OVERHEAD RATES: ACTUAL VS PREDETERMINED

The basic purpose of overhead absorption rates is to absorb total overhead in products or jobs manufactured. This objective can be achieved through actual overhead rate or predetermined overhead rate.

Actual Overhead Rate:

When the absorption is based on actual overhead, it is known as actual absorption rate. This can be calculated only after the end of the accounting period when all cost and production figures have been collected. This method has the following disadvantages.

  1. Product costs cannot be determined until some considerable time after the end of the accounting period. This may not help in controlling cost and in fixing selling prices.
  2. There are likely to be variations in the overhead incurred because of the seasonal nature of some overhead costs, change in the volume of production and efficiency of the factory for different periods. Vacation pay tends to increase primarily during summer. Heating and lighting costs are more during winter than in the spring months. If actual overhead costs from individual months is used, the overhead cost pr unit will vary because of seasonal costs. In some months heating would be part of the overhead costs per unit and in other months it would not. Where actual costs are used to calculate selling prices, difficulties arise because the product cost fluctuates from period to period and there is a considerable delay in product cost

determination.              .

  1. Some overhead costs are of fixed nature, such as depreciation, supervision, property ‘taxes, etc. These overhead costs being constant give a different per unit cost when divided by differing production volumes. Also, some overheads like fire insurance premium are paid in advance but this should be charged to all work done/products manufactured during the year. How should the absorption be done? It creates an inequitable situation. Similar absorption problems would result if actual costs incurred for repairs and maintenance were charged directly to a job or product processed during the month when the repairs were done. This is not equitable. Ordinarily, repairs are necessary because of wear and tear over a much larger period than one month and are done to permit continuous production.

A different overhead cost per unit (higher or lower) is misleading as it prompts one to conclude that management is less efficient in one period as compared to the other. But the variation in total cost and unit cost just reflect the time of the year the units were manufactured, a factor outside the control of management. Cost accountants aim to average out these variations through the use of a predetermined overhead rate calculated on an annual basis. All the seasonal overhead costs are merged together and spread over (charged to) the production for the entire year.

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