Methods of Absorption - I Factory Overheads Distribution:

The methods of absorption are to be applied in order to absorb factory overhead to individual articles or jobs. The rate which is used to charge overhead cost to the articles or jobs is called as absorption rate. We are going to discuss two of the methods in this chapter and they are Percentage on Direct Materials and Percentage on Direct Wages.

(i) Percentage on Direct Materials :

An absorption rate base on materials cost is acquired by dividing aggregate approximate factory overhead by aggregate direct materials cost likely to be used in manufacturing course. For instance, if factory overhead is $150,000 and materials cost is $125,000, the absorption rate will be as below: 150,000 125,000

Every job or manufactured goods would be charged on the base of 120% absorption rate. For instance, if materials cost of article is $25,000, the factory overhead to be charged for their article would be $30,000 i.e. (25,000 * 120%).

Merits:
The percentage on direct material cost method is uncomplicated and effortless to learn and apply. This method will give correct overhead cost figure where the prices of raw materials do not differ importantly, where quantity and cost materials in every article are similar and where processing for the varied articles are also similar. It is constructive in very simple forms of small business concerns.

Demerits:
1. There is no rational association amidst material cost of an article and factory overhead utilized in manufacture. 2. Material prices are matter to changes somewhat frequently and this phenomenon tends to high or low overhead costs even though overhead figures stay unaffected.

Demerits:
3. Most of the overhead expenses diverge with time phase. For instance, an article or job using inexpensive materials however a longer period of processing must bear more for overhead as contrasted to a job or an article which utilizes costly materials but a shorter period of processing. However the use of direct material cost completely pays no attention to the time phase which is a significant part in distribution of overhead costs.

Demerits:
4. This method is improper where part of the materials surpass through all stages and part through only some stages.
5. The mere aspect that a job takes materials of a very costly nature does not mean that the overhead occurred on that job or article will also be weighty. If the materials cost basis is used to charge overhead, the product using costly materials will in this crate be charged with more than its part of overhead.

(ii) Percentage on Direct Wages:

This method is computed as below: Factory Overhead x 100 Direct Labor Cost
5. The mere aspect that a job takes materials of a very costly nature does not mean that the overhead occurred on that job or article will also be weighty. If the materials cost basis is used to charge overhead, the product using costly materials will in this crate be charged with more than its part of overhead.

If for instance, factory overhead is $100,000 and the direct labor cost is also $100,000 then absorption rate based on direct wages will be 100%. A job or an article with a direct labor cost of $15,000 would be charged with $15,000 for factory overhead.

Merits

1. It is effortless to operate and comprehend. 2. It judges the time aspect as labor cost is calculated by multiplying number of hours expended on work by an hourly labor rate. 3. Labor rate changes however less often than that of prices of materials.

Demerits:
1. It is based on cost of direct labor which may not reflect precisely the contribution of factory overhead in the cost of product. Many costs such as taxes, property insurance, and depreciation are task of time 2. It does not considers disparities if any, in the rates of compensation for various types of labor and hence, the wages incurred on various jobs are not required in the like proportion as the hours expended.

More Info: Tutorsonnet