Recovery of Overhead (i.e. Absorption of overhead by Production Units)
We know that some expenses may be incurred by each
production department which is exclusively for that department. On the other hand,
for a number of production departments as well as for service departments, some expenses
are incurred, which on some equitable basis, are to be shared by all the departments.
The reapportionment of the cost of service departments is done to the production departments.
Thus, production departments own expenses, its share of the expenses of the service
department & its share of joint expenses are included in the total expenses of
the production department. Again, ultimately, total factory overhead shall be equal
to the grand total of all the production department’s total expenses.
Allocation is made, of the total expense of each
production department, to that department’s units of output. This allocation
is known as recovery of overhead, absorption of overhead, charging of overhead to products
etc.
For the purpose of making an attempt for absorption
or recovery of overhead, consideration has to be given to the following points:
(1) As much
as possible, the absorption should be accurate i.e. overhead which has been incurred
should be absorbed fully.
(2) In the
process of absorption, clerical error & cost to be involved should be less.
(3) Due consideration
has to be given to the factors of production, like production time, worker’s
skill etc. For example, when with the time of production, overhead varies; determination
of overhead rate should be on the basis of time.
(4) In every
department, the nature & method of production may vary. So methods of production
adopted in one department may not be the same as in the other department. As a result,
each department, on the basis of its own nature & method of production, will be
having a method of absorption.
(5) Accurate
cost ascertainment & appropriate cost control must be assured by the method of
absorption, irrespective of the method of absorption followed by any production department.
Commonly used methods of absorption:
There are various methods of absorption which
can be grouped as under:
(a) Production unit or Cost unit method: Under
this method, the rate per unit can be obtained by dividing the total actual overhead
of the department by the total actual unit of the output. Under historical costing
method this is done. However, if before the production, the rate is to be obtained,
then for the purpose of obtaining the predetermined rate of absorption, the total predetermined
overhead is to be divided by the predetermined number of production units. To all the
units produced, this predetermined rate is applied.
This method is the most simple & direct method.
For departments, where only one product of homogenous nature is produced or where more
than one product is produced which are capable of being measured in terms of a common
yardstick, this production unit or cost unit method is suitable.
(b) (i) Percentage of Direct Materials Cost method:
In this the percentage will be worked out
as: Actual (or estimated) overhead________ * 100
Actual
(or estimated) direct material cost
There are number of limitations in this method
as:
(a) There will be always fluctuation in the prices
of materials & hence, even though the overhead cost may remain constant, if overhead
is charged as a percentage of cost of direct material, there shall be fluctuation in
the amount of overhead charged, thereby resulting in over or under-recovery of overhead.
(b) There is no relationship between material cost & time
factor, but with time, most of the overhead expenses vary. There is a seldom use of
the material cost which as a basis of overhead recovery, fails to recognize time factor.
(c) When very costly materials are consumed by
a job but the period for which the job will be executed is very short, then with heavy
overhead, the job will be charged, although the actual overhead which depends upon
the period of execution will be low. On the other hand, when very cheap materials are
consumed by a job but the period for which the job will be executed is long, then with
small amount of overhead, the job will be charged, although the actual overhead involved
will be large. Thus for comparisons of cost, a suitable ground does not get established
by the recovery of overhead which is based upon material cost.
(b) (ii) Percentage of Direct wages method:
In this case, the percentage of recovery is worked out as below:
Actual (or estimated) overhead__ *100
Actual (or estimated) direct wages
The merits & demerits of this method are:
(a) This method is simple to understand & can
be applied easily.
(b) There is a good relationship between direct
wages & time factor. Normally, longer period of execution of a job may be indicated
by higher amount of wages for that job & thus logically there is an involvement
of higher amount of overhead.
(c) Like material cost, there will not be always
fluctuation in the rates of wages & therefore, compared to direct materials cost
basis, direct wages basis is more suitable.
(d) As compared to direct materials cost method,
under direct wages method, period to period costs comparison becomes more dependable.
However, most satisfactory result will be obtained
under this method when (i) there is a predominance of labour factor, (ii) there is
uniformity in production, & (iii) more or less hourly rates received by the workers
are same.
Demerits:
(a) When on the piece wages
basis, the workers are getting paid; this method does not suit the condition because
in that case, the dependency of wages is upon the output & not upon time, whereas
the overhead expenses depend largely upon time.
(b) Same wage will be earned by two workers who
are paid on the basis of same time rate & working for the same period, but one
working with very costly equipment & the other working with hand tool. Overhead
absorbed on the basis of direct wage shall also be equal, but in the former work, overhead
shall be higher in compared to that in the latter work.
(c)When with the help
of automatic or semi automatic machines, work is being
carried out; the workers will act as an attendant.
In this case, there is very little relationship between
the wages of the worker & the amount
of overhead involved. However, there is a relation
between overhead & the hours
of machine work. Thereby, the direct wages method shall
not be generally suitable, where automation has been
fully achieved or where automation has been achieved
in some departments but in others there is a predominance
of hand work.
(b) (iii) Percentage of Prime cost method:
In this case, the percentage of recovery, is worked
out as below:
Actual (or estimated) overhead_ * 100
Actual (or estimated) prime cost
This method suits the condition where- (i) there
is a production of a standard product, (ii) there is a consumption of standard quantity
of material at standard rate, (iii) for production, there is a requirement of standard
number of labour hours at standard rate.
Often, all these requirements do not get fulfilled.
The advantages of this method are:
(a) This method is simple to understand & can
be applied easily.
(b) Both direct material cost & direct wages
are recognized by this method. More particularly, time factor is recognized by this
method.
Demerits of this method are:
(a) If in the prime cost, there is a predominance
of material cost, then in that case, due importance is not received by the time factor.
(b) Let us assume that there are two workers of
the same trade & having the same skill. One of the workers is using very expensive
machines while the other is working with hand tools. Same wage is earned by both
of the workers & this enters into the prime cost. In this case, does the additional
expense which arises out of the use of the expensive machine is taken into consideration
by the recovery rate which is worked out as a percentage of prime cost.
(c) (i) Direct Labour Hour Rate method:
For
the purpose of recovering factory overhead, direct labour method is used. This method
can be applied suitably in the case of those factories where more important role is
played by the manual labour in comparison to the machinery.
Since upon the time factor, overhead depends largely,
accurate result will be produced by any recovery rate which has been calculated on
the basis of the hours of work. Overhead rate per direct labour hour is worked out & suitably
applied in the case of factories where hand work is the rule.
The rate is worked out
as below:
Actual
(or estimated) overhead ___________
Actual (or estimated) hours of direct labour work
Direct labour hour rate is applied where – (a)
there is a predominance of labour factor in production, (b) there is no uniformity
of output, (c) no percentage method suits the condition.
For each department or for each group of workers,
calculation of direct labour hour rate may be done.
From the job cards of the workers, direct labour
hours which have been consumed by a particular job can be obtained. If we multiply
these hours by the rate for the department or the group of workers, then we will obtain
the amount of overhead which can be charged to that job.
Effective hours of work have to be taken into consideration
for the purpose of calculating the recovery rate & for the purpose if charging
overhead; this can be obtained by making a provision for normal idle time.
Illustration1: A Ltd has 3 manufacturing departments
X, Y & Z & 1 service department P. For 1 month comprising of 25 working days
with 8 hours each day, where work is being done on all the days by each department
with full attendance, the following information’s are available:
Service
deptt. Production deptts.
Expenses Total($) P($) X($) Y($) Z($)
Rent 1500 - - - -
Welfare 1800 - - - -
Power & Lighting 3300 720 600 900 1080
Salary of supervisor 6000 - - - -
Others 3600 600 600 1200 1200
16200
Salary of supervisor 20% 30% 30% 30%
Floor area (in sq. ft.) 500 600 800 600
Services rendered to production
Departments by service department 50% 30% 20%
No. of workers 10 30 40 20
For Each of the departments X, Y & Z, calculate labour hour rate.
Man-hours worked during the month:
Department X = 30*25*8 = 6000
Department Y = 40*25*8 = 8000
Department Z = 20*25*8 = 4000
Labour hour rate:
Department X =$5400/6000 = 90 paise
Department Y = $6000/8000 = 75 paise
Department X = $4800/4000 = Rs.1.20
(c) (i) Machine Hour Rate (MHR) method: Machine hour rate
is a method by which factory overhead can be recovered & which can be applied suitably
in cases where there is no uniformity of the product & there is a predominance
of the machine-work.
Machine hour rate can be obtained by dividing the actual factory overhead or
estimated factory overhead for a period of time being by that period’s actual
or estimated machine hours.
MHR = Actual (or estimated) factory overhead
Actual (or estimated)
machine hours
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