 If you like, we’ve charged a little bit too much and we need to make a correction in our management accounts. On the other hand, if the overhead absorbed was less than the actual overheads, we have under absorbed. (3) Ascertainment of machine hour rate requires skill and detailed working knowledge. Machine hour rate can be computed for the entire plant (called composite machine https://accounting-services.net/what-is-a-plant-asset/ hour rate) or machine hour rate for individual machines (simple machine hour rate). A particular job carried out during the period involving 50 hours of direct labor absorbs \$100 (50 hours x \$2) by way of overhead. A job carried out by the department involving direct material costing \$200 means the job absorbs \$80 (40% of \$200) and Rs. (40% 01′ Rs. 2()()) by way of overhead.

### How do you calculate overhead absorb?

1. Overhead absorption rate per unit = Total estimated overheads / Total estimated units of output.
2. Overhead absorption rate = (Total estimated overheads / Total direct material cost for all production ) x 100.

Absorption of the overhead reflects the number of hours involving direct labor. If the prime cost of a job done by the department amounts to \$300, the job will absorb \$75 (25% of \$300) by way of overhead. Salaries, rent, insurance, and taxes are examples of the overheads that are related to the time factor. Therefore, it becomes necessary to charge overheads to the cost of products, jobs, and processes according to certain well-established norms and scientific reasoning.

## ( Dual Hour Rate Method

This method calculates the overhead absorption rate by giving the overhead expense that needs to be absorbed as a percentage of the cost of direct labour for the same period. The main purpose of absorption of factory overheads is to allocate all the indirect costs of running a factory to individual products or services. This is done in order to determine the cost of each product or service and thereby ascertain whether a business is making profits or losses on specific items. Under this method, total direct labor hours are used to determine the overhead absorption rate. Overhead absorption is based on a combination of the overhead rate and the usage of the allocation base by the cost object.

• It is more realistic because machine hour rate is applied only when the machine is used in production of the job or cost unit.
• For example, the budgeted production overhead is Rs. 3,00,000 and estimated machine hours is 15,000.
• The overhead rate is applied to determine the amount of overhead to be charged to a job.
• (b) This method is fair in situation where more than one product is made, and each product requires different amounts of various grades of labour, which are paid at different rates.
• The overhead rate can be determined by dividing the total estimated overheads of the cost center or job by the total estimated units of output.
• When a cost centre produces dissimilar units e.g., jobs to customer order, the volume of production must be expressed in a common measurement e.g., direct labour hours, machine hours etc.

Product X when it passes through department A is expected to use two machine hours per unit and 0.5 labour hours per unit. It’s the two machine hours which is really the important one because we have previously calculated an overhead absorption rate for department A of \$20 per machine hour. So, we have to charge or absorb overheads to our products using a machine hour rate. So, it’s two machine hours which is important here with respect to Product X and department A. Absorption costing is said to be a simple approach to absorb overheads into cost units. Now, in order to do this, what we first have to do is calculate for each department or cost centre (both terms mean the same thing), what’s called an overhead absorption rate, which is often abbreviated to an OAR.