Overhead absorption means charging overheads to products. Let us suppose that the production department produce two product. Then it is necessary to distribute the total cost that particular department on the some specific basis.
Overhead absorption to products may be done on the following basis:
- Raw material consumed
- Prime cost
- Units produced
- Labour hours
- Machine hours
Appropriate base is chosen considering the relevance of the absorption base to the products. In case incidence of overhead is related to machine hours consumed, then only machine hours should be used as absorption basis.
In case of labour intensive production, direct wages or labour hours may be chosen as absorption base. Labour hours are considered only when labour rates vary widely.
Prime cost does not reflect proper relationship between products and cost. When raw materials or any other elements of prime cost dominate, absorption on the basis of prime cost ratio more or less resembles the allocation on the basis of such element although overheads are not linked to that element.
Units produced generally do not have any relationship with the incidence of overhead. It is necessary to link overheads to production with reference to consumption of services.
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