## Methods of Overhead Absorption
After overheads are collected in production departments, they must be charged to individual products/jobs. This is done using an overhead absorption rate (OAR).
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## Method 1: Overheads as a Percentage of Direct Labour Cost
Formula:
$$OAR = \frac{\text{Overhead Cost}}{\text{Direct Labour Cost}} \times 100$$
Overhead charged to a job = Direct Labour Cost of job × OAR%
### Pros
- Simple and economical to apply
- Gives indirect recognition to the time factor (higher wages → more time spent)
- Total recovered overheads are relatively stable since wages do not fluctuate widely
### Cons
- Time factor not fully captured (a skilled worker earns more but may finish faster)
- Does not account for machine usage – unsuitable where machinery is significant
- Varying worker skill levels distort the absorption
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## Method 2: Machine Hour Rate
Formula:
$$\text{Machine Hour Rate} = \frac{\text{Total Machine-Related Overheads}}{\text{Total Machine Hours}}$$
Overhead charged to a job = Machine hours used by job × Machine Hour Rate
Components included in Machine Hour Rate:
- Depreciation of machine
- Repairs and maintenance
- Power consumed
- Operator wages (if dedicated)
- Insurance on machine
- Machine space cost (rent apportioned)
### Pros
- Best method where machines are the primary production factor
- Under-absorption directly reveals the extent of machine idle time
- Suits situations where one operator handles multiple machines OR multiple operators work on one machine
### Cons
- Requires additional data on machine operation time not otherwise recorded
- Computing a separate rate for each machine in a department significantly increases clerical work
- A general departmental machine rate may be inaccurate for individual machines with very different costs