Absorption of Overheads: Overhead Rate and Methods

After secondary distribution, the whole of the factory overhead sits in the production departments. The final step is to charge this overhead to the actual products (cost units) that pass through each department — this is called absorption of overhead (also 'recovery', 'application' or 'levy' of overhead). Absorption is done by means of an overhead absorption rate (or 'overhead rate'), computed as:

Overhead absorption rate = Overhead of the department ÷ Quantity of the base

The rate is then applied to each product according to how much of that base the product consumes. So if the base is machine hours and the rate is ₹5 per machine hour, a product needing 4 machine hours absorbs ₹20 of overhead.

Methods of absorbing (recovering) overhead — each uses a different base:

1. Production unit (cost unit) method. Rate = Overhead ÷ Number of units produced. Simple; suitable only where all units are identical (a single product, uniform output). If products differ, it charges them all the same overhead regardless of the effort each takes, so it is unfair for a varied product mix.

2. Percentage on direct material cost. Rate = (Overhead ÷ Direct material cost) × 100. Overhead is recovered as a percentage of the material cost of each job. Weakness: material prices fluctuate and bear little relation to the time a job spends in the factory, so an expensive-material job is over-charged with overhead.

3. Percentage on direct labour (wages) cost. Rate = (Overhead ÷ Direct wages) × 100. Popular and simple. It is reasonable where labour is the dominant factor, but it ignores the difference between a highly-paid worker who finishes fast and a low-paid worker who takes long — and it does not reflect machine time at all.

4. Percentage on prime cost. Rate = (Overhead ÷ Prime cost) × 100, where prime cost = direct material + direct labour (+ direct expenses). It combines the material and labour bases, but inherits the weaknesses of both.

5. Direct labour hour rate. Rate = Overhead ÷ Direct labour hours. Overhead is charged per hour of labour worked on the job. This is sound where work is labour-intensive, because overhead often accrues with the passage of time and labour hours measure time directly (unlike wages, which mix time with wage rates).

6. Machine hour rate. Rate = Overhead ÷ Machine hours. Overhead is charged per hour a machine runs on the job. This is the most appropriate method where work is machine-intensive, since most factory overhead (power, depreciation, repairs) is caused by machine running rather than by human labour. (Machine hour rate is important enough to be studied separately in the next section.)

Summary of when each method suits: