Year: 2020

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.

Unit or output costing is that method of costing in which cost are ascertained per unit of a single product in a continuous manufacturing activity. Per unit cost is calculated by dividing total production cost by number of units produced. This method is also known as single costing. This method is known as ‘single costing’ as industries adopting this method manufacture, in most cases, a single variety of product.

This method is also known as ‘unit costing’, as not only the cost of the total output, but also the cost per unit of output is ascertained under this method. Under this method cost units are identical. This method is also called ‘output costing’, as cost is ascertained for the total output of a product.

Expert view

1. According to J.R. Batliboi, “Unit costing or output costing may be defined as single or output cost system is used in business where a standard product is turned out and it is desired to find out the cost of a basic unit of production.”
2. According to Walter W. Bigg, “Unit Costing Method is a method of costing applied to ascertain the cost per unit of production where standard and identical products are manufactured.”
3. According to Harold J. Wheldon, “Production Cost Accounting or Unit Cost Accounting is such a method of cost ascertainment which is based on production unit. It is applicable where the production work is done continuously and the units are of same types or manufactured identical.”
4. The Institute of Cost and Management Accountants, London, “output costing is the basic costing method applicable where goods or services result from a series of continuous or repetitive operations or processes to which costs are charged before being averaged over the units produced during the period.”

From above definitions it is clear that single costing is a method of costing under which there is the costing of a single product which is produced by a continuous manufacturing activity. Though under this method of costing a single variety of product is manufactured, it may vary in respect of size, grade, colour, etc. The example of industries which make use of this method of costing are – brick, sugar, cloth, coal, cement, fisheries, food canning, quarries, plantation industries, etc.

Features of Output Costing:

Output costing has certain characteristics features.

The important features of output costing are:

(1) Output costing is the method of costing adopted in concerns where there is a production of single product or a few grades of the same product differing only in size, shape or quality by continuous process of manufacture. The units of production or output are identical and the costs of units are physical and natural.

(2) Under this method, the cost per unit of output, say, per ton, per barrel, per kilogram, per metre, per quintal, per bag, etc. is ascertained. The cost per unit of output is ascertained by dividing the total cost incurred on a product during a given period of time by output produced during the period.

Where the products manufactured are of different grades, first, the costs of products are ascertained grade-wise, and then the total cost of each grade of the product is divided by the number of units of that grade so as to ascertain the cost per unit of each grade of the product.

(3) Equality of cost is an important feature of this method. That is, under this method, cost units, which are identical, will have identical cost.

(4) Under this method, the cost of product is ascertained at the end of the accounting period.

(5) Under this method, the cost information relating to a product may be presented in the form of either cost sheet or production account.

(6) This method is the simplest method of all the methods of costing; in the sense that the cost collection and the cost ascertainment are quite simple.

(7) The cost per unit of output, determined under single. Costing enables the management to make real comparison between different periods and between different firms within the same industry, as the unit of output is a common factor between different periods and between different firms within the same industry.

Objectives of Output Costing:

Output costing has the certain objectives.

They are:

(1) To ascertain the total cost of the output as well as the cost per unit of output.

(2) To ascertain the profit or loss on production.

(3) To analyse the expenditure by nature, classify them into element of cost and know the extent to which each element of cost contributes to the total cost.

(4) To facilitate comparison of the cost of one period with the cost of another period to know the efficiency or otherwise of the production.

(5) To facilitate the preparation of tender or quotation.

(6) To control the cost of the product through comparative study of the costs of any two periods or through the comparison of the actual costs with the pre-determined standard cost.

Important Items Regarding Preparation of Statement of Cost and Cost Sheet:

1. Normal Loss of Materials:

This type of loss is unavoidable and arises due to the nature of material. For example – loss by evaporation of liquid materials, loss due to loading and unloading of materials, etc. This loss is not deducted from the cost of material rather it is charged to the output because it is a principle of costing that all normal expenses which are necessarily to be incurred should be included in the cost of production.

Therefore, in order to absorb normal material losses in cost, the rates of usable materials are inflated so that such losses are covered. In other words, such normal loss should be ignored and this will get automatically charged to output.

2. Abnormal Loss of Materials:

Abnormal losses are those losses which arise due to abnormal reasons such as loss by theft, loss by fire, careless handling etc. The cost of materials abnormally lost should be deducted from the value of materials purchased so that output is charged only for the materials used in production. Abnormal losses are charged to Costing Profit and Loss Account.

3. Wages of Normal Idle Time:

Normal idle time is inherent in any work situation and cannot be reduced. The cost of normal idle labour time is charged to the cost of production. Hence, wages of normal idle time is not subtracted from the labour cost.

4. Wages of Abnormal Idle Time:

Abnormal idle time arises due to unanticipated causes such as strikes, lockouts, fire, accidents, major machine break-down, earthquakes, etc. Loss of time due to such abnormal causes cannot be planned. Such causes are sudden and non-frequent.

The cost of abnormal idle time is not included in cost of production. The wages paid for abnormal idle time should be debited to Costing P/L A/c. Hence, wages of abnormal idle time is subtracted from the labour cost.

5. Sale of Scrap, Defective, Salvage or Residue:

If clear information is given, then adjustment of these sales will be made accordingly. But, if it is not clear that what the nature of scrap defective, etc., the sale value of scrap etc. is deducted before computing factory cost.

6. Defective or Rejected Work:

Sometimes, under production process there might be defective goods. The production not conforming to the standard set is known as defective. If such goods cannot be rectified, then it may be sold in the market at lower rate. Whatever the amount is collected from such sale is deducted from the factory cost. Similarly the defective units are also deducted from the number of units produced.

On the other hand, the defective units which can be rectified by incurring extra expenses, then such extra expenses incurred on such a rectification can be added in factory overhead as an extra factory overhead. After that the saleable units and their costs can be determined.

7. Cash Discount and Trade Discount:

Cash discount is not considered as the part of cost of production, since it is of financial nature. Whereas, trade discount is treated as sales promotion expense and is included in selling and distribution expenses or may be deducted from gross sales.

8. Allocation of Joint Expenses:

In absence of clear-cut information factory overhead is allocated on the basis of wages ratio and office and administration expenses and selling and distribution expenses on the basis of works cost ratio.

9. Packing Charges:

Treatment of packing charges depends upon its nature. If, in absence of packing, goods cannot be sold, then it should be treated as direct expense (i.e. packing of mustard oil etc.). Packing charges in respect of partly finished goods are considered as factory overhead. In the same way, packing expenses concerned with finished goods are included in selling and distribution expenses.

5. Cost Collection or Cost Accumulation:

Usually the following procedure is adopted under output costing for the cost accumulation of the various elements of cost:

1. Materials:

As materials both direct and indirect are issued to production against properly authorised material requisitions. The direct and indirect material costs can be ascertained through material requisitions.

Through the analysis of material requisitions, the quantities of direct and indirect materials issued to production can be ascertained, and on the basis of the prevalent method of pricing material issues, the direct and indirect material costs can be ascertained.

Accounting of Materials:

Materials are dealt in cost accounting as follows:

(i) The direct material costs are taken as a part of Prime Cost.

(ii) Indirect material costs are charged to Factory Overheads.

(iii) Normal loss of materials is adjusted by inflating the issue price of materials.

(iv) Abnormal loss of materials is not taken into account in the cost of production. It is charged to the Costing Profit and Loss Account.

2. Labour:

The labour costs are collected periodically through pay rolls kept separately for each section or type of work without the detailed job cards or chits required in job costing.

Treatment of Labour Cost in Cost Accounting:

Labour cost is dealt as follows:

(i) Direct labour costs are treated as a part of Prime Cost.

(ii) Indirect labour costs are charged to Factory Overheads.

3. Direct Expenses:

Direct expenses or chargeable expenses are separately collected from the financial record where the actual direct expenses incurred are recorded.

The main expenses under this head are:

(i) Royalty

(ii) Architect and surveyor’s fees

(iii) Expenses of drawing and designs

(iv) Excise duty etc.

Treatment:

It is treated as a part of Prime Cost.

4. Overheads:

Where cost finding is undertaken at the end of long interval, i.e., at the end of the year, after the overheads incurred are actually recorded in the financial book, the actual overheads incurred during the year are collected from the financial records.

The actual overheads collected from the financial records are analysed into three broad categories, viz.:

(1) Factory Overheads,

(2) Office and Administration Overheads, and

(3) Selling and Distribution Overheads and are treated as such for cost finding.

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines indirect cost as “expenditure on labour, materials or services which cannot be conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a particular cost centre or cost unit but it can be apportioned to or absorbed by cost centres or cost units.

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines indirect cost as “expenditure on labour, materials or services which cannot be conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a particular cost centre or cost unit but it can be apportioned to or absorbed by cost centres or cost units.

Broadly speaking, any expenditure over and above prime cost is known as overhead. In general terms, overheads comprise all expenditure incurred for or in connection with the general organisation of the whole or part of the undertaking i.e. the cost of operating supplies and services used by the undertaking including the maintenance of capital assets. The terms ‘burden’, ‘supplementary costs’, ‘on costs’, ‘indirect expenses’ are used interchangeably for overhead.

Importance of Overhead Costs:

In various five-year plans, industrialisation was given due importance. The result is that a large number of establishments have grown up both in the public and private sectors for mass production for which use of improved and costlier and special type of machines has become absolutely necessary. With the increasing trend towards plant automation, heavy expenditure is being incurred which cannot be charged directly to any particular unit and can be called as cost common to all units of production.

Overhead expenses being a significant proportion of the total cost have assumed an added importance and require analysis for purposes of cost ascertainment and control by function and for guidance in certain managerial decisions by the extent of the variability with production.

Overhead costs cannot be allocated but have to be suitably apportioned and then absorbed by suitable methods. The cost accountant is required to pay so much attention to the accounting of overhead cost as prudence choice of various bases used for apportionment and absorbing the overheads in the cost of products has to be made by him.

Are High Overhead Costs an Indication of Inefficiency?

These days we find that overhead expenses are increasing in every organisation. Some people may have the feeling that high overhead costs are an indication of inefficiency. But this is not correct.

High overhead costs do not indicate inefficiency if it is accompanied by:

(i) Large scale production or mass production

(ii) Increase in efficiency and productivity of labour

(iii) Less human efforts will be required because of automatic machines but more machine expenses will have to be incurred

(iv) More depreciation, maintenance expenditure and similar other items because of more use of machinery

(v) Improved methods of managerial control like work study, production control, cost and management accountancy techniques may reduce the direct cost but will increase the overhead costs.

Classification of Overhead Costs:

Cost classification is the process of grouping costs according to their common characteristics and establishing a series of special groups according to which costs are classified.

Thus, it involves two steps:

(i) The determination of the class or groups in which the overhead costs are subdivided,

(ii) The actual process of classification of the various items of expenses into one or the other of the groups.

The method to be adopted for the classification of overhead costs depends upon the type and size of the business, nature of the product or services rendered and policy of the management.

The various classifications are:

(i) Functional classification

(ii) Classification with regard to behaviour of the expenditure

(iii) Element-wise classification

(iv) Classification according to nature of expenditure.

A concern may adopt one or more of the above classifications. For example, the overhead expenses in a concern may be first divided according to functions i.e. manufacturing, administration, selling and distribution groups. The expenses pertaining to one group say manufacturing may further be classified into fixed, variable and semi-variable.

Each of these groups may then be grouped into the elements i.e. indirect material, indirect labour and indirect expenses and under each element, the expenses may be further subdivided according to their nature i.e. depreciation, salary, repairs and maintenance etc.

1. Functional Classification of Overhead:

When overhead expenses are classified with reference to major activity divisions of a concern, it is called functional classification of overhead. This classification is necessary for the segregation of the cost of each of the principal functional division of the concern and for having separate methods of accounting and control for the diverse nature of expenses in each division.

The main groups forming the basis of the classification are:

(a) Manufacturing Overhead

(b) Administration Overhead

(c) Selling Overhead

(d) Distribution Overhead

(e) Research and Development Expenses

2. Classification with Regard to Behaviour of Expenditure:

Under this overheads are classified with reference to their tendency to vary with production/sales volume or activity level. Some expenses vary directly with the rise and fall in output, some remain constant in spite of change in the level of activity of the concern whereas there are some other items which are constant only upto a certain level and then change their character to become variable or which vary with volume of output but less than proportionately.

Based on this behaviour, the expenses may be classified into:

(a) Fixed overhead

(b) Variable overhead

(c) Semi-variable or Semi­-fixed overhead.

The following methods are used in separation of such costs into fixed cost and variable cost. They are: 1. Industrial Engineering Method 2. Account Inspection Method 3. Scatter Graph Method 4. High and Low Method.

1. Industrial Engineering Method:

This method is used to collect cost information that is not available in an organization’s records and is particularly relevant when an organization is just beginning a new activity. Every productive process involves employing a particular mix of materials, labour and capital equipment in order to yield physical output.

When the relationship between the input and output is established by an engineer or technical expert e.g., 2 kgs. of materials + 3 hours of labour = 1 unit of output. The material and labour costs can be estimated by imputing material prices and wage rates to physical input needs. It is important to note that these costs are estimates because of possible uncertainty with regard to wastage in material usage and changes in labour efficiency in production process.

The engineering method is particularly useful when applied to material and labour costs which represent a large proportion of the total output cost. If the relationship between material and labour inputs and outputs remain static over time, then these cost estimates can be used in the future without significant adjustment. When costing new products, the engineering method is the only approach that can be used due to lack of historic data.

However, there are three main disadvantages of the engineering method:

(1) It is expensive as work measurement involves detailed analysis of the physical movements required in each task, in order to produce one unit of output.

(2) There are other costs incurred in the production process e.g., machine maintenance and supervision which cannot be associated with specific units of output, but may be direct costs of the department. The engineering method cannot be applied to these costs, whose equations will have to be derived from an analysis of past data or from subjective evaluation.

(3) Different mixes of materials and skills may be used to produce the same unit of output, leading to several conflicting cost estimates.

Although the engineering method is usually associated with production, work study techniques are applied to other areas, such as selling and administrative functions of the organization.

2. Account Inspection Method:

This method is a fast and inexpensive way of estimating costs as it simply involves examining each account and subjectively classifying the account’s total cost into either fixed or variable elements. This requires that the Management Accountant inspect each item of expenditure within the ledgers at a given level of output to determine whether a cost is fixed, variable or semi-variable.

Limitations:

This technique has the following limitations:

(a) It depends heavily on the initial decision to classify an account as fixed or variable.

(b) It fails to recognize that semi-variable costs exist.

(c) It relies on a single observation of the account to determine the cost equation rather than using an average based on several observations of each account.

(d) It assumes that transactions have been correctly charged to one account or another. The account inspection method should be used only when a crude approximation of cost behaviour is sufficient for making decisions.

3. Scatter Graph Method:

In this method, it involves plotting several observed levels of cost and their associated levels of activity on a scatter-graph and then applying statistical analysis to fit the best line through these points.

Illustration:

Output (unit)	1000	2000	3000	4000	5000	6000
Costs (Rs.)	10500	12500	13800	15100	15900	17200

The point at which the line of best fit touches the ordinate indicates fixed component of the cost i.e., Rs. 9,500 in this case. The slope of the line indicates the degree of variability of costs.

The scatter-graph as shown in figure 2.4 can be drawn with the help of the above data

The line of best fit is relatively simple to apply and it does attempt to use all the information in the relevant range of production to arrive at the estimated cost function. However, it remains rather crude and does not adequately handle data points which are far away from the main body of points (called out liners).

Another problem with this method is that each accountant using the same cost data to estimate the cost of equation may draw different total cost lines by eye, to describe the relationship between cost and activity. Despite the short-coming, the method may be sufficient for the small company that does not possess the expertise to use complicated statistical technique.

4. High and Low Method:

Under this method, the highest and lowest volumes of output and the relevant cost figures are taken into consideration. The difference of cost between volumes, i.e., incremental cost for incremental output will be arrived at. The incremental cost will be further divided by the incremental output. This will give the variable cost per unit.

Total variable cost for any level of output can be determined easily. Now, the total cost of the volume of output less the total variable cost at that level of output gives the fixed cost which will remain for all levels of activity.