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Absorption of Overheads

The term absorption refers to charging of overheads of a cost centre to different cost units in such a way that each cost unit bears an appropriate portion of its share of overheads. This is done by means of overhead rates. The term ‘Overhead Rate’ refers to the rate at which the overheads are to be charged to different cost units. It may be in the form of a percentage or a rate per unit. For instance, if the overheads of a department are $ 10,000, the total wages paid for different jobs completed in the department are $ 40,000 and the overheads are to be charged as a percentage of wages to different jobs, the overhead rate will be 25% of wages. The share of overheads of each job completed in the department will now calculated on this basis.

Blanket and departmental overhead rates: Overheads may be absorbed either on the basis of one single rate computed for the entire factory or on the basis of separate rates for each individual department/cost centre. Where one product is manufactured or where work performed in different departments is more or less on a uniform pattern, blanket rate may be applied, plantwide, i.e. over the entire plant.

Different overhead rates are used for absorption of different categories of overheads. However, the following factors should be taken into account for determining the rate of overheads absorption.

(i) Adequacy: The rate should be such as would not give rise to large difference between the amount of recovered overheads and actual overheads, otherwise the cost of jobs or products determined on such basis would not be correct.

(ii) Convenience: The computation of overhead rates should not require unnecessary clerical labour. For example, the apportionment of works manager’s salary according to time spent by him on different jobs would not be of much use. It will be better to distribute it on the basis of wages charged to different jobs since this basis is more convenient, though not more equitable, than the former basis.

(iii) Time factor: Time factor should be given due consideration while determining overhead rate in those cases where different jobs require different jobs on the basis of hours for which the machine cost center has worked for each of them. It will be, therefore, appropriate to charge overheads in such a case on an hourly rate method.

(iv) Skill factor: Different jobs require different degrees of skill. It will not therefore be appropriate to charge all jobs with the same overhead rate. This factor should be taken care of while determining the rate.

(v) Rational productivity factor: The overhead rate should also be related to the method of production followed. For example, in a department where work is done mainly by machines.