What methods adopted for overhead absorption

The method adopted for overhead absorption varies from industry to industry and from one

undertaking to another. Some firms use separate rates for each type after classifying the overhead expenses into several types. The choice of a most equitable method is very important as the method adopted, if unsuitable, will distort costs and will be useless for control and decision making purposes. Type of industry, nature of product and process of manufacture, organization setup, individual requirement and policy of management are the factors which affect the choice of an overhead rate. Besides these, a satisfactory overhead rate should be simple, easy to operate, practical, accurate, economic in application, fairly stable and related to time factor. It should be preferably department rates as compare to blanket rates, homogeneous cost unit and should lay stress on the main production element of the concern.

The main factor should be taken into consideration before formulating overhead rates or deciding upon the basis for applying overheads to product.

Equitable apportionment of overhead.- the overhead rate should be such that overhead should be equitable apportioned to the cost centres or cost units. The amount of overheads recovered should also be equivalent to the amount of overheads incurred.

Simple and easy to understand- the overhead rate should be simple to calculate and easy to understand. It should not require unnecessary or additional clerical work.

Relation with time factor.- overhead rate should have some relation to the time taken by various jobs for completion. Thus, if a job takes twice as much time as another job, the first job should be charged twice the amount charged to the second job. It is because of this reason that direct wages percentage rate is preferred over direct material cost percentage rate.

Separate rates for manual or machine work.- the work done by manual labor should be distinguished from work done by machine and different overhead rates should be applied for manual and machine work.

Different overhead rates for different departments.- different overhead rates should be ascertained for different departments where the nature of the work done by one department is different from the work done by other department or departments.

What necessity for classifying overhead into fixed and variable

The necessity for classifying the overhead into fixed and variable arises for fixation of selling price, framing the budget, effective cost control, helps management decisions, marginal costing and break even charts, method of absorption of overheads. The distinction is helpful in determining the price policy of a concern. Sometimes, different prices are charged for the same article in different markets to meet varying degree of competition. However, the lowest selling price of an article is any market should at least cover prime cost plus variable overheads. The corresponding fixed overheads may  or may not be recovered if it is not practical to do so. Such fixed overheads may be recovered from sales in more favorable markets. If the selling price in a market does not cover the variable overheads, it is better not to sell good in that market. Segregating the fixed overhead from the variable overhead will be helpful in framing the fixed budget for various levels of capacity utilization. The behavior of the cost will also forcefully brought out. Fixed expenses are incurred by management decision and as such can be controlled by the top management while variable expenses can be controlled by the lower level of management. By segregating these, the lower levels of management will know the types of expenditure which is with in their control. In management decision regarding the utilization of capacity , this segregation will be found useful. After all the concept of fixed or variable expenditure is in relation to a particular rate of output. For example, supervisory salary may have to be doubled, if a new shift is to be started. In such cases, the management has to see whether the production of the second shift will be able to bear such an increase in the cost of production. the technique of marginal costing, preparation of break- even charts and study of cost volume profit relationship, segregation of cost into fixed and variable is quite essential. Different methods may be adopted for determination of absorption rates for fixed and variable overheads. The fixed overheads rates serves as a measure of utilization of the facilities while the extent of idle capacity is indicated by under absorption.

In short the classification of costs into fixed and variable is not prefect as it is based on assumption that costs are influence only by volume is not true. But there are many other factors which influence cost of production specification, product mix, method of production, technology etc.