Q64. What is absorption? What are various methods of absorption?
Ans. Total cost of production department is charged or applied on any variable factor. Such variable factor maybe Machine Hours, Labor Hours, Material Cost, Labor Cost, Prime Cost etc. Charging of overhead on any suitable basis is called absorption of overhead.
Methods of Absorption:
- Percentage of Direct Material: In such method, factory overhead are shown as a percentage direct material cost. Total factory overhead is divided by total material cost and absorption percentage is calculated.
- It is not suitable due to following reasons:
- Factory overheads are generally related to time rather than material cost. Such method ignore time completely. Such method will give misleading result if two job require same processing time but one direct material cost is differ from other. Such method will give also false result is there is no change in processing cost but there is change in material price of goods.
- Percentage of Direct Labor: In this method, direct labor cost are considered instead of direct material cost. In this method, a percentage recovery rate is calculated by dividing total factory overhead from total direct labor cost.
- Simple and economical,
- Time factors to some extent is considered.
- Disadvantages: Time factor not been given full importance.
- No consideration to machine used.
- It does not provide for varying skill of workers.
- Percentage of Prime Cost: Prime cost include Direct Material, Direct Labor and Direct Expense. Percentage recovery rate is calculated by dividing total factory overhead from total Prime cost.
- Labor Hour Rate: In such method, factory overhead are absorbed on labor hours. Total factory overhead is divided by total labor hours and labor hour rate is calculated.
- Machine Hour Rate: In this method, collection of overhead are made machine wise. All overheads related to a machine are collected and divided by machinery in the main factor of production.
- It is best method where machinery is the main factor of production.
- It indicate the idleness of machinery.
- It considers time Factor completely.
- Recording additional data relating to machine hour etc.
- It gives inaccurate result if labor is equally important.