Overheads: The Different Types Of Absorption Methods.

August 3rd, 2006 Comments off
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There are many ways to absorb overheads which are as follows:

DIRECT MATERIAL COST PERCENTAGE

Suitable in situations where:

  • the material value has some relationship with the overheads;
  • quality and prices of materials do not vary drastically;
  • quantity and cost of materials in each product is almost the same and
  • where processing is uniform

Unsuitable when:

  • overheads are time-based where there is little relationship with the cost of material used hence products with high material content absorb more overheads.

DIRECT LABOUR COST PERCENTAGE

Suitable in situations where:

  • wages have some relationship with the overheads
  • one type of labour rate and one type of pay rate in the cost centre.

Need to be careful to charge overheads with higher labour costs in the event of different level of skill.

PRIME COST PERCENTAGE

Prime cost consist of direct material and direct labour. Not a good absorption method as it has little relationship with overheads.

DIRECT LABOUR HOUR RATE

Suitable in labour intensive industry or where certain departments is still using manual means. Uses time as a basis.

Disadvantages:

  • it assumes that operations that takes the same time are costed with the same overheads irrespective of the operators’ different pay rates.
  • also, more businesses are deploying machines, hence this absorption method is getting more unpopular.

MACHINE HOUR RATE

Is suitable when the business is of capital intensive in nature or production being carried out by machines.

Disadvantage:

  • If a cost centre uses different type of machines, then we cannot use a single machine rate. A separate machine rate must be computed for each machine or group of machines. \Also, there is a need to keep records of the machine time for each operation.  This method therefore can be very tedious and increases clerical work.

COST UNIT RATE

Suitable where cost units passing through a cost centre are homogenous.

Applies in standard costing or budgetary control systems.

Cost Unit Rate method is very simple and a more direct mean.

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Financial Accounting

 
 

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