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The typical procedure for allocating overhead is to accumulate all

manufacturing overhead costs into one or more cost pools, and to then
use an activity measure to apportion the overhead costs in the cost pools
to inventory. Thus, the overhead allocation formula is:

Cost pool / Total activity measure = Overhead allocation per unit

One can allocates overhead costs by any reasonable measure, as

long as it is consistently applied across reporting periods. Common
bases of allocation are direct labor hours charged against a product, or
the amount of machine hours used during the production of a product.
The amount of allocation charged per unit is known as the overhead rate.

Absorption of Overheads
The next step in the process of overhead control is to recover it
while ascertaining the cost of production. Charging overheads to
individual products or jobs is known as overhead absorption. The
overhead expenses pertaining to a cost center are ultimately to be
charged to the products, jobs etc, which pass through that cost center.
The method apportionment of overheads of an individual cost center is
known as absorption. The terms overhead absorption, recovery change,
application of overhead are used interchangeably.

Basis of Absorption
For the purpose of absorption of overhead to individual jobs,
processes or products overheads absorption rates are applied. The
overhead rates of expenses for apportioning them to production may be
estimated on the following three bases.
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1. On the basis of the figure of the previous year or period

overhead rate may be ascertained and applied to production in
the current year.

2. The overhead rate for the year may be determined on the

basis if the estimated expenses and anticipated volume of
production or activity.

3. The overhead rate for the year be determined on the basis of

the normal volume of output or capacity of the business.

Blanket and Departmental Overhead Rate: Blanket overhead rate

refers to use of one single or general overhead rate for the whole factory.
Departmental overhead rates refers to a separate rate for each individual
cost center or department.

The blanket rate is used in those factories:

1. where only one major product in continuous process is being

produced.

2. and where several products are produced, it can be applied

only if (a) all products pass through all departments, and (b)
all products are processed for the same length of time in each
department.

If the above conditions do not prevail, departmental rates should be

used.

These are several methods in use for determining overhead rates.

The overhead rate is calculated as under:

Overhead Expenses
Overhead Rate =
Base
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Overhead absorbed in a product or job

= Overhead rate ´ No. of units produced

Methods of Absorption of Factory Overheads

The methods generally applied for the absorption of factory
overheads are:

1. Percentage on Direct Material: The actual or predetermined rate

of overhead absorption is calculated by dividing the manufacturing
overheads by the material cost incurred or expected to be incurred and
expressing the result as a percentage. The formula is given below:

Percentage of Works Overhead to Direct material

Factory Overheads
= ´ 100
Direct Material Cost

2. Percentage on Direct Wages: An actual or predetermined rate of

overhead absorption is calculated by dividing the cost to be apportioned
absorption by the wages paid or expected to be paid and expressing the
result as a percentage. The formula for computing the percentage rate for
a period is given below:

Percentage of works overheads to direct wages

Factory Overheads
= ´ 100
Direct Wages

3. Percentage in Prime Cost: An actual or predetermined rate of

overhead absorption is calculated by dividing the overheads to be
absorbed by the prime cost in incurred or expected to be incurred and
expressing the result as a percentage. The formula for computing the
percentage rate for a period is given below:
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Percentage of Work Overheads of Prime Cost

Factory Overheads
= ´ 100
Prime Cost

4. Direct Labour Hour Rate: An actual or predetermined rate of

overhead absorption which is calculated by dividing the cost to be
absorbed by the labour hours worked or expected to be worked. The
labour hour rate for a period is given below:

Direct Labour Hour Rate

Factory Overhead
=
[Direct Labour Hours during a given Period]

The effective working hours for which the factory works during a
particular period is ascertained as shown below:

Effective Working Hours = [Number of average workers employed

during a given period for which the factory works] * [No. of hours for
which the factory works during each day]

5. Machine Hour Method: This is a method of allocating factory

overheads to different job or products by first calculating the amount
spent to run a machine for one hour and then calculating the amount
chargeable to a job or products by first calculating the amount spent to
run a machine for one hour and then calculating the amount chargeable
to a job or product by multiplying the rate and the number of hours, the
machine is used on that job.
Factory Overheads
Machine hour rate =
Machine Hours
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6. Cost Unit Rate Method: For actual or predetermined rate of

overhead absorbed by the number of cost units produced or expected to
be produced. The formula for computing the cost unit rate is given
below:

Factory overheads per unit

Factory Overheads
=
[No. of Units Produced in the Base Period]

ABSORPTION OF OFFICE AND ADMINISTRATIVE

OVERHEADS
These overheads can be absorbed in one of the following ways:

(1) These expenses are constant because they are period costs. So
some people suggest that these expenses should be fully
charged to profit and loss account directly. If this view is
taken, the value put on the closing stock will be less than if
these expenses are included in cost of production.

(2) On the ground that administration overheads are generally

concerned with both production and sales, the office and
administration expenses should first be apportioned over the
production and sales departments. The part that is apportioned
to production should be added to factory overheads and the
other to selling expenses.

(3) The third approach to observe these overheads is to add them

as a serrate item to the cost on a suitable basis and then to
determine the total cost of production.
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Although there is not much logical connection between works cost

and office expenses, the traditional method of charging office expenses
is that of a percentage on work cost or works overheads.

Percentage of Office and Administration Overheads

Office and Administration Expenses
= ´ 100
[Works Cost]

Absorption of Selling and Distribution Overheads

Selling and distribution expenses are sometimes called after
production costs also. These are those expenses which are incurred for
the purpose of promoting the marketing and sales of different products.
Distribution expenses are concerned with the delivery and dispatch of
goods sold. Some people try to distinguish these both types of expenses,
while other group together these tow types of overheads expenses in to
one composite class.

In concerns where selling and distribution overheads are small, they

may prefer to exclude such expenditure entirely from cost accounts. But
when the quantum of expenditure and selling and distribution is sizable,
it has to be charged in the cost accounts.

Methods of Absorption
(i) Rate per Article : Under this method, the total fixed selling costs
are divided by the number of units of a product sold. The rate per article
is arrived at by the following formula:

Rate per Article

[Total Selling and Distribution Costs ( base period )]
=
[Number of Units Sold ( of base period )]
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(ii) Percentage on the Selling Price of each Article : Under this

method fixed selling costs may be charged by way of percentage on the
selling price. The percentage is ascertained from the analysis of the past
accounts and is arrived at as follows:

Percentage on the Selling Price

[Fixed Selling Expenses for the Base Period]
= ´ 100
[TotalTurnover of the Base Period]

This method works quite satisfactory, if the products of a business

are sold at standard prices and the proposition of each type of product is
constant.

(iii) A Percentage on Work Cost : Under this method, a certain

percentage on works cost is taken as a basis for the absorption of selling
and distribution expenses. The percentage is ascertained in the same way
as it is ascertained on the selling price under the second method.

Percentage of selling and distributing overheads to the work cost

[Selling and Distribution Expenses]
= ´ 100
[Works Cost]

Of all the three method, the rate per article is considered to be one
of the best methods of absorption of selling and distribution expenses.
The percentage on the work cost method is usually unsound unless a
business produces one product only. In such a case, this method will
have the advantage of simplicity.8

8. Sharma N.K., Costing Methods, op.cit., p.86.

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COMPONENTS OF OVERHEADS

Factory Overheads
Factory overhead costs are operating costs of a business enterprise
which cannot be traced directly to a particular unit of output, product or
jobs. Factory overhead is the aggregate of indirect materials, indirect
wages and indirect expenses.

Factory Overhead - Fixed, Semi-variable and Variable

Factory overhead costs can be divided into fixed, semi-variable
costs. Fixed overhead costs are commonly described as those that do not
vary in total amount with increase or decrease in productive activity or
volume of output for a given period of time, usually, an year. Fixed costs
are constant in total amount, but vary per unit as production activity
changes. Semi-variable or semi-fixed are those which remain fixed in
total amount over a relatively short range of variation in output and then
are abruptly changed to a new level, where they remain fixed in total
amount for another short range of output.

Variable costs include repairs, powers, workmen’s compensation,

supplies and indirect labour which are typical of cost varying in total
amount, with changes in productive activity.

Variable costs per unit remain relatively constant with changes in

production. Thus, variable costs fluctuate in total amount but tend to
remain constant per unit as production activity changes.

Factory Overheads - Accounting and Distribution