Month: April 2020

Reasons for Replacement of Equipment’s:

Equipment are generally considered for replacement for the following reasons:

(i) Deterioration:

It is the decline in performance due to wear and tear or misalignment indicated by;

(i) Increase in maintenance costs.

(ii) Reduction in product quality and rate of production.

(iii) Increase in labour costs, and

(iv) Loss of operating time due to breakdowns.

(ii) Obsolescence:

Technology is progressing fast, newer and better equipment are being developed and produced every year.

The equipment gets obsolete due to advancement in technology and the unwarranted manufacturing costs arising from such obsolete equipment will:

(i) Reduce profits.

(ii) Impair competition.

(iii) Cause loss in value of machinery.

(iii) Inadequacy:

When the existing equipment becomes inadequate to meet the demand or it is not able to increase the production rate to desired level, the question of replacement arises.

(iv) Working Conditions:

It may be thought of replacing the old equipment and machinery which creates unpleasantness i.e. give rise to unsafe conditions for workers and leads to accidents, making the environment noisy and smoky etc.

(v) Economy:

The existing units/equipment have outlived their effective life and it is not economical to continue with them.

Factors Necessary for Replacement of Equipment:

The factors which necessitate the replacement of machinery and equipment can be classified as:

(i) Technical Factors.

(ii) Financial or Cost Factors.

(iii) Tangible Factors.

(i) Technical Factors:

They tend to consider:

(i) Whether the present equipment has become obsolete due to technological developments,

(ii) If the present equipment is inadequate in meeting increased product demand.

(iii) Whether the present equipment has deteriorated due to wear and tear. It may be indicated by increase in maintenance costs, reduction in product quality, rate of output, and increase in labour cost and down time etc.

(iv) Reduced safety as compared to new machine available/developed.

(v) Can the present equipment provide desired surface finish?

(vi) If the present equipment is polluting or spoiling working condition of the industry.

(vii) Possibility of performing additional operations by new machine.

(viii) Does the present equipment make noise and vibrations and thus causing diversion of the workers.

(ix) How often the present equipment requires maintenance and repairs.

(ii) Financial/Cost Factors:

These are:

(i) High repair and maintenance cost of the existing equipment/machinery).

(ii) Possibility of combining some operations and resulting increase in productivity by challenger (new machine).

(iii) The initial cost of challenger.

(iv) Salvage value of existing equipment and challenger at the end of its useful life.

(v) Improvement in productivity and quality by use of challenger.

(vi) Saving in space by use of new machine.

(vii) Reduction in scrap and waste by use of new machine.

(viii) Down time cost of present machine.

(ix) Reduction in cost of jigs and fixtures by using challenger.

(x) Effect on consumption of power by replacing the existing machine by new machine.

(iii) Tangible Factors:

These factors involve sociological and humanitarian considerations with far reaching effects:

(i) Like replacing the existing machine which causes unpleasantness (may be noise and smoke pollution) and unsafe working conditions leading to accidents.

(ii) Replacement may cause displacement of workers.

At the time of replacement a well-designed replacement policy should be adopted, rather than considering only the factors pertaining to the particular equipment involved, should compare thoroughly all the existing equipment with its possible replacement.

For the purpose of sound economic comparison all factors should be converted into cost and possible increase in revenue. Break even analysis can be utilized for the purpose of taking replacement decision or selection of investment alternatives.

1. Research your customers and competition

Use market research to analyze your customers and competitors on multiple levels. This will help you evaluate whether the demand for a product/service is real, and whether expanding into a potential new market is worthwhile for your company.

Identify consumers segments that share common characteristics such as age, gender, education, income, occupation, and place of residence, or softer variables such as lifestyle and values. Also consider consumer motivation. What “job” is the customer trying to get done? What barriers may be constraining consumption?

Knowing who your key competitors are and assessing their strengths and weaknesses can also illuminate specific growth strategies and ways to differentiate your products and services.

2. Get a high-level view of the market

However, assessing your customers and competitors is not enough. You also need to obtain a broader understanding of the market as a whole and what the potential of success is in the market. 

Otherwise, your organization could be trapped into thinking that a few percentage points increase is enough, where there is actually much more potential. Market researchers are experts at providing the overall objective picture and can help you step away from intra-company thinking.

When analyzing a market, these high-level questions come into play:

• What is the market size?
• How quickly is the market expanding or contracting?
• How many buyers are there?
• What are the barriers to entry?
• What is the bargaining power of suppliers?
• What is the intensity of the competition?
• Is there a threat of new entrants or substitute products or services?

3. Explore adjacent opportunities

Pursuing adjacent opportunities can also be a winning strategy.

In a five-year study, researchers analyzed the growth and performance of 1,850 corporations. They found that the companies with the most sustained profitable growth had used a systematic, disciplined approach to expand the boundaries of their core business into an adjacent space. Some companies expanded from one geographic market to another, while others applied an existing business model to adjacent segments.

Take Procter & Gamble’s Crest toothpaste brand as an example. In the late 1990s, Crest was floundering, but Procter & Gamble revitalized the brand by moving into two other categories  teeth whitening and brushing with the introduction of Crest Whitestrips and SpinBrush.

The company used the same channels to reach the same customers with the same marketing framework and added more than $200 million of new sales for each new brand in one year.

Keeping your finger on the pulse of a market will help you to maintain a proactive approach and profitably outgrow your rivals by finding ways to expand outside your core business.

4. Understand the business environment factors

Another area to explore is the overall business environment, which can have a profound impact on company performance and the ways industries operate.

The business environment includes factors such as:

• Technological developments
• Government regulations
• Geopolitical shifts
• Economic indicators
• Trade policies
• Social and cultural norms

As an example, companies in the life science and healthcare sectors currently face a number of potential disruptors that contribute to ongoing uncertainty, as noted by market research firm Kalorama Information, including attempts to repeal and replace the Affordable Care Act, health IT policies, and President Trump’s statements about drug pricing.

Other factors impacting markets include Brexit, rising out-of-pocket spending on healthcare, and physician shortages. Any new business opportunity in these sectors will need to be evaluated in the context of these factors and challenges.

5. Find the market research you need fast

Gathering and synthesizing information about all these categories can take significant time, effort, and expertise, but market research reports can give you a helpful leg up.

“Off-the-shelf” reports, such as those available on MarketResearch.com, can supply you with much of the information you need for a comprehensive understanding of the customer, competition, industry, and business environment.

In these reports, you’ll find information on market size, market share, market forecasts, information on regulations, consumer demographics, and much more. In addition, many reports explicitly share analysis on key opportunities for future growth, next-generation product innovation, and emerging marketing strategies.

Tools of Management accounting

The various tools used at present in management accounting may be classified into the following groups.

1. Financial Planning

The main objective of any business organization is maximization of profits. This objective is achieved by making proper or sound financial planning. Hence, financial planning is considered as best tool for achieving business objectives.

2. Financial Statement Analysis

Profit and Loss account and Balance Sheet are important financial statements. These statements are analyzed for different period. This type of analysis helps the management to know the rate of growth of business concern. This analysis is done through comparative financial statements, common size statements and ratio analysis.

3. Cost Accounting

Cost accounting presents cost data in product wise, process wise, department wise, branch wise and the like. These cost data are compared with predetermined one. This comparison of two costs enables the management to decide the reasons responsible for the difference between these costs.

4. Fund Flow Analysis

This analysis find out the movement of fund from one period to another. Moreover, this analysis is very useful to know whether the fund is properly used or not in a year when compared to the previous year. The working capital changes and funds from operation are also find out through this analysis.

5. Cash Flow Analysis

The movement of cash from one period to another can be find out through this analysis. Besides, the reasons for cash balance and changes between two periods are also find out. It studies the cash from operation and the movement of cash in a period.

6. Management Information System

The free flow communication within the organization is essential for effective functioning of business. Hence, the management can design the system through which every employee of an organization can assess the information and used for discharging their duties and taking quality decisions.

7. Statistical Techniques

There are a lot of statistical techniques used in removing management problems. Methods of least square, regression and quality control etc. are some examples of statistical techniques.

8. Management Reporting

The management accountant is preparing the report on the basis of the contents of profit and loss account and balance sheet and submit the same before the top management. Thus prepared reports disclose the strength and weakness indifferent areas of operating activities and financial activities. These identification are highly useful to management for exercising control and decision-making.

9. Historical Cost Accounting

It means that costs are recorded after being incurred. This is used for comparing with predetermined costs to evaluate performance.

10. Ratio Analysis

It is used to management in the discharge of its basic functions of forecasting, planning, coordination, communication and control. It paves the way for effective control of business operations by undertaking an appraisal of both the physical and monetary targets.

11. Standard Costing

Standard costing is predetermined cost. It provides a yard stick for measuring actual performance. It is used to find the reasons for the deviations if any.

12. Marginal Costing

Marginal costing technique is used to fix the selling price, selection of best sales mix, best use of scarce raw materials or resources, to take make or buy decision, acceptance or rejection of bulk order and foreign order and the like. This is based on the fixed cost, variable cost and contribution.

13. Budgetary Control

Under Budgetary control techniques, future financial needs are estimated and arranged according to an orderly basis. It is used to control the financial performances of business concern. Business operations are directed in a desired direction.

14. Revaluation Accounting

The fixed assets are revalued as per the revaluation accounting method so that the capital is properly represented with the assets value. It helps to find out the fair return on capital employed.

15. Decision-making Accounting

A business problem can be solved by choosing any one of the best and most profitable alternative. To select such alternative, the relevant costs are compared. Thus, accounting information are used to solve the business problem which are arising out of increasing complexity of nature of business.

Techniques of Management Accounting

1. Communicating:

The success or failure of the management is dependent on the fact, whether requisite information is provided to the management in right form at the right time so as to enable them to carry out the functions of planning, controlling and decision-making effectively.

The management accountant will prepare the necessary reports for providing information to the different levels of management by proper selection of data to be presented, organisation of data and selecting the appropriate method of reporting.

2. Analysis of Financial Statements:

The analysis is an attempt to determine the significance and meaning of the financial statement data so that a forecast may be made of the prospects for future earnings, ability to pay interest and debt maturities and profitability of a sound dividend policy.

The techniques of such analysis are comparative financial statements, trend analysis, cash funds flow statements and ratio analysis. This analysis results in the presentation of information which will help the business executives, investors and creditors.

3. Standard Costing:

Standard costing is the establishment of standard costs under most efficient operating conditions, comparison of actual with the standard, calculation and analysis of variance, in order to know the reasons and to pinpoint the responsibility and to take remedial action so that adverse things may not happen again. This aspect is necessary to have cost control.

4. Budgetary Control:

The management accountant uses the tool of budgetary control for planning and control of the various activities of the business. Budgetary control is an important technique of directing business operations in a desired direction, i.e., achieves a satisfactory return on investment.

5. Financial Planning:

Financial planning is the act of deciding in advance about the financial activities necessary for the concern to achieve its primary objectives. It includes determining both long term and short term financial objectives of the enterprise, formulating financial policies and developing the financial procedure to achieve the objectives.

The role of financial policies cannot be emphasized to achieve the maximum return on the capital employed. Financial policies may relate to the determination of the amount of capital required, sources of funds, govern the determination and distribution of income, act as a guide in the use of debt and equity capital and determination of the optimum level of investment in various assets.

6. Funds Flow Statement:

The management accountant uses the technique of funds flow statement in order to analyse the changes in the financial position of a business enterprise between two dates. It tells wherefrom the funds are coming in the business and how these are being used in the business. It helps a lot in financial analysis and control, future guidance and comparative studies.

7. Marginal Costing:

The management accountant uses the technique of marginal costing, differential costing and break even analysis for cost control, decision-making and profit maximisation.

8. Cash Flow Statement:

A funds flow statement based on increase or decrease in working capital is very useful in long-range financial planning. It is quite possible that there may be sufficient working capital as revealed by the funds flow statement and still the company may be unable to meet its current liabilities as and when they fall due. It may be due to an accumulation of inventories and an increase in trade debtors.

In such a situation, a cash flow statement is more useful because it gives detailed information of cash inflows and outflows. Cash flow statement is an important tool of cash control because it summarises sources of cash inflows and uses of cash outflows of a firm during a particular period of time, say a month or a year. It is very useful tool for liquidity analysis of the enterprise.

9. Historical Cost Accounting:

The historical cost accounting provides past data to the management relating to the cost of each job, process and department so that comparison may be made with the standard costs. Such comparison may be helpful to the management for cost control and for future planning.

10. Decision Making:

Whenever there are different alternatives of doing a particular work, it becomes necessary to select the best out of all alternatives. This requires decision on the part of the management. The management accounting helps the management through the techniques of marginal costing, capital budgeting, differential costing to select the best alternative which will maximise the profits of the business.

11. Revaluation Accounting:

The management accountant, through this technique assures the maintenance and preservation of the capital of the enterprise. It brings into account the impact of changes in the prices on the preparation of the financial statements.

12. Statistical and Graphical Techniques:

The management accountant uses various statistical and graphical techniques in order to make the information more meaningful and presentation of the same in such form so that it may help the management in decision-making. The techniques used are Master Chart, Chart of Sales: and Earnings, Investment Chart, Linear Programming, Statistical Quality Control, etc.

Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization’s balance sheet. A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.

Absorption Costing Components

The key costs assigned to products under an absorption costing system are:

• Direct materials: Those materials that are included in a finished product.
• Direct labor: The factory labor costs required to construct a product.
• Variable manufacturing overhead: The costs to operate a manufacturing facility, which vary with production volume: Examples are supplies and electricity for production equipment.
• Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate costs to be in accordance with GAAP or IFRS.

You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is:

• Assign costs to cost pools: This is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.
• Calculate usage: Determine the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.
• Assign costs: Divide the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assign overhead costs to produced goods based on this usage rate.

Overhead Absorption

Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is over absorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount is under absorbed when the amount allocated is lower than the actual amount of overhead.

For example, Theintactone Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Theintactone only produced 45,000 widgets, so it allocated just $90,000. The actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Theintactone experienced $8,000 of underabsorbed overhead.

In February, Theintactone produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Theintactone experienced $11,000 of overabsorbed overhead.

Absorption Costing Problems

Since absorption costing requires the allocation of what may be a considerable amount of overhead costs to products, a large proportion of a product’s costs may not be directly traceable to the product. Direct costing or constraint analysis do not require the allocation of overhead to a product, and so may be more useful than absorption costing for incremental pricing decisions where you are more concerned with only the costs required to build the next incremental unit of product.

It is also possible that an entity could generate extra profits simply by manufacturing more products that it does not sell. This situation arises because absorption costing requires fixed manufacturing overhead to be allocated to the total number of units produced – if some of those units are not subsequently sold, then the fixed overhead costs assigned to the excess units are never charged to expense, thereby resulting in increased profits. A manager could falsely authorize excess production to create these extra profits, but it burdens the entity with potentially obsolete inventory, and also requires the investment of working capital in the extra inventory.

Advantages of Absorption Costing:

1. It suitably recognises the importance of including fixed manufacturing costs in product cost determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related to production should be charged to units manufactured. Price based on absorption costing ensures that all costs are covered. Prices are well regulated where full cost is the basis.
2. It will show correct profit calculation in case where production is done to have sales in future (e.g., seasonal sales) as compared to variable costing.
3. It helps to conform with accrual and matching concepts which require matching cost with revenue for a particular period.
4. It has been recognised by various bodies as FASB (USA), ASG (UK), ASB (India) for the purpose of preparing external reports and for valuation of inventory.
5. It avoids the separation of costs into fixed and variable elements which cannot be done easily and accurately.
6. It discloses inefficient or efficient utilisation of production resources by indicating under-absorption or over-absorption of factory overheads.
7. It helps to make the managers more responsible for the costs and services provided to their centres/departments due to correct allocation and apportionment of fixed factory overheads.
8. It helps to calculate gross profit and net profit separately in income statement.

Disadvantages of Absorption Costing:

1. Difficulty in Comparison and Control of Cost:

Absorption costing is dependent on level of output; so different unit costs are obtained for different levels of output. An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to the existence of fixed expenses. This makes comparison and control of cost difficult.

2. Not Helpful in Managerial Decisions:

Absorption costing is not very helpful in taking managerial decisions such as selection of suitable product mix, whether to buy or manufacture, whether to accept the export order or not, choice of alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a desired profit etc.

3. Cost Vitiated because of Fixed Cost included in Inventory Valuation:

In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.

4. Fixed Cost Inclusion in Cost not Justified:

Many accountants argue that fixed manufacturing, administration and selling and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of product.

5. Apportionment of Fixed Overheads by Arbitrary Methods:

The validity of product costs under this technique depends on correct apportionment of overhead costs. But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make the product costs inaccurate and unreliable.

6. Not Helpful for Preparation of Flexible Budget:

In absorption costing no distinction is made between fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.

According to CIMA, absorption of overhead means “the process of absorbing all overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”. In other words, apportion of overhead means the process of apportionment of overhead to cost centre.

In order to find out the total cost per unit, each unit of production is charged with its respective share of overhead. So, absorption of overhead is the charge made on each job for recording indirect cost. After careful consideration of all relevant factors a suitable basis is to be selected, e.g., direct labour hours, machine hours, direct wages, production units, etc.

The absorption rate is, thus, obtained by dividing the total departmental overhead by the basis which is applied to various production units for calculating cost of each unit of production, the so-called calculated rate is multiplied to the base unit of each product.

It can be written as:

Overhead Rate = overhead Expenses/ Total quantum (quantity or Value) of basis

Absorption of Overhead = Overhead Rate x Units of the base contained in the product.

Rate of Determination:

(a) Actual Rate:

Actual overhead rate/historical overhead rate is determined by dividing actual cost of overhead by the actual base of a certain period. It is calculated as

Actual Rate = Actual overhead Cost/ Actual Base

It is needless to say that actual rate may be computed monthly, quarterly, or annually.

(b) Predetermined Overhead Rate:

This rate can be computed as:

Pre-determined Overhead Rate = Budgeted overhead cost for the Year/Budgeted base for the Year

According to CIMA, absorption of overhead means “the process of absorbing all overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”. In other words, apportion of overhead means the process of apportionment of overhead to cost centre.

In order to find out the total cost per unit, each unit of production is charged with its respective share of overhead. So, absorption of overhead is the charge made on each job for recording indirect cost. After careful consideration of all relevant factors a suitable basis is to be selected, e.g., direct labour hours, machine hours, direct wages, production units, etc.

The absorption rate is, thus, obtained by dividing the total departmental overhead by the basis which is applied to various production units for calculating cost of each unit of production, the so-called calculated rate is multiplied to the base unit of each product.

Over Absorption

The amount of overhead absorption in costs is the total amount of the overhead costs allotted to individual cost units by application of overhead rate. Overhead costs are fully recovered from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overheads incurred. But when a predetermined rate is used on the basis of budgeted overheads and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses.

If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and/or the output or hours worked being less than the estimates, the difference is known as under-absorption. Under-absorption of overheads thus means the amount by which the absorbed overheads fall short of the actual amount of overheads incurred. It represents understating the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, processes etc.

On the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and/or the output or hours worked exceeding the estimates, it would mean over-absorption of overheads and will inflate the costs. Over-absorption of overheads thus means the excess of overheads absorbed over the actual amount of overheads incurred.

Suppose actual production overheads are Rs 3,38,000 and overheads recovered are Rs 3,24,480, then there will be under-absorption of Rs 13,520 (i.e. Rs 3,38,000 – 7 3,24,480). Suppose in the above case the overheads recovered are Rs 3, 48,000, then there will be over-absorption of Rs 10,000 (i.e. Rs 3, 48,000 – Rs 3, 38,000).

Causes of Under or Over-Absorption of Overheads:

Under or over-absorption of overheads may arise due to any of the following reasons:

(i) Error in estimating overheads:

The total overheads actually incurred for a department may be more or less than the amount estimated because of error in estimating. This may be due to deliberate decision in this regard or lack of proper control.

(ii) Error in estimating of proper volume:

The actual volume of output may be more or less than the output anticipated because of error in estimating the level of production.

(iii) The actual hours worked may be more or less than hours anticipated.

(iv) The basis upon which the factory overheads are recovered from production may no longer be correct on account of changes in the prices of material or wages rates.

(v) Work-in-progress might not have been charged with its share of overhead in cost accounts.

(vi) Major unanticipated changes in method of production might have occurred due to which an expense of a non-recurring nature might have been incurred during the year.

(vii) Seasonal fluctuations in the overhead expenses from period to period. Overhead rate is calculated by averaging the peaks and troughs. This results in under-absorption of overheads if the rate is calculated with reference to full capacity and under-absorption of overhead cost represents the overheads pertaining to the unutilized capacity.

(viii) There may be some important changes in the work situation such as heavy overtime, introduction of another shift, substitution of manual labour by equipment etc.

Accounting of Under and Over-Absorbed Overheads:

The accounting treatment of under or over-absorption of overheads depends upon the extent of such under or over-absorption and the circumstances under which it arises. Following are the main methods of disposal of under or over-absorption of overheads.

(i) Use of Supplementary Rates:

If the amount of under or over-absorption is considerable; the cost of job or process is adjusted by means of supplementary levy of the overhead. Supplementary rate is calculated by dividing the amount of under or over-absorption by the actual base. Under-absorption is set right by the plus rate while over-absorption is adjusted by minus rate. The supplementary rate may also be calculated as a percentage of the amount absorbed.

Correction of overheads costs by a supplementary rate is nothing but recovering the overhead by actual rates. All the shortcomings of actual rate method will make the supplementary rate as unnecessary and add to the clerical expenses. When the overhead rate is linked with maximum attainable or normal capacity but other than actual capacity, then calculation of supplementary rate will defeat the purpose (i.e. to reveal the idle capacity) for which it is calculated.

Supplementary rate is useless in those cases where in order to have a uniform charge of overhead throughout, the accounting period is fixed in order to avoid seasonal fluctuations in the overhead cost or level of activity.

Correction of costs through supplementary rate is necessary when the management likes to maintain actual historical costs for future comparison. Its use is made when prices are fixed on cost plus basis.

The amount of under or over-absorption at the end of the accounting period is adjusted in work-in-progress, finished stock and cost of sales in proportion to direct labour hours or machine hours or the values of the balances in each of these accounts by the use of supplementary rate. Subsidiary records or individual items are not corrected. The amounts so adjusted will be shown in the Balance Sheet as deductions from or additions to the work-in-progress and finished goods stock.

Under this method, the profit for the period will be reduced or increased by the amount adjusted to cost of sales and value of stock will increase or decrease by the amount adjusted to work-in- progress and finished goods stock. The latter will affect the profit of the subsequent period.

(ii) By Writing Off to Costing Profit and Loss Account:

If the amount of under or over- absorption is small it may be written off to Costing Profit and Loss Account instead of calculating a supplementary rate by complicated procedure. Under-absorption due to idle facilities should be written off in this manner whatever the amount may be.

The amount of under or over-absorption at the end of accounting period is transferred to the Overhead Suspense Account which is ultimately transferred to the Costing Profit and Loss Account or directly to Costing Profit and Loss Account. If some portion of under or over-absorption arises due to abnormal causes such as strikes, lock-outs, major breakdown etc., then such portion should be carried over to the next year and is taken into account while fixing the rate for that period.

The main defect of this method is that it will distort the value of stock as the amount of under or over-absorption of overheads is directly transferred to Costing Profit and Loss Account and not allocated to the stock of work-in-progress and finished goods. The value of such stock will either be under or over-stated in the next accounting period. Under-absorption will reduce the profit of the concern by the same figure for the period.

(iii) Absorption in the Accounts in Subsequent Years:

The amount of under or over- absorption of overheads may be carried over as deferred charge or deferred credit to the next accounting period by transferring to a Suspense or Overhead Reserve Account. The use of this method is justified when the normal business cycle is more than one year and in the case of new projects and schemes when the output is low in the initial stages of production and cannot bear the entire share of overheads.

Under such circumstances, it is desirable that some portion of such cost be carried over to the next period to be absorbed in the production of subsequent years. One criticism which is generally levied against this method is that cost should be absorbed in the period in which it is incurred and utilised and should not be carried over to the next period for the purpose of absorption as it will distort the costs for the purpose of comparison.

General Principles for Items of Overhead Expenditure:

Following general principles should be kept in view while considering whether an item of expenditure is to be treated as overhead:

1. Overhead comprises of indirect costs, i.e. the costs which cannot be directly charged or allocated to any particular job, process or product. Thus, the relationship of the items of expenditure to product, job etc., must be seen.
2. Direct costs are not to be treated as overheads. But in certain cases even direct expenses may be treated as overheads; for example, when the cost of a particular item like screws, nuts, bolts etc. though incurred for a particular job or product is so small that it is not convenient to charge them as direct costs, is to be apportioned as overheads over the jobs or products.
3. Overheads may be attached to a cost centre in accordance with the principles of benefit and I or responsibilities. The benefit principle implies that if a cost centre occupies a proportion of a larger unit of space for which standing charges such as rent and rates are exactly ascertainable, it should be charged with a due proportion of such costs. The responsibility principle implies that as the departmental head has no control over the amount of rent and rates paid, these being fixed by decisions of others, his department should not bear any allocation of them.
4. All expenditures of capital nature should be excluded from costs and shall not be treated as overheads.
5. All expenditures which do not relate to cost, such as penal rates of interest on loans, donations, subscriptions, income-tax etc., are excluded from costs and shall not be treated as overheads.
6. While it is not convenient to charge items of direct costs to individual jobs, processes or products, it is advisable to allocate or apportion these costs as overhead. For example, electricity charges can be treated as direct costs if electric consumption metres are installed for separate machines or departments but when this is not so, the total electricity bill may be allocated and apportioned over various jobs, products or processes in the form of overheads.
7. All indirect expenses of such nature for which cash has been paid or liability contracted or a loss in capital value sustained should be treated as overheads. An example of the first type would be telephone bills or electricity charges paid by the factory and an example of the third type would be depreciation of fixed assets in the factory or the office.

Overhead allocation is the apportionment of indirect costs to produced goods. It is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.

There are two types of overhead, which are administrative overhead and manufacturing overhead. Administrative overhead includes those costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing overhead. Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

You need to allocate the costs of manufacturing overhead to any inventory items that are classified as work-in-process or finished goods. Overhead is not allocated to raw materials inventory, since the operations giving rise to overhead costs only impact work-in-process and finished goods inventory.

Method 1. Distribution in Proportion to Prime Cost:

According to this method, the rate of overhead equals the total overhead cost of the enterprise expressed as a fraction of the prime costs. Thus we get,

Rate of overhead = Total overhead costs/Total prime cost

This rate of overhead multiplied by the prime costs on the item of manufacture, gives the part of total overhead costs allocated to that item of manufacture. Evidently this method of distribution of overhead costs ignores the fact that in the manufacture of two different items, labour and material employed may be of different rates and the machines used may also be of different capacities and efficiencies.

Method 2. Distribution in Proportion Direct Labour Cost:

According to this method, the rate of overhead equals the total overhead cost of the enterprise expressed as a fraction of the direct labour costs.

Thus we have:

Rate of overhead = Total overhead costs/Total direct labour cost

This rate of overhead multiplied by the direct labour costs on the item of manufacture gives the part of total overhead costs allocated to that item of manufacture. This method suffers from the drawback that no difference has been made in the cost of manual labour and the cost of machine labour.

Method 3. Distribution in to Direct Material Costs:

According to this method, the rate of overhead equals the total costs of the enterprise expressed as a fraction of the direct material costs. Thus we have.

Rate of overhead = Total overhead costs/Total direct material cost

This rate of overhead multiplied by the direct material costs on the item of manufacture gives the overhead costs allocated to that item of manufacture. This method has the serious drawback that values of materials used in different items of manufacture may vary widely.

Method 4. Distribution on Man-Hour Rate:

According to this method, the rate of overhead equals the total overhead costs of the enterprise divided by the total productive man-hour utilised during the period. Thus we have,

Rate of overhead = Total overhead costs/Total productive hours worked

The rate of overhead multiplied by the productive man-hours used in the manufacture of the item under consideration, gives overhead costs allocated to that item of manufacture.

This method considers only the man-hours and ignores the efficiency of machines that may be used. On different items of manufacture, the machines used may have widely.

Method 5. Distribution on Machine-Hour Rate:

This method assumes that the production overhead expenses are proportional to the operating hours of the machines. Accordingly we have, the rate of overhead costs or machine-hour = total overhead costs on machines divided by the number of machine-hours.

This rate of overhead costs multiplied by the number of machine hours gives the overhead costs allocated to the item of manufacture under consideration.

Method 6. Distribution on Unit Output Rate:

This method assumes that the total, overhead costs are proportional to the total output. Thus we have, the Rate of overhead costs per unit production

Rate to overhead costs per unit production = Total overhead costs/Number of units produced

This rate of overhead costs multiplied by the number of units of the item manufactured gives the overhead costs allocated to that item of manufacture. This method is, however, applicable to such shops only which produce one type of products. This method has the advantage that it provides a standard rate of overhead costs for all items of manufacture.

Direct expense is an expense incurred that varies directly with changes in the volume of a cost object. A cost object is any item for which you are measuring expenses, such as products, product lines, services, sales regions, employees, and customers.  Here are several examples of direct expenses:

• The materials used to construct a product for sale
• The cost of the freight needed to transport goods to and from a manufacturing facility
• The labor incurred to produce hours billable to a client
• Labor and payroll taxes paid based on the number of units produced
• Production materials consumed during the manufacture of goods
• The commission and payroll taxes related to the sale of goods or services

Direct expenses are typically listed within the cost of goods sold section of the income statement. However, commission expenses are sometimes categorized lower down, in the selling and administrative expenses section of the income statement.

When the income statement is revised to only include direct expenses in the cost of goods sold, this is called a contribution margin income statement.

There are many more types of expenses that are not direct expenses – they are called indirect expenses, because they do not vary with changes in the volume of a cost object. Examples of indirect expenses are:

• Facility rent
• Facility insurance
• Salaried compensation
• Secretarial wages
• Depreciation and amortization
• Research and development

There are various methods of absorption of factory overhead. Some of the methods are briefly explained below.

1. Production Unit or Cost Unit Method

This method is followed under historical costing. The rate is calculated by dividing the overhead by the number of units produced. The following formula is used to calculate the rate.

OH Rate = Budgeted or Actual Overhead / No. of units budgeted or produced

Advantages of Production Unit or Cost Unit Method

1. This method is suitable for the department which produces only one product or homogeneous products or products measured in terms of a common yardstick.
2. It is applicable to the company where the manufacturing methods are simple.
3. This method is simple to understand and easy to apply.

2. Percentage of Direct Material or Direct Material Cost Method

Under this method, the rate is calculated by expressing the overhead cost as a percentage of direct materials for the same period. The following formula is used to calculate the rate.

OH Rate = Budgeted or Actual Overhead / Budgeted or Actual Direct Material Cost x 100

Advantages of Direct Material Cost Method

1. This method is very simple to understand and easy to apply.
2. This method is suitable to the cost unit or cost centre where materials are formed as major part of the finished product.
3. This method is useful if grades of materials and prices of materials do not widely fluctuate.

Disadvantages of Material Cost Method

1. There is no logical relationship between the items of overhead and material cost.
2. Time factor item of overhead is not considered under this method. For example: Rent.
3. This method is not suitable if some materials passes through all processes and some materials passes through few processes.
4. The price fluctuation of material will not be accompanied by similar fluctuations in overhead.
5. Time spent on the completion of product is ignored in this method. For example cheap raw materials or inferior quality material requires more time than quality raw material. If so, cheap raw materials absorb high overhead and quality raw material absorb less overhead. This is undesirable.

3. Percentage of Direct Wages Method (or) Direct Labour Cost Method

Under this method, the rate is calculated by expressing the overhead cost as a percentage of cost of direct labour for the same period. The following formula is used to calculate the rate.

OH Rate = Budgeted OR Actual Overhead / Budgeted OR Actual Direct Labour Cost x 100

Advantages of Direct Labour Cost Method

1. This method is used where labour cost forms a major portion of the total cost.
2. If different grades of labourers are employed to produce a product, this method is fair.
3. It is simple to understand and easy to apply.
4. This method is better than percentage of direct material cost method since the labour cost is less flexible than material cost.
5. There is a direct relationship between time factor and direct wages. If more time is required to finish a product, there must be a payment of high amount of wages.
6. Comparison of direct wages from one period to another is more dependable.

Disadvantages of Direct Labour Cost Method

1. This method is not suitable if the workers are paid on piece rate basis. The reason is that overhead depends upon the time instead of output.
2. Sometimes, workers are employed with costly equipment and hand tools. If costly equipment is used, the overhead is high and vice versa in the case of using hand tools. But, overhead absorbed on direct wages basis is equal. This is not acceptable.
3. If skilled workers perform a job, the wages is high. If unskilled worker performs the same job, the wages is low. These practices lead to absorption of overhead in different rate. This is unfair.

4. Percentage of Prime Cost Method

This method is the combination of both percentage of direct material cost method and percentage of direct labour cost method. The following formula is used to calculate the rate.

OH Rate = Budgeted OR Actual Overhead / Budgeted Prime Cost x 100

Advantages of Percentage of Prime Cost Method

1. This method is very simple to understand and easy to apply.
2. It gives equal importance to direct material and direct labour.
3. It recognizes time factor.

Disadvantages of Percentage of Prime Cost Method

1. This method suffers from the limitation of both percentage of direct material cost method and percentage of direct labour cost method.
2. If the portion of direct material cost is more than direct labour cost, giving equal importance is not acceptable.
3. If the portion of direct labour cost is more than direct material cost, insufficient allowance is given for the time factor.

5. Suitability of Percentage of Prime Cost Method

This method is suitable if the following conditions are satisfied.

1. A standard product is produced.
2. A standard quantity of materials at standard rate is consumed.
3. A standard number of labour hours at standard rate is required for production.

6. Direct Labour Hour Rate Method:

Generally, time is the key factor, which determines the amount of indirect expenses. Hence, any recovery rate calculated on the basis of the hours of work shall give accurate result. In a manufacturing process, if handwork is the rule, the rate of overhead per direct labour hour is worked out and applied suitably. The following formula is used to calculate the rate.

OH Rate = Budgeted OR Actual Overhead / Budgeted OR Actual Direct Labour Hour

A direct labour hour rate may be calculated for each department or for each group of workers.

Advantages of Direct Labour Hour Rate Method

1. If the production units are heterogeneous, the time spent by the labour is considered in the calculation of overhead rate.
2. This method can be easily adopted if proper records of time booking are maintained.

Disadvantages of Direct Labour Hour Rate Method

1. If mechanical production is followed, this method is not suitable.
2. The maintenance of direct labor hours are required for overhead rate calculation. This is very difficult.
3. There is no difference between the time spent by the skilled labour and unskilled labour.

7. Suitability of Direct Labour Hour Rate Method

This method is highly suitable if the following conditions are satisfied.

1. Labour is very important in production process.
2. Output is not uniform.
3. Any percentage method fails to suit the condition.

Machine Hour Rate Method

If automatic and semi-automatic machines are used in the manufacturing process, machine hour rate is applied in the case of overhead absorption.

Now a day, machine, production is getting importance and, therefore, the overhead may be absorbed on the basis of machine hour rate.

Types of Machine Hour Rate

The following are the important types of machine hour rate.

1. Ordinary Machine Hour Rate

It is calculated by taking into account of all the indirect expenses, which are relating to the running of a machine. All these indirect expenses are classified into two categories. They are

• Expenses incurred proportionately according to the running of the machine and
• Expenses incurred in no way connected with the running of the machine.

The expenses like power, repairs and maintenance and depreciation are incurred directly proportionate to the running of the machine. These are known as machine expenses or variable expenses. Moreover, expenses like insurance, taxes, lubricants etc. are incurred but not in proportion to the running of the machine included in the machine hour rate. All these expenses are totaled which is divided by machine hours to determine the machine hour rate.

1. Composite Machine Hour Rate

Under this method, both variable expenses and fixed expenses are taken into account to calculate machine hour rate. The fixed expenses like supervision, rent, lighting, heating etc. are included along with the variable expenses to calculate the machine hour rate.

These fixed expenses are known as standing charges. The standing charges of each machine are divided by the working hours of that machine to determine the machine hour rate for standing charges. To calculate the composite machine hour rate, ordinary machine hour rate is added with the machine hour rate for standing charges.

1. Group Machine Hour Rate

Under this method, a machine hour rate is prepared for a group of machines. Such group of machines is treated as a cost centre. This method is followed if identical machines are used in a factory. All direct expenses are allocated to the cost centre. All the indirect expenses are apportioned on a suitable basis.

Consideration for the Computation of Machine Hour Rate

The following points are considered while computing machine hour rate

1. Group of machines should be treated as single cost centre.
2. The estimated overhead expenses for the period should be determined for group of machines.
3. All the expenses should be classified into two categories. They are standing charges and machine expenses.
4. Both direct and indirect expenses are combined to obtain total overhead expenses to operate the machine during the period. The total overhead expenses are divided by the number of hours to be operated for the specific period to obtain machine hour rate.
5. The wages of operator should be included in the direct wages and should not be included in machine expenses. If so, misleading machine hour rate is calculated. Hence, accountants prefer to include such wages into the machine expenses for computing actual machine hour rate.

Advantages of Machine Hour Rate

The followings are the advantages of machine hour rate.

1. If machine work is predominant in any production, the machine hour rate ensures equitable charge.
2. An operator operates many machines or many operators operate single machine, machine hour rate becomes the best method of recovery.
3. Only productive time is taken into consideration for the calculation of machine hour rate. Hence, it is a logical method.
4. It is very easy to calculate machine hour rate well in advance.
5. The idle time of the machine is disclosed through analyzing under absorption of overhead.
6. It helps the allocation of indirect expenses to each job.
7. The share of expense of a job is determined with high degree of accuracy by using job specification sheets and route sheets.
8. If this method is followed, the price for the job is accurately fixed.

Disadvantages of Machine Hour Rate

The followings are the disadvantages of machine hour rate.

1. The calculation requires more clerical work.
2. Indirect expenses are apportioned on suitable basis. If suitable basis is not followed, the calculation of machine from rate is misleading.
3. This method is not useful if one single rate for the factory is to be used.
4. If most of the work is done manually, this method has limited application.

Sales Price Method:

Under this method, sales value is taken into consideration for the calculation of machine hour rate. The budgeted or actual overhead is divided by sales realized or to be realized. This method is rarely used by many organizations. The reason is that there is no relationship between the overhead absorption and sales value realized. Hence, it leads to inequitable absorption of overhead to a job or a product.

This method is accepted for the absorption of administration overhead and selling and distribution overhead. But, this is not accepted method for the absorption for production overhead.