equally
apportioned to the cost centres or cost units. The amount of overhead recovered
should also be equivalent to the amount of overheads incurred.
2. Convenience: The overhead rate should be simple to calculate and easy to understand.
It should be convenient in application. It should not require unnecessary or additional
clerical work.
Contd…

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