Overhead Absorption :: Pre Determined Rates of Absorption

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What is Absorption?  
 
The direct material, direct labour/labor and direct expenses which form part of the prime-cost are all direct costs. They are capable of being allocated (attributed) to the manufacture of a product directly.

Costs apart from the prime cost are collectively called overheads. These costs are not attributed directly to products or services or cost centers. They are attributed by the process of allocation and apportionment of overheads, apportionment being done depending on some rational rational basis.

We can understand what absorption means, if we go through the process of preparation of a cost sheet.

• Absorption of

» Direct Costs

We first consider the prime cost which is made up of Direct Material, Direct Labor and Direct Expenses. We can say that the direct material, direct labour/labor and direct expenses are absorbed into costs.

However, we do not find the term "absorption" being used with regard to direct costs in arriving at prime cost.

» Factory Overheads

We add up factory overheads to prime cost to arrive at factory/works cost.

We can say that Factory Overheads are absorbed into cost to arrive at the factory cost.

» Office/Administrative Overheads

We add up administrative overheads to factory/works cost to arrive at cost of producti0n.

We can say that Office/Administrative Overheads are absorbed into cost to arrive at the cost of production.

» Selling and Distribution Overheads

We add up selling and distribution overheads to cost of production to arrive at cost of sales.

We can say that Selling and Distribution Overheads are absorbed into cost to arrive at the cost of sales.

Thus, in cost accounting, Absorption can be understood to mean making a part of the cost or total cost.

Costing » Accounting  
 
Accounting for transactions involving Costing are recorded in two different methods.
  1. Cost Ledger Accounting

    Under this method, separate accounting records (independent of the financial accounting records) are maintained for the purpose of cost accounting.

    Each set of books are self balancing i.e. a trial balance (a statement of ledger account balances) can be prepared for each set of books i.e. financial records and cost records separately.

  2. Integrated Accounting

    Under this method, the cost accounting and financial accounting transactions are integrated and recorded in the same set of books.

    Since there is only one set of books, if at all a trial balance is prepared, it would contain all the ledger accounts balances we come across in cost accounting as well as in financial accounting.

» Assumption

All the explanations relating to analysis of overhead variances are given under the assumption that separate cost accounting records are being maintained for recording the transactions relevant to costing.

Recording Transactions :: Factory Overhead Incurrence/Absorption  
 
In variance analysis overheads implies manufacturing overheads only. Since we are concerned about only the Factory or manufacturing overheads we will look into transactions relating to absorption of factory overheads only.

• Incurrence

The factory overhead incurred includes the indirect materials, indirect labour, indirect expenses etc., incurred in relation to the factory area. These are charged to the "Factory Overhead Control a/c" by transfer from the relevant accounts.

Recording factory overheads incurred involves the following transactions

  1. Recording the Indirect Materials issued for the factory
  2. Recording the Indirect Labor/Labour employed for factory
  3. Recording the Indirect expenses incurred (paid/payable) for the factory

Journal in the books of M/s __ for the period from ____ to _____
Date V/R
No.
L/F Debit Amount
(in Rs)
Credit Amount
(in Rs)
01. Dr
xxx
xxx
[For the value of Indirect Materials used for the factory.]
02. Dr
xxx
xxx
[For the value of Indirect Wages incurred for the factory.]
03. Dr
xxx
xxx
[For the value of indirect expenses incurred for the factory.]

• Absorption

Factory overheads are absorbed into Works Cost. This id done by adding up the factory overheads to the Prime-Cost which is collected in the Work-In-Progress Control a/c.

Recording factory overhead absorption involves the following transactions

  1. Recording the amount of Factory Overhead absorbed into production cost

Journal in the books of M/s __ for the period from ____ to _____
Date V/R
No.
L/F Debit Amount
(in Rs)
Credit Amount
(in Rs)
01. Dr
xxx
xxx
[For the amount of factory overheads absorbed to production i.e. into works cost.]

» Ledger Posting

DrFactory Overhead Control a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)

01.
02.
03.

To SLCA a/c
WLCA a/c
GLA a/c


 

xxxxx
 

01.

By WIP a/c
 



xxx

Overheads Absorbed are not Overheads Incurred  
 
The absorption of overheads is not done based on the overheads incurred but based on some predetermined rates for absorption of overheads. This creates a possibility for a difference between the overheads incurred and overheads absorbed.

• Why can't incurred overheads be absorbed?

Factory overheads include a number of expenses which are varied in nature and magnitude. It consists of all those costs which are incurred in the factory area which are not capable of being appropriated directly. Eg: Factory rent, indirect materials, indirect wages, depreciation on machinery, factory lighting, heating, consumable stores etc.

» Cost implies Normal Cost

Whether it be in Financial accounting or Cost accounting, cost implies normal cost only. The profits that are revealed by the accounts should be the ones derived by taking only the normal costs into consideration. Profits should not be influenced by abnormal natured costs or losses.

To ensure that only normal costs are absorbed, the overheads are absorbed on some predetermined basis. The rates at which overheads are to be absorbed are determined based on the historical cost data i.e. data relating to the past accounting periods.

» Non – Availability of Cost Data

Overheads include indirect expenses which are to be apportioned among the various products or services or cost centers. This apportionment is to be done based on varied factors. [Eg: Rent of the factory building is apportioned based on the area utilised for the production process of each product, depreciation of machinery is apportioned based on the number of hours of machine use for each product, indirect wages are apportioned based on the direct wage cost of each product etc.].

The actual overhead cost that is to be attributed to a product can be obtained only after all the expenses/costs involved in overheads are apportioned and distributed among the various products. Most of the information that is used for apportioning overheads is obtained towards the end of the accounting period which may delay the process of ascertainment of cost.

The overhead cost incurred can be ascertained only after the apportionment of overheads is completed. This would delay the process of accounting for the cost relating to a product as well as pose a difficulty in estimating the cost of the product.

Where the estimate is needed for quoting the price or deciding the sale price etc., it would not be available. To overcome this difficulty, the overheads are absorbed on a pre determined basis.

Under/Over Absorption of Overheads  
 

• Absorbed Overhead may not be equal to Incurred Overhead

The overheads are absorbed based on some pre-determined rates for absorption of overheads. The actual overheads incurred may or may not be equal to the overheads absorbed.

This creates a possibility for a difference between the incurred overhead and absorbed overhead.

» Under Absorption of Factory Overhead

Where the actual overhead incurred is more than the overhead absorbed , we say that the overhead has been under absorbed.

DrFactory Overhead Control a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)
01.
02.
03.
To SLCA a/c
WLCA a/c
GLA a/c

 
2,00,000
1,45,000
65,000
01.
By WIP a/c
By Costing P/L a/c

4,00,000
10,000
      4,10,000       4,10,000

Under absorbed Overhead = Incurred Overhead − Absorbed Overhead

The adjustment/correction of under absorbed overhead would result in a loss in the form of increase in cost where the under absorption is normal and in the form of abnormal loss where it is abnormal.

» Over Absorption of Factory Overhead

Where the actual overhead incurred is less than the overhead absorbed , we say that the overhead has been over absorbed.

DrFactory Overhead Control a/cCr
Date Particulars J/F Amount
(in Rs)
Date Particulars J/F Amount
(in Rs)
01.
02.
03.
04.
To SLCA a/c
To WLCA a/c
To GLA a/c
To Costing P/L a/c

 

2,00,000
1,45,000
65,000
40,000
01.
By WIP a/c 4,50,000
      4,50,000       4,50,000

Over absorbed Overhead = Absorbed Overhead − Incurred Overhead

The adjustment/correction of over absorbed overhead would result in a gain in the form of reduction in cost where the over absorption is normal and in the form of abnormal profit where it is abnormal.

• Overhead Variance

The under/over absorbed overhead is what we identify as the overhead variance. The reasons for the variance are found out and depending on whether the variance is normal or abnormal, it is disposed off from the Factory Overhead Control a/c (in the absence of standard costing systems). The normal part of the variance is transferred to the Work In Progress Control a/c, the Cost of Sales a/c and the Finished Goods Ledger Control a/c as appropriate and the abnormal part is transferred to the Costing P/L a/c.

Rates of Absorption of Overheads  
 
The basis chosen for estimating the overhead cost is dependent on the overhead cost in consideration. The same bases need not be used for absorption of all types of overheads.

• Common Bases used

» for Factory Overheads

Direct Wages Cost is used as a basis for estimating "Factory Overheads"

Direct Wages Cost is only one of the many other bases that may be used for absorption of factory overheads.

» for Office/Administrative Overheads

Works Cost is used as a basis for estimating "Office/Administrative Overheads".

Works Cost is only one of the many other bases that may be used for absorption of office/administrative overheads.

» for Selling and Distribution Overheads

Works Cost is used as a basis for estimating "Selling and Distribution Overheads".

Works Cost is only one of the many other bases that may be used for absorption of selling and distribution overheads.

• Bases for Absorption of Factory/Works/Manufacturing Overheads

Since variance analysis involves only "Factory Overheads", we will know the about the six commonly used rates for absorption of factory overheads.

» Direct Wages Rate or Labour Cost Rate

=
Factory Overheads
Direct Wages
× 100
(Eg: Factory overheads are 75% of Direct Wages Cost)

Where this rate is applied, the
    Overhead Absorbed = Direct Wages Incurred × % of Overheads on Direct Wages

» Direct Material Rate

=
Factory Overheads
Direct Materials
× 100
(Eg: Factory overheads are 45% of Direct Material Cost)

Where this rate is applied, the
    Overhead Absorbed = Direct Material Cost Incurred × % of Overheads on Direct Material Cost

» Prime-Cost Rate

=
Factory Overheads
Prime-Cost
× 100
(Eg: Factory overheads are 50% of Prime-Cost)

Where this rate is applied, the
    Overhead Absorbed = Prime Cost Incurred × % of Overheads on Prime Cost

» Unit Rate

=
Factory Overheads
Production in Units
(Eg: Factory overheads is Rs. 24 per unit)

Where this rate is applied, the
    Overhead Absorbed = Number of Units Manufactured × Overhead absorption Rate per unit

» Labour Hour Rate

=
Factory Overheads
Number of Direct Labour Hours
(Eg: Factory overheads is Rs. 2 per Labour Hour Worked
       for producing the product)

Where this rate is applied, the
    Overhead Absorbed = Actual Direct Labour/Labor hours worked × Overhead absorption Rate per labour/labor hour

» Machine Hour Rate

=
Factory Overheads
Number of Machine Hours Worked
(Eg: Factory overheads is Rs. 5 per Machine Hour used
       for producing the product)

Where this rate is applied, the
    Overhead Absorbed = Actual Machine hours used × Overhead absorption Rate per machine hour

There is a particular rationale behind using each rate.

» Illustration

The production process is such that for each laborer/labourer there are 4 helpers (whose cost is indirect cost) in the factory and the overheads consist mostly of indirect labour cost.

The more the laborers/labourers, the more the helpers. The more the helpers, the more the indirect labor/labour cost. The more the indirect labour/labor cost the more the overhead cost.

This indicates that the overhead cost varies as the direct labour cost. In such a situation it would be appropriate to assess the overhead cost based on direct wages, which explains the reason for adopting the direct wage rate of absorption of overhead

• Why are they called Pre-Determined?

The rate of absorption of overheads is decided based on the data relating to the previous periods. It is determined before the actual overhead expenditure is incurred. That is the reason it is called a pre-determined rate.

» Example

The factory overheads are considered @ 75% of direct wages. This is called the rate of absorption of overheads i.e. the rate at which overheads are taken into consideration.

The overheads during the current period are absorbed at this rate. The previous periods factory overheads and direct wages are taken into consideration in deciding this rate, i.e. this rate is dependent on historical cost.

The rate of absorption is not decided by taking the actual cost incurred in the current period into consideration.

Absorption is based on Actual Activity  
 
Where overheads are being absorbed, the amount of overhead absorbed is dependent on the actual activity.

For example,

  • Where the overheads are being absorbed on a unit basis, the amount of overhead absorbed is dependent on the actual number of units produced.

    Overhead Absorbed = Actual Units Produced × Rate of Overhead Absorption (per unit)

  • Where the overheads are being absorbed on a machine hour basis, the amount of overhead absorbed is dependent on the actual number of machine hours worked for producing the output.
  • Overhead Absorbed = Actual No. of machine hours used × Overhead Absorption Rate (per machine hour)

Hourly and Unit Rates only  
 
In variance analysis, overheads implies Factory Overheads only. We consider only the Hourly Rate and the Unit Rate of absorption of overhead for calculating the absorbed overheads in this topic.

Though theoretically overhead absorption need not be based only on these two rates, we come across problems involving absorption based on hours and units i.e. hourly rate and unit rate.

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