Before we describe the various methods, it would be better to know how to judge whether a method will give good results or not.
Percentage of direct material cost: In this method the cost of direct materials used in the manufacture of a product is used as the base in absorption of factory overheads. The overhead rate is calculated on the basis of the following formula:
Overhead rate = (Factory overheads ) / Direct material cost x 100
This method gives satisfactory results in the following circumstances:
- Where the proportion of overheads to the total cost is significant.
- Where the prices of materials are stable.
- Where the output is uniform i.e. only one kind of article is produced.
Advantages:
- The calculation of overhead rate is simple as the cost of direct material is easily available.
- This method is more suitable when prices of materials are fairly stable.
- Overhead cost pertaining to upkeep and handling of materials can be absorbed equitably by this method.
Percentage on prime cost: An actual or pre-determined rate of overhead absorption is calculated by dividing the overheads to be absorbed by the prime cost incurred or expected to be incurred and expressing the result as a percentage. This is calculated as follows:
Prime cost percentage rate = (Amount of factory over heads) / Prime cost x 100
This method has the advantage of simplicity and is applied because it considers both material and labour which gives rise to overhead expenses.
These two methods are generally considered to be unsuitable on account of the following reasons.
- Manufacturing overhead expenses are firstly a function of time, i.e., time is the determining factor for the incurrence and application of manufacturing overhead expenses. The overhead expenses, specially manufacturing expenses, can in the ultimate analysis be regarded as expenditure incurred in providing the necessary facilities and services to workers employed in the productive processes. The question of facilities and services made available to workers naturally is dependent on the length of the time during which the workers make use of these facilities. It may, therefore, be said that the job or product on which more time has been spent would entail larger manufacturing expenses than the job requiring lesser time. This factor is altogether ignored by the first method.
- When the overhead cost is allocated as a percentage of direct materials or prime cost, the same is the determining factor. As a result, when there are two jobs, otherwise absolutely similar and requiring same operational time but using materials having varying prices, their manufacturing overhead cost would be different; these should not normally vary if time taken is the same.
- The method of apportioning overhead costs on the basis of prime cost also does not take into consideration the time factor. The fact that the amount includes labour cost over and above materials cost, does not render the prime cost any more suitable; in fact, the results are liable to be more misleading because of the cumulative error of using both the labour and materials cost as the basis of allocation of overhead expenses, on neither of which they are dependent.
- There is no close or direct connection between the manufacturing expenses and the direct materials cost or prime cost of jobs produced.
- Since material prices are prone to frequent and wide fluctuations, the amount of manufacturing overheads recovered, if based on material cost or prime cost, also would fluctuate violently from job to job and from period to period.
- The skill of the workers involved and whether machines were used or not, are ignored.
Percentage of direct labour cost: According to this method, the manufacturing overhead expenses are charged as a percentage of the direct wages incurred on jobs. The formula for computing the percentage rate for a period is as follows:
(Manufacturing overhead expenses ) / Direct wages or labour cost x 100
The numerator for overhead expenses and the denominator for direct wages may be an estimated sum, actual amount or normal amount. As has been stated earlier, overhead rates are usually predetermined and the use of actual figures is not very common.
This method also fails to give due recognition to the element of time which is of prime importance in the accounting for and treatment of manufacturing overhead expenses except in so far as the amount of wages is a product of the rate factor multiplied by the time factor. Thus, the time factor is taken to consideration only indirectly or partially in the computation of the overhead percentage rate. This method, therefore, cannot be depended upon to produce very accurate results where the same type of work is performed at the same time by different type of workers, skilled and unskilled, with varying rates of pay. Also no distinction is made between jobs done by manual labour and those done by machines.
Inspite of the inaccuracies which may arise under this method, it is widely used in actual practice, because it is simple and does not involve much calculations; for in costing any job, the labour cost has to be ascertained anyhow. If, on the other hand, a more scientific method is employed, e.g., the labour hour or the machine hour rate, which gives proper allowance to the time element, these would introduce more complexities in the overhead accounting procedure. Thus, the advantage of elimination of a small error in practice may be a heavy price to pay on account of introduction of complexities aforementioned. Also, under this method, there is no large over or under recovery of overheads.
Advantages of Percentage of Direct Labour Cost
- The method is simple and economical to apply;
- The time factor is given fair recognition;
- Total expenses recovered will not differ much from the estimated figure since total wages paid are not likely to fluctuate much.
Disadvantages of Percentage of Direct Labour Cost
- It gives rise to certain inaccuracies as the time factor is not being given adequate importance;
- Where machinery is used to some extent in the process of manufacture, an allowance for such a factor is not made; and
- It does not provide for varying skills of workers.
It is possible to consider the time factor fully by ascertaining the factory overheads per productive labour hour. Suppose the total of direct productive labour hours is 1,50,000 and the factory overheads total 3,00,000, then the productive labour hour rate is 2.
Direct labour hour rate: This method is a distinct improvement on the percentage of direct wages basis, as it fully recognizes the significance of the element of time in the incurring and application of manufacturing overhead expenses. This method is admirably suited to operations which do not involve any large use of machinery. A direct labour hour rate is calculated for each category of workers. The expenses incurred, other than wages paid to workers, on each category of workers are listed and totaled for a period. The figure is divided by the number of hours to be put in by that category of workers. Thus, full attention will be paid to the skill of the workers for charging overheads. Productive labour hour rate is a variation of this method. It is computed by dividing the total factory expenses for a period by the total number of hours put in by all the direct workers during that period. Thus, this method, though making no allowance for the skill of workers, gives full recognition to the time factor.
Machine hour rate: By the machine hour rate method, manufacturing overhead expenses are charged to production on the basis of a number of hours a machine or machines are used on jobs or work orders. There is a basic similarity between the machine hour and the direct labour hour rate methods, in so far as both are based on the time factor. The choice of one or the other method is conditioned by the actual circumstances of the individual case. In respect of departments or operations, in which machines predominate and the operators perform relatively a passive part, the machine hour rate is more appropriate. This is generally the case for operations or processes performed by costly machines, which are automatic or semiautomatic and where operators are needed merely for feeding and tending them rather than for regulating the quality or quantity of their output. In such cases, the machine hour rate method alone can be depended on to correctly apportion the manufacturing overhead expenses to different items of production. What is needed for computing the machine hour rate is to divide overhead expenses for a specific machine or group of machines for a period by the operating hours of the machine or the group of machines for the period. It is calculated as follows:
Machine hour rate = Amount of overheads / Machine hours during a given period
Usually, the computation is made on the basis of the estimated expense or the normal expense for the coming period. Thus, the machine hour rate usually is a predetermined rate. Rate for each individual machine may be worked out or, where a number of similar machines are working in a group, there may be a single rate for the whole group.
Steps for Calculation of Machine Hour Rate
The following steps are required to be taken for the calculation of machine hour rate:
- Each machine or group of machine should be treated as a cost centre.
- The estimated overhead expenses for the period should be determined for each machine or group of machines.
- Overheads relating to a machine are divided into two parts i.e. fixed or standing charges and variable or machine expenses.
- Standing charges are estimated for a period for every machine and the amount so estimated is divided by the total number of normal working hours of the machine during that period in order to calculate an hourly rate for fixed charges. For machine expenses, an hourly rate is calculated for each item of expenses separately by dividing the expenses by the normal working hours.
- Total of standing charges and machine expenses rates will give the ordinary machine hour rate.
There are two ways of computing the machine hour rate. According to the first method, only indirect expenses directly or immediately connected with the operation of the machine are taken into account, e.g., power, depreciation, repairs and maintenance, insurance, etc. The rate is calculated by dividing the estimated total of these expenses for a period by the estimated number of operating hours of the machines during the period.
Advantages of Machine Hour Rate
- Where machinery is the main factor in production, it is usually the best method of charging machine operating expenses to production.
- The under-absorption of machine overheads would indicate the extent the machines have been idle.
- It is particularly advantageous where one operator uses several machines (e.g., automatic screw manufacturing machines) or where several operators are engaged in one machine (e.g., the belt press used in making conveyor belts).
- It is a logical method and takes into consideration the time factor completely.
Disadvantages of Machine Hour Rate
- Additional data concerning the operating time of machines, not otherwise necessary, must be recorded and maintained.
- As general data concerning rates for all the machines in a department may be suitable, the computation of a separate machine hour rate for each machine or group of machines would mean additional work.
- It gives inaccurate result if hand labour is equally important.
If production is carried on in different departments having different degrees of mechanization, the best method would be the machine hour rate. The machine may be treated as a small department or cost centre and the total cost for, say, a month may be divided by the effective hours for which the machine is usually used. Suppose the total cost of running a machine, including, expenses on rent, lighting, insurance, supervision, depreciation, power, etc. for a month is 12,600 and the total number of hours is 200 including 20 for maintenance, the machine hour rate is 70 i.e. 12,600 / 180. If the machine is used on job for 5 hours, the job should be charged with 350 i.e. 70 x 5 as production overheads.
[In small firms however, quite good results are obtained by working out the percentage of factory overheads to direct wages or by dividing the total factory overheads by the total number of direct labour hours (productive labour hour rate); production overheads may then be charged to jobs or products using one of these methods. Office expenses are usually charged as a percentage of works cost].Combined machine hour and direct labour hour rate
Where the work is done partly by machines and partly by manual labour, a combination of Machine Hour and Direct Labour Hour Method is used for the purpose of absorbing works expenses. Such expenses as are inseparable from the running of the machine are allocated on the basis of the Machine Hour Rate and the other expenses which are not directly attached to the machines are allocated on the basis of the direct labour hour basis. In fact, because of inconvenience, it may not be possible to cover all the items included in factory overheads while computing machine hour and direct labour hour rates. For example, it is likely that such overhead items as salary of the works manager or the factory clerical staff, stationery, etc. are left out. To cover such items also there will be need to apply the method of the percentage of wages to overhead (remaining items only). Suppose the various rates worked out are the following:
Machine A 35 per hour
Machine B 45 per hour
Skilled workers:
Category 1 3.00 per hour
Category 2 2.50 per hour
The total wages (direct) for a month come to 1,50,000 and the items of overheads not covered while computing the rates mentioned above totaled 22,500 per month. For a job undertaken during the month, the following information is available:
Time spent: Machine A 10 hours
Machine B 5 hour
Skilled workers:
Category 1 25 hours
Category 2 20 hours
Total of direct wages 600
The overheads to be applied to the job will be 790 i.e.
Machine A 10 hours @ 35 350
Machine B 5 hours @ 45 225
Workers
Category 1 25 hours @ 3.00 75
Category 2 20 hours @ 2.50 50
“Remaining” overheads (15% on 600) 90
790
Rate per unit of production
This is also known as unit cost method. Under this method, actual or pre-determined overhead rate is calculated by dividing the overheads to be absorbed by number of units produced or expected to be produced. The rate is calculated as under:
Overhead rate= (Overhead expenses) / No. of units produced
This method is very simple. The main limitation of this method is that it is restricted to those concerns which produce only one item of product or a few sizes, quantities or grades of the same product.
