Absorption Of Overheads By Products

The object of absorption of overheads is to charge an equitable proportion of the total factory overheads to each unit of production. The total factory overheads are distributed to the production cost centres (a) by allocating departmental expenses, (b) by apportioning common costs along with service department expenses, and (c) by redistributing service department cost to the production cost centres. The total overhead of each production cost centre will be absorbed or recovered by the output of the department concerned. The rate may be actual or predetermined. Again, the rate may be a single or blanket rate to the entire factory or separate rates for each production departments or cost centres.

Actual vs. Pre-determined Rate

Actual overhead recovery rate is computed by dividing actual overheads cost by actual base in a particular period. It is obvious that one has to wait till the close of the accounting period for calculating actual rate.  Predetermined overhead recovery rate, on the other hand, is determined before the commencement of the period during which the same will be used. The rate is computed with reference to the budgeted overhead cost for the year and a predetermined quantity of the base (say, labour hour) for the year, which will be used as a denominator. When historical cost ascertainment is the sole objective, actual overhead rate may lead to desired result. Otherwise, considerable delay will occur in arriving at the production using actual overhead rate. Even if the actual rate is calculated on a monthly basis, it will not serve the purpose due to the following reasons:

Questions:

• Some of the expenses are not evenly incurred throughout the year. Examples are repairs and maintenance, lighting and heating, etc.
• Production volume fluctuates month to month due to more or less working days in a month or seasonal nature of product. As a result monthly overhead rates will fluctuate and consequently, production cost will vary from month to month, when such fluctuating rates will be applied to products in busy seasons, the cost will be low, while in slack season, the cost will be higher.  Predetermined overhead absorption rates, on the other hand, have the following advantages:
• Product cost can be worked out promptly.
• Product cost can be estimated prior to commencement of production and can help the management in price quotation and fixing selling price well in advance.
• Product costs are not affected unnecessarily due to the vagaries of the calendar or seasonal fluctuations.
• Use of predetermined rate will provide data available for cost control as well as decision making.
• By using normal capacity as base while determining rate, losses due to idle capacity is highlighted and real cost of production is reflected.