Chanderprabhu Jain College of Higher Studies

&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

E-Notes
Class : B.COM (H) III Semester
Paper Code : B.COM 201
Subject : Cost Accounting
Faculty Name : Ms. Saumya Goel

Unit-II

Concept and meaning of Labour Cost Control

Introduction
Labor cost represents human contribution. Labor cost is sensitive in nature. The reason is that
the labor cost is fully based on the human behavior i.e. labor behavior.
Meaning of Labour Cost Control
Labor cost covers one of the major portions of the total cost of a product or job. It may
increase unnecessarily due to inefficiency of workers, wastage of materials by workers, idle
time, unusual overtime work and high labor turnover. Hence, the management should devise
effective techniques for controlling labor cost to ensure maximum outputs of better quality at
low cost through proper utilization of the labor force.
Basically, management is concerned with controlling labor cost. Labor cost control involves
such systems, procedures, techniques and tools used by the management in order to keep the
labor cost of the product or job as minimum as possible. Labor cost
control consists of a number of such regular activities which are carried on by various
departments of the organization in a coordinated manner to ensure the availability of the best
employees and their optimum utilization. It is the system followed by the management to
maximize quality output at a minimum cost. Labor cost control includes the process of
developing various forms, studying and recording the activities and performance of workers,
calculating the correct amount of wages and making payment in time. It also includes the
process of analyzing and reporting labor cost to the management for planning and decision
making.
The control of labour costs requires the control of the labor behavior. Therefore, the
management should study human behavior, performance of labour, time and motion study,
labor turnover, labour approach in order to control the labour cost.
Labour cannot be stored for future reference. It is very much similar to the perishable nature
of materials. Some materials may lose its quality and not used for the purpose of production.
Such materials will be waste one. Likewise, once labour is lost, the same cannot be recovered
and not effectively used in the days to come.
If labour is kept idle, the management should pay remuneration or wages for such idle time.
Hence, the management incurred two losses. They are loss of labour working hours and
monetary loss. Hence, the management is very keen in the control of labour cost.
Importance of Labour Cost Control
(i) Labour cost control is important to make economic utilization of labour force in

1
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

production process.
(ii) Labour cost control is important to obtain maximum quantity of output with the
least amount of materials and other resources.
(iii) Labour cost control helps to obtain better quality output with the least effort and time of
workers.
(iv) Labour cost control reduces the cost of production of products manufactured or services
rendered.

Attendance and Payroll Procedures

The following points highlight the four main types of accounting of labour cost. The types
are:
(1) Payroll Accounting
(2) Labour Cost Accounting
(3) Time Keeping
(4) Time Booking.
(1) Payroll Accounting
It is concerned with the maintenance of records for the amounts due to the employees like
salaries, wages, allowances, contributions to provident fund and E.S.I, etc. and the deduction
to be made from the employees’ earnings. Payroll accounting requires the information
relating to employee’s attendance, leaves, rates of pay, amounts to be deducted etc.
(2) Labour Cost Accounting
It is concerned with identifying the amount of labour cost to be charged to individual jobs and
overhead accounts. For this purpose, information relating to the time spent on each job or
process or number of units produced is obtained from the job cards, piece work tickets etc.
The idle time analysis is also necessary for labour cost accounting.
(3) Time booking
Time booking is recording the time actually spent by a worker on various jobs done by him in
the factory for cost analysis and dividing labour cost into various jobs and departments. It
also helps in control over wastage of time- idle time.
(4) Time keeping
Timekeeping is the process of tracking and reporting work and leave time. Everyone is
responsible for accurate timekeeping.

Overtime
Overtime is the amount of time someone works beyond normal working hours. Normal hours
may be determined in several ways:
(i) By custom (what is considered healthy or reasonable by society),
(ii) By practices of a given trade or profession,
(iii) By legislation,
(iv) By agreement between employers and workers or their representatives.
Idle Time
Idle time is unproductive time on the part of employees or machines as a result of factors
beyond their control. Idle time is the time associated with waiting, or when a piece of
machinery is not being used but could be. Idle time could also be associated with computing,
and in that case refers to processing time. In other words, the loss of time for which the
employer pays but obtains no direct benefit is termed as ‘idle time’.

2
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Direct and Indirect Labour

Direct labour can be described as the labour which is engaged directly in production of a
product or in particular job or service, while indirect labour represents such labour which is
not directly engaged in the manufacturer of a product or in a job or service. The cost of
labour is broken into direct and indirect (overhead) costs. Direct costs include wages for the
employees that produce a product, including workers on an assembly line, while indirect
costs are associated with support labor, such as employees who maintain factory equipment.
Remuneration systems and Incentive Schemes
Systems of wage payment
Labour is one of the main factors of production. The success of a concern depends upon the
efficiency of a labour to a great extent. However, there are some factors which are to be
considered carefully before adopting any particular method of labour remuneration.
Therefore, the importance of the method of wages payment should never be under-estimated.
Method or system of wages payment must possess the following characteristics:
(i) Should be simple to operate and easy to understand.
(ii) Should guarantee a minimum wage to every worker.
(iii) Should be acceptable to the employer and the employee.
(iv) Should be flexible enough so the changes may be made according to the requirements.
(v) Should ensure the establishment of industrial peace.
There are two basic methods of labour remuneration, i.e., time rate and piece rate system of
wage payment. In modern days a number of incentive plans to induce workers to work hard
so as to produce more and earn more are being used. The principle methods of wages
payment are as follow:

(1) Time wage payment (Payment by time)

The system under which the payment is made to the worker according to the time for which
they work is known as Time-wage system. This is the age-old and most prevalent method in
which the employee is paid on the basis of time worked such as per hour, per day, per week
and per month rather than output. This is the main difference between this system and the
incentive system. The wage rate is predetermined by negotiation, by reference to local rates,
or by job evaluation.
This method is useful when a worker has to do unstandardized job. This is generally the
method adopted for white collar clerical and managerial jobs. The advantage of payment by
time rate for an employee is that earnings are predictable and steady. This breeds a sense of
security by assuring employee a fixed packet. The employee also does not need to argue with
wage fixer about his/her remuneration. However, the disadvantage of time rate system is that
it does not provide any motivation of a direct incentive relating the reward to the effort.
The amount of wages payable to a workman under this method is to be calculated as follows:
Total wages = actual time taken x time rate
Or, total wages = total hours worked x wages rate per hour.
This method is suitable to be applied in the following circumstances:
• Where the quality of work is more important than production.
• Where the volume of production is not within the control of labour.
• Where it is difficult to fix the unit of output.
• When it is volume of production is not within the control of labour.
• The nature of work is such that there is no basis for incentive plan.

3
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

• Where the amount of output cannot be accurately measured, counted and standardized.
Advantages of time rate system
This method is widely used even at the present time on account of the following advantages
(i) Simplicity
It is very easy to understand and simple to calculate the earnings of worker under this
method.
(ii) Guarantee of minimum wages
It guarantees a minimum wages to the workers.
(iii) Quality production
Since this amount of wages is not linked with the quantity of output, this method ensures
production of better quality due to the careful attention of the workers.
(iv) Unity among workers
Under this method, all workers falling under a particular category are paid at equal rate
without any consideration of their quantity of output. It encourages a feeling of equality
among workers on account of which this method is also favored by trade unions.
(v) Economical
It involves less clerical work and detailed records are not necessary. Since the output is not
the criteria for determination of wages, tool and materials are handled carefully. Wastage are
also minimized.
Disadvantages of time rate system
This method has the following disadvantages
(i) No incentive to the efficient workers
This system lacks incentive to efficient workers since all works are paid equally and no
distinction is made between efficient and inefficient workers. So efforts and rewards are not
correlated.
(ii) Go-slow policy
The workers, in order to earn higher wages for overtime work, may try to perform the worker
slowly which leads to increase in labor cost per unit.
(iii) Dissatisfaction among the efficient workers
The efficient workers are paid wages at the rate equal to these payable ton inefficient
workers, which creates dissatisfaction among the efficient workers.
(iv) Payment for idle time
Under this method, idle time of the workers is also paid that increase the cost of production.
(v) High cost of supervision
Since there is no direct link between quantity of output and wages, wastage of time on the
part of the workers is common, the avoidance of which requires considerable supervision
leading to increase costs.

(2) Piece wage payment (Payment by results) (PBR)

The payment under this system is made in proportion to the work done, no regard being given
to time taken in performing the work. Under this method, the wage/pay of an employee is
paid on the basis of the number of items an employee’s produces in the organisation, rather
than considering the job done by the employee at a given time.
This amount of wages payable to a workman under this method is to be calculated as follows:
Total wages = total output x wages rate per unit of output
=output units x unit rate

4
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

=actual yield x unit or piece rate

This system is suitable in the following cases
• Where a work is of a repetitive natures.
• Where the measurement of work is simple.
• Where the quality and accuracy of output is not very important.
• Where strict supervision is not possible.
Advantages of piece rate system
The main advantages of piece rate systems are as follows
(a) Simplicity
Just like time rate system, the piece rate system is also simple to operate and easy to
understand. It does not involve tedious calculations.
(b) Incentive to workers
This system provides an increase to the workers to work hard as the wages are paid on the
basis of quantity of output not on the basis of time. So efforts and rewards are correlated.
(c) Ascertainment of accurate labour cost
Since the wages are paid on the basis of output, the exact cost of labour per unit of output or
job can be considerable.
(d) No payment for idle time
Under piece rate system, any payment is made to the workers for the idle time as a result of
which the cost of supervision is not considerable.
(e) Proper care and use of machine and tools
The workers rake proper care of their machine and tools since breakdown of machine and
tools means decrease in output resulting in less remuneration to them.
Disadvantages of piece rate system
This system has the following disadvantages
(a) Less attention to quality
As the payment of wages is made on the basis of output, the workers, in order to maximize
their output, work with sense of hurry, which may affect the quality of the output adversely.
(b) Inefficient use of machine and materials
Since the wages are paid on the basis of quantity of output, an excursive wastage of materials
and frequent breakdown of machinery may be caused by the workers due to their efforts to
obtain maximum output.
(c) No guarantee of minimum wages
Since there is direct relationship between quality of output and wages, the workers suffer if
they fail to work efficiently. There is no guarantee of minimum daily wages o workers.
(d) Dissatisfaction among inefficient workers
The inefficient workers, who work slowly, become dissatisfied by reason of lower wages as
compared to the wages paid to their efficient counterparts.

(e) Adverse effect on worker's health

The worker may try to abnormally to earn more which has an adverse effect on their health
and efficiency. So, this method is not accepted by trade union.
Piece rate system can be of the following two types (systems):
(i) Straight piece-work system
(ii) Differential piece-work system
(i) Straight piece-work system

5
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Under this method, wage payment is made to employees at a uniform rate per unit of
production. In other words, in this system, employee is paid a flat price (in money) for each
unit or piece completed, or paid for time allowed to compete the particular task. This method
of wage payment is more appropriate where production is of repetitive character and easily be
divided into similar units of production.
(ii) Differential piece-work system (Taylor’s differential piece rate system)
Differential piece rate system was introduced by Taylor, the father of scientific management.
The underlying principle of this system is to penalise a slow worker by paying him a low
piece rate for low production and to reward an efficient worker by giving him a higher piece
rate for a higher production. Taylor was of the view that an inefficient worker should have no
place in the organisation and he should be compelled to leave the organisation by paying him
a low piece rate for low production.
Taylor proceeded on the assumption that through time and motion study it is possible to fix a
standard time for doing a particular task. To encourage the workers to complete the work
within the standard time, Taylor advocated two piece rates, so that if a worker performs the
work within or less than the standard time, he is pad a higher piece rate,
and if he does not complete the work within the standard time, he is given a lower piece rate.
Thus, if the standard production has been fixed at 8 units per day of 8 hours (taking normal
piece rate as Re 1), the higher piece rate for 8 units or beyond may be Rs 1.20 per unit and
the lower rate for an output of less than 8 units per day, may be 80 P. per unit. Hence, Taylor
decided to give a large reward to those who would complete the work within or less than the
standard time and much less wages to those who would not complete the job within the
standard time. The system is very harsh to the inefficient workers because they earn much
less wages on account of lower output and lower rate.
Moreover, minimum wages are not guaranteed under this method. Another drawback of the
system is that if a worker just fails to complete the work within the standard time earns much
less wages than a worker who just completes the job within the standard time. Therefore, the
system is now almost out of use.
Incentive Plans
Meaning
An incentive scheme is a plan to motivate individual or group performance. An incentive
scheme basically involves monetary rewards, i.e., incentive pay but also includes non-
monetary rewards. Incentives are variable rewards granted according to level of achievement
of specific results. There are three important types of incentive plans.
(I) Individual Incentives
Individual incentives are offered to reward the effort and performance of individuals.
(II) Group Incentive plans
Group incentive plans reward team members with incentive bonus when agreed targets
are achieved.
(III) Organisation-wide incentives
Organisation-reward people for the performance of the entire organisation.
In many organisations, managers are paid incentives based on individual performance and
corporate results. The incentives are higher for senior manager and lower for executives.
(I) Individual Incentive Plans
Individual incentive plans are widely used for pay for performance plans in the organisations.
The employee has to produce more, earn monetary benefits and kept it to himself.

6
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Types of individual incentive plans are given below:

(1) Taylor’s Differential Piece Rate System
F.W. Taylor, the father of Scientific Management, came out with the system.
The objectives are:
(a) To provide incentives to workers to produce more
(b) To remove the fear of wage cut
In the system, there are two work rates, one is lower and the other is higher. Those who reach
the standard output are given a higher piece rate. The lower rate is applicable to those
workers whose output is below standard. The standard is determined by time and motion
study.
Example: Standard output 50 units per day. The piece rates will be Rs.1.50 and Rs.1.40 per
unit. Those who produce 50 units or more will be paid @ Rs.1.50 per unit, while those
producing less than 50 units will be paid Rs.1.40 per unit. The worker who
produces 50 units will get Rs.75 per day and another worker who produces only 40 units per
day will get Rs.56.00 per day.
Comments
(i) The system penalise the slow worker and rewards an efficient worker.
(ii) It also provides an opportunity to the slow worker to increase production and earn higher
income.
(iii) It is easy to understand the system.
(iv) There are number of minimum wage payment to employees.
(v) It treats employees as machines and not as human beings.
(vi) Trade unions do not approve of such payment system.
(2) Merrick’s Multiple Piece Rate System
The system is also based on the principle of low piece rate for slow worker and higher piece
rate for higher production, but it offers three grade piece rates instead of two. As per the
scheme, up to 83% of standard output, workers are paid at the ordinary piece rate, 83% to
100% at 110% of ordinary piece rate and above 100% at 120% of the ordinary piece rate.
(3) Halsey Plan (Standard Hour Plan)
The plan developed by F.S. Halsey recognises individual productivity and pays incentive on
the basis of the time saved. Standard time is fixed for each job. Time rate is guaranteed and
the worker receives guaranteed wages irrespective of whether he completes the job in the
time allowed. If the job is completed in less than the standard time, the workers are paid
incentive of 33 1/3% of time saved in addition to his normal time wages.
The system guarantees minimum wages and provides incentives to efficient workmen. The
worker may overlook quality of production to save more time and earn higher incentive.
Further, fixation of standard is not easy.
(4) Rowan Plan
The plan is similar to Halsey plan and only difference is in the method of determination of
incentive. The time saved is expressed as a percentage of the time allowed and hourly rate of
pay is increased by that percentage so that the total earnings of the worker are the total
number of hours multiplied by the increased hourly wages.
(5) Gantt Task and Bonus Plan
The plan combines time, piece and bonus systems. Fixed time rates are guaranteed. Standard
time for task is fixed and both time wages as well as high rate per piece are determined. A
worker who cannot finish the work within the standard time is paid on time basis. If the

7
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

worker reaches the standard he will be paid time wage plan bonus as fixed percentage of
normal wage rate. If the worker exceeds the standards, he is paid a higher piece rate.
The systems guarantee time wages to ordinary workers. It makes distinction between efficient
and inefficient workers. Labour cost per unit comes down with increase in production.
(6) Bordeaux Plan
Under the plan, every job is expressed in terms of standard minutes known as Bordeaux units.
Up to 100% performance, i.e., up to standard units, a worker is paid time wages without
incentive. If actual performance exceeds the standard performance in terms of standard
minutes, then 75% of the wages of the time saved is paid to the worker as
bonus and 25% is earned by foreman.
(7) Haynes’ Manit Plan
The plan is similar to Bordeaux plan with the difference, i.e., the bonus is only 50% and out
of the remaining 50%, 10% is paid to supervisors and 40% retained by employer.
(8) Emerson’s Efficiency Plan
When the efficiency of the worker reaches 67%, he gets bonus at the given rate. The rate of
bonus increases gradually from 67% to 100% efficiency. Above 100% efficiency, the bonus
is 20% of the guaranteed wage.

Bonus
A bonus is an incentive payment that is given to an employee beyond one’s normal standard
wage. It is generally given at the end of the year and does not become part of base pay. It is
extra payment to workers, over and above normal wage.
In India, the law relating to profit sharing is known as Payment of Bonus Act and sharing of
profit is not linked to performance but to the level of profit made by the company. The Bonus
Act defines an employee who is covered by it as one earning basic salary of 2500/- (effective
April 1993) plus dearness allowance.
The minimum bonus to be paid has been increased to 8.33 per cent of salary. The Act applies
to every factory or establishment in which 20 or more are employed in an accounting year.
Even if there is a loss, a minimum bonus needs to be paid, treating the same as deficit to be
carried forward and set off against profits in subsequent years.
Merit Pay
Merit pay is a reward based on how well an employee has done the assigned job. The
payment is based on individual employee’s performance. Rewarding the best performer
with merit pay is a powerful motivation. Merit pay motivates the employees to work hard and
achieve the assigned tasks. Merit pay may be in the form of lump sum amount or as a
percentage base pay.
Some of the problems in designing a merit pay scheme are:
(i) It is difficult to measure performance objectively.
(ii) Employees, very often, fail to understand the connections between merit pay and
performance.
(iii) Bias in assessing performance.
(iv) The superior may not be a competent evaluator.
Compensation Plan for Salespeople
Compensation plan for salespeople consist of a straight salary plan, a straight commission
plan or a combination of salary and commission plan.

8
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

(1) Straight Salary Plan

It provides stable income and provides freedom from financial uncertainties. But there is no
additional incentive for good performance.
Example- Straight salary plan can be used in jobs where non-selling activities are more in the
total times spent by the salesperson like sales and service engineers. Also in the case of
salespersons, who do more of sales promotion activities in the field.
(2) Straight Commission Plan
Here, payment is made as per sales productivity. The person receives no compensation if
sales are not made. A high performing salesperson can earn very high commission based on
business generated. Example- Selling insurance and financial products.
The disadvantages of the system are:
(i) The person may be careless in sending reports on market situation, competition and
performance of products.
(ii) The person may consider individual accounts as private property.
(iii) May shade prices to make sales.
(iv) Use high pressure tactics to sell.
(v) May push easy-to-sell products.
(vi) May not focus on new products or difficult to sell products.
(3) Salary plus Commission Plan
The plan provides security of stable income and additional income through commission for
achieving sales targets. The plan is very useful for maintaining the morale of sales people.
Therefore salary plus commission plan is being increasingly used by most of the companies
in our country.
Sales Incentives
The objectives of sales incentive are:
(i) Motivation of salesperson to achieve sales targets.
(ii) Increase selling effort (meeting more number of prospects/customer/extended working
hours, selling full range of products, conducting sales campaigns etc.).
(iii) Increase in sales, market share and profits.
Types of Sales Incentives
(i) Financial Incentive
The salesperson is eligible for cash incentive for achievement of sales target/exceeding the
sales target. The sales target may be for a quarter or for the whole year.
(ii) Non-Financial Incentives
While financial reward is a powerful motivation, money is not the sole motivator. Therefore,
companies have come out with non-financial incentive such as recognition of outstanding
performance, annual conferences in hill stations/foreign countries, membership in Achievers’
Club, members of the task force, personal letters of commendations, etc. to motivate sales
people.
(iii) Combination of Financial and Non-Financial Incentives
Many companies dealing with pharma products, consumer goods and durables are
increasingly using a combination of financial and non-financial incentive system to motivate
sales people and achieve increase in sales, market share and profits.
(II) Group or Team-Based Incentive Plan
The plan rewards all team members equally based an overall performance of the team
members. Performance is evaluated using an objective standard. Payments to team members

9
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

may be made in the form of cash bonus or non-cash rewards such as luxury goods or pleasure
trips. Team based incentives can motivate the members to work as a team rather than brilliant
individuals. It is relatively easy to measure team performance.

A few of the important team-based incentive plans are given below:

(i) Production bonus
Under the plan, standard is fixed in terms of units or points. If the actual output exceeds the
standard, the workers will receive bonus in proportion to the increase.
(ii) If the actual cost of production is lower than the standard cost, a bonus whose money
value is a percentage of the cost reduction is paid. Here, the workers should be able to
influence such cost reduction by working hard, saving in materials, fuels, lubricants, etc.
(iii) The Scanlon Plan developed by Joseph Scanlon is designed to involve the workers in
making suggestions for reducing the cost of operations and sharing the gains of increased
productivity. The plan has two components, i.e., financial incentive aimed at cutting cost and
increasing efficiency and suggestion scheme. The suggestion received from employees is
screened and evaluated by a committee. If the suggestion is implemented and successful, the
employees usually share 75% of the savings and the balance is set aside for the months in
which labour costs exceed standard cost.
(iv) Reduction in labour cost
The main objective is to bring about cost reduction by supervisors and workers. Bonus is paid
upon reduction in labour cost alone.
(III) Organisation-Wide Incentive Plan
The employees are rewarded on the basis of the success of the organisation over a specified
time period. Those plans develop a sense of belongingness, co-operation, understanding and
teamwork among employees. There are three types of incentive plans, i.e., profit sharing,
gain sharing and employee stock ownership scheme.

(i) Profit Sharing

Profit sharing involves the determination of organisation’s profit at the end of the financial
year and the distribution of a percentage of the profits to employees, qualified to share the
earnings. To enable the workers to participate in profit sharing, they are required to work a
certain number of years and develop some seniority. Profit sharing is an additional payment
over and above regular salary payment. Professional management consider workers as
partners in the production process and profit is an outcome of the efforts of employees and
therefore it could be shared between employer and employees.
According to ILO, “Profit sharing is a method of industrial remuneration under which an
employer undertakes to pay to his employees, a share in the net profit of the enterprise in
addition to their regular wages”.
According to Henry Seager, “Profit sharing is an arrangement freely entered into by which
the employee receives a share fixed in advance of the profits”.
Features of Profit Sharing
(i) The proportion of the profits to be distributed is determined in advance.
(ii) The amount to be distributed depends upon the profits earned by the enterprise and is
computed on the basis of agreed formula.
(iii) The employee should have some qualifications such as length of service to become

10
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

eligible for the financial benefit.

(iv) Profit sharing is reward for collective efforts of employees and is over and above wages.
(v) That are paid regularly.
(vi) The extra payment is generally paid in cash. However, it can be in kind such as equity
shares,
(vii) Profit sharing may be on industry basis, locality, unit, department or individual basis
also.
Objectives of Profit Sharing
(i) To develop employer-employee relations and employee morale.
(ii) To improve efficiency of operations by reducing costs and increasing output.
(iii) To eliminate waste in the use of materials and equipments.
(iv) To supplement the regular income of the workers.
(v) To provide group incentive for higher output.
(vi) To provide for employee security in the case of death, retirement or physical disability.
Limitations of Profit Sharing
(i) The payment is made only when the profit exceeds a particular limit and therefore the
scheme does not guarantee payment to workers.
(ii) During period of depression, it may not be possible for its management to make payment
to worker.
(iii) It gives equal benefit to all workers and there is no distinction between good and bad
performance.
(iv) Trade unions and workers feel that bonus payment is better compared to profit sharing.
(ii) Gain Sharing
Gain Sharing aims at increasing productivity or decreasing labour cost and sharing the gains
with employees. When productivity exceeds the baseline, an agreed savings is shared with
employees. Gain sharing plan increases co-operation and understanding among workers and
teams and they work for achievement of common goals. Example- Scanlon plan aims at cost
cutting and increasing efficiency of operations and sharing the gains with employees. It also
includes suggestion scheme for cost-cutting.

(iii) Employee Stock Plans

Employee Stock Plan is one of the important pay for performance devices to attract and
retain promising employees. It commands employee loyalty. Stock options are tremendous
motivators because they directly link performance to the marketplace. The principle of stock
option is to let employee add value to the company and benefit from it.
It is a form of compensation which enables the employees to purchase shares of their
company and gain from possible rises. Under the scheme, employees who are eligible for
receiving the award are they offered specified number of shares. They gain when the share
prices go up. Stock options create wealth for employees without involving large cash flow to
the company.
Types of Employee Stock Plans
(i) Employee stock option scheme
The Company grants an option to its employees to acquire shares at a future date. The options
are offered at a predetermined price.
(ii) Employee stock purchase plan is followed in listed companies
The employees are given the right to acquire share of the company immediately after they

11
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

earn them based on length of service/performance, normally at a price lower than market
price. Shares issued will be subject to lock-in period during which the employee cannot sell
them.
(iii) Restricted stock plan
The employee need not put in money. However, shares are subjected to some restrictions.
The employee has to continue to work in the company for a specific period, otherwise shares
may be forfeited.
(iv) Phantom Stock Pan
Phantom stock plan is a special type of stock option scheme that protects the holder against
any depreciation in the value of stocks.
Advantages of Stock Plan
(i) Employee remains loyal and committed to the company.
(ii) Develops long-term relations between employer and employee. The employees feel that
they are owners of the company and not just paid servants.
(iii) Develops teamwork among employees.
(iv) Reduces employee turnover.
(v) The companies are able to attract and retain employees.
(vi) The scheme links compensation to performance.
Limitations
(i) The scheme can be implemented only by profit-making companies.
(ii) Falling share prices lead to losses.
(iii) Employees are forced to continue employment with the company for availing the
scheme.
Advantages and Limitations of Incentive Plans
Advantages
(i) A well-designed incentive plan generally leads to increased output, lowers the cost of
production and brings a higher income to employees.
(ii) Labour and total costs per unit of output can be estimated more accurately in advance
goods.
(iii) To attract and retain employees and reduce turnover.
(iv) Less direct supervision is needed to keep output at a reasonable level.
(v) Provides additional income, over and above wages, to employees.
(vi) Promotes industrial harmony and stabilisation of workforce.

Limitations
Many incentive plans aimed at increasing the motivation of employees often fail to have the
desired impact due to the following reasons:
(i) Very often, management keeps unfair standards and they are a great hindrance in the way
of motivating employees.
(ii) There is fear in the mind of employees that the management will keep on increasing the
targets or rates will be reduced if they earn too much.
(iii) Difficult to understand incentive plan. If the employees cannot understand how
performance will lead to rewards, they may not put efforts to achieve targets.
(iv) The incentive plan differentiates between good and poor performances. It is harsh on
labour average worker.
(v) Workers are affected if the production or sale is affected due to certain reasons beyond

12
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

their control.
(vi) Trade union may oppose such plan.
Requirements of an Effective Incentive Plan
(i) The incentive plan should reward employee in direct proportion to their performance and
increased productivity.
(ii) The monetary earnings must have the potential to satisfy the existing needs of the
employees.
(iii) The policies and procedures for granting incentives should be clear to the
employees.
(iv) The standard should be fair, specific and complete and the focus should be on quantity as
well as quality of output.
(v) The plant employees should be guaranteed base rate.
(vi) The reward must be given promptly without delay.
(vii) The incentive plan must be within the financial capacity of the firm.
(viii) The plan must motivate workers and encourage teamwork.
(ix) The incentive plan must be beneficial to the organisation by increasing output and
profits.
(x) The incentive plan should be in line with government regulations.
Overheads
Basic Concepts
Overhead costs are also termed as indirect or supplementary costs. These are costs which
cannot be wholly debited to a particular job. They may arise either inside or outside the
factory, e.g., foreman salary is an overhead charge occurring within the factory while office
manager’s salary is an overhead charge occurring outside the factory.
In business, overhead or overhead expense refers to an ongoing expense of operating a
business; it is also known as an "operating expense". Overheads are the expenditure which
cannot be conveniently traced to or identified with any particular cost unit. Therefore,
overheads cannot be immediately associated with the products or services being offered, thus
do not directly generate profits. However, overheads are still vital to business operations as
they provide critical support for the business to carry out profit
making activities. For example, overhead costs such as the rent for a factory allows workers
to manufacture products which can then be sold for a profit. Such expenses are incurred for
output generally and not for particular work order e.g., wages paid to watch and ward staff,
heating and lighting expenses of factory etc. Overheads are also very important cost element
along with direct materials and direct labour.
Some Important Costs
# Fixed Cost
It is a cost that does not change in total for a given time period despite wide fluctuations in
the output or volume of activity. These costs are also known as standby costs, capacity costs,
or period costs. E.g., rent, property taxes, supervising salaries, depreciation of office
facilities, advertising, and insurance.
Classification of Fixed Cost
There are various classifications under fixed cost.
(i) Committed Cost
Such costs are primarily incurred to maintain the company’s facilities and physical existence
and over which management has little or no discretion. E.g., depreciation on Plant &

13
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

Machinery, taxes, insurance, rent etc.

(ii) Managed Cost
Such costs relate to the current operations which must continue to be paid to ensure the
continued operating existence of the company. E.g., staff and management salaries.
(iii) Discretionary Cost
Such costs are also known as programmed cost. They are incurred due to special policy
decision, management programme, new research, or new system development.

(iv) Step Cost

Such costs are constant for a given amount of output and then increase by a fixed amount at a
higher output level. E.g., one supervisor is required for a salary of Rs.10000 per month for
every 50 workers. The cost of supervisor salary increases to Rs.20000 per month on
employing the 51st worker.
# Variable cost
Variable cost varies directly and proportionately with the output. There is a constant ratio
between the change in the cost and the change in the level of output. E.g., direct material,
direct labour, and variable overheads (factory supplies, indirect materials, sales commission,
office supplies). If the factory is shut down, variable costs are eliminated.
Mixed cost is made up of fixed and variable element. This cost is a combination of semi-
variable cost and semi-fixed costs. It fluctuates with volume due to the variable component.
However, due to the fixed component it does not change in direct proportion to output.
Semi-fixed cost is the cost which remains constant up to a certain level of output after which
it becomes variable.
Semi-variable cost is the cost which is basically variable but whose slope may change
abruptly when a certain output level is reached.
Classification of overheads
Overheads may be classified according to their nature, variability, function and a number of
other characteristics. The classification can be summarised as follows:

Classification of overheads based on element (nature)

Based on the components or elements, overheads can be classified as indirect materials,
indirect labor and other indirect expenses. This classification is also known as classification
of overheads according to their nature or sources.
(i) Indirect material
(ii) Indirect labour
(iii) Indirect expenses
(i) Indirect materials
All materials other than direct ones are indirect materials. Indirect materials do not form the
part of the finished products. They cannot be identified with or traceable to a particular cost
unit or cost centers. They cannot be allocated but can be apportioned to a number of cost
units or centers. The cost of lubricants, cotton waste, grease and materials used by service
department are some of the examples of indirect materials.
(ii) Indirect Labour (Wages)
The labour who is not directly involved in production process is called indirect labour and
wages paid to such labour are called indirect wages. Indirect labour, however, assists in the
production process. The costs of such indirect labour can not be identified and allocated to a

14
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

particular cost center but can be apportioned to a number of cost centers. The wages paid to
watch-men, sweepers, workers of service department, supervisors, and works clerical staffs
are the examples of indirect labour or indirect wages.
(iii) Other Indirect Expenses
The indirect expenses other than indirect materials and indirect labour are called
indirect expenses. These expenses also cannot be directly traced to any product unit or cost
center.
Therefore, they are apportioned to a number of cost centers. Some examples of such expenses
are rent, insurance, telephone charges, lighting, office salaries and depreciation.
Classification of overheads based on normality
On the basis of normality overheads are classified into normal overheads and abnormal
overheads.
(i) Normal Overheads
(ii) Abnormal Overheads
(i) Normal Overheads
Normal overheads are incurred in achieving the target output or fixed plan.
(ii) Abnormal Overheads
On the other hand, abnormal overhead costs are not expected to be incurred at a given level
of output in the conditions in which the level of output is normally produced. For example,
abnormal idle time, abnormal wastage etc. Such expenses are transferred to Profit and Loss
Account.
Classification of Overheads based on controllability
It is one of important classifications of overhead on the basis of control. Based on control it is
grouped into controllable overhead and uncontrollable overhead.
(i) Controllable Overheads
(ii) Uncontrollable Overheads
(i) Controllable Overheads
(i) Controllable overhead
Controllable Overheads are the ones which can be controlled by the action of a specified
number of undertaking. For example, idle time, wastage etc. can be controlled.
(ii) Uncontrollable overheads
Uncontrollable overheads cannot be controlled by the action of the executive heading the
responsibility centre. For example, rent and rates of building cannot be controlled.
Classification of overheads based on variability
One of the important classifications is on the basis of variability. According to this, the
expenses can be grouped into
(i) Fixed Overhead
(ii) Variable Overhead
(iii) Semi-Variable Overhead
(i) Fixed Overhead
Fixed cost or overhead incurred remain constant due to change in the volume output or
change in the volume of sales. For example, rent and rates of buildings, depreciation of plant,
salaries of supervisors etc.
(ii) Variable Overhead
Variable overhead may be defined as “they tend to increase or decrease in total amount with
changes in the volume of output or volume of sales.” Accordingly the change is in direct

15
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

proportion to output. Indirect materials, indirect labour, repair and maintenance, power, fuel,
lubricants etc. are examples of variable overhead costs.
(iii) Semi-Variable Overheads
Semi-variable overheads are incurred with a change in the volume of output or turnover.
They neither remain fixed nor do they tend to vary directly with the output. These costs
remain fixed up to a certain volume of output but they will vary at other part of activity.
Semi-variable overheads are mixed cost, i.e. partly fixed and partly variable. For example,
power, repairs and maintenance, depreciation of plant and machinery telephone etc.
Classification of overheads based on function
The classification overheads on the basis of the various function of the business concern are
known as function wise overheads. Here, there are four important functional overheads such
as
(i) Production/Manufacturing/Works/Factory Overhead
(ii) Administration Overhead
(iii) Selling and distribution Overhead
(i) Production/Manufacturing/Works/Factory Overhead
Production overhead is also termed as manufacturing overhead or works overhead or factory
overhead. It is the aggregate of all indirect expenses which are incurred for work in operation
or factory. These costs are normally incurred during the period when the productions process
is carried on. For example, factory rent, factory light, power, factory employee salary, oil,
lubrication of plant & machinery, etc.
(ii) Office and Administrative Overhead
Administrative expenses are incurred in general for management to discharge its functions of
planning organizing, controlling, co-ordination and directing. These expenses are not
specifically incurred and cannot be identified with the specific job. It is also termed as office
cost. For example, office rent, rates, printing, stationery, postage, telegram, legal expenses
etc. are the office and administrative costs.
(iii) Selling and Distribution Overheads
(a) Selling Overheads
Selling expenses are overheads which are incurred for promoting sales, securing orders,
creating demand and retaining customers. For example, salesmen’s salaries, advertisement,
rent and rates of show room, samples, commission etc.
(b) Distribution Overheads
Distribution overheads are incurred for distribution of products or output from producers to
the ultimate consumers. For example, warehouse staff salaries, expenses of delivery van,
storage expenses, packing etc.
Stages of overheads – Distribution
There are three stages involved in the distribution of overheads:
(1) Collection and Classification of Overheads
After the overheads have been classified as factory, office and selling, it will be advisable to
group items covered by each category under suitable account headings. For example,
depreciation may relate to factory buildings, factory plant, factory furniture, etc. It will be
appropriate to group all items of depreciation relating to factory assets at one place under a
common heading ‘Depreciation’ with suitable sub-heading. This grouping of like items with
the like is necessary to collect overhead items in a convenient and expeditious manner. The
guiding principle selecting such headings must be that the headings are clear and

16
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

unambiguous so that these may not be confused with each other. Usually, a code number is
allotted to each heading of expense.
It may be defined as allotment of codes to individual heads of expense is termed as
codification of overheads. It may be defined as a technique of short description of a particular
head, which is otherwise lengthy. It also ensures secrecy and ease in classification,
accounting and control.
Codes are particularly useful under computerized system of accounting. Codification may be
done according to any one of the following methods.
(i) Numerical method
According to this method numbers are allotted to each heading and subheading of expense.
(ii) Alphabetical or mnemonic method
According to this method, the alphabets are used for identifying the expenses of cost centres.
(iii) Alphabetical cum numerical method
According to this method the alphabet denotes the main expenditure while the numerical
denotes its sub-division.
Code numbers given to different items of overheads are listed in a schedule or manual for
ready reference. No standard list of these code numbers can be suggested since the number
and types under which the overheads may be grouped depend upon the size of the factory, the
nature of industry and the degree of control required.
Standing order and cost account numbers
The code number given to a factory overhead item is termed as standing order number
and that to an administration or selling and distribution item as a cost account number.
A card is maintained for every standing order or cost account number, the performa of such a
card is given below:

Item ……..
Basis of Appointment ………. Code No …..
Reference Total Departments
1 2 3 4

Entries in the card are made periodically from purchases journal, stores requisitions, petty
cash books, wages analysis book etc. for example, consumable stores is an item of factory
overhead. If the stores have been purchased and supplied directly to the factory, the
information will be there in the Purchase Journal. In case stores were first received by the
storekeeper and then issued, the information can be obtained from the stores requisitions. The
details regarding the source of information are entered in reference column.
(2) Departmentalization of overheads
After collecting and categorizing overheads within suitable account headings the next step
included overhead distribution is the departmentalization of these overheads to different cost
centers on an appropriate basis. This includes two stages
(a) Allocation of overheads
The process of charging the full amount of overhead costs to a specific cost centre is known
as Allocation. This is feasible while the nature of expenses is such that it can be simply

17
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

identified with a particular cost centre. For instance, the salary paid to a foreman of a specific
production department can be directly recognized with that department and so it will be
directly charged to that department.
(b) Apportionment of overheads
It is the technique of dividing up an item of overhead cost and charging it to the cost centres
on an equitable basis. This is completed in case of those overhead items that cannot be fully
allocated to a particular department. For instance, the salary paid to the works manager of the
factory cannot be charged fully to a particular production department but must be charged to
all departments of the factory on an equitable basis.
Though, in common parlance no such type of distinction is observed.
The basis of apportionment and the explanation of apportionment are referred to in the card
maintained for each Standing Order/ Cost Account Number. For instance, rent of the factory
will be apportioned over several departments of the factory as per to the area occupied
through each department. The amount of rent that each department has to bear will be
referred to in the standing order number card allotted to rent. Similar is true for other items.
(3) Absorption of overheads
The term absorption refers to charging of overheads of a cost centre to different cost units in
such a way that each cost unit bears an appropriate portion of its share of overheads. This is
done by means of overhead rates. The term ‘Overhead Rate’ refers to the rate at which the
overheads are to be charged to different cost units. It may be in the form of a percentage or a
rate per unit.
For instance, if the overheads of a department are Rs 10,000, the total wages for paid for
different jobs completed in the department are Rs 40,000 and the overheads are to be charged
a percentage of wages to different jobs, the overhead rate will be 25% of wages. The share of
overheads of each job completed in the department will now be calculated on this basis.
Blanket and Departmental Overhead Rates
When a single overhead rate is computed for the factory as a whole it is known as single or
blanket or plant wide rate (over the plant rate). It is calculated as under:
Blanket Rate = Overhead cost for the entire factory/Total quantum of the base selected.
Different overhead rates are used for absorption of different categories of overheads.
However, following factors should be taken into account for determining the rate of
overheads absorption:
(a) Adequacy
(b) Convenience
(c) Time factor
(d) Skill factor
(e) Rational productivity factor
(f) No frequent changes in overhead rates
Important Tables
The following table will help in remembering the conventional, basis of apportionment of
overheads:

Overhead Basis of apportionment

1. Factory Rent 1. According to the floor area occupied or
Depreciation of factory building capital value of the asset.
(if owned) Insurance of building.

18
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

2. Heating and lighting. 2. Number of light points or floor area

occupied, hours used, or watts if separate
meters are available.
3. Depreciation and Insurance of 3. Value of machinery.
machinery.
4. Electric power. 4. Horse power of machines or machine
hours.
5. Supervision. 5. Number of workmen or amount of wages
paid or floor area.
6. Stores overhead. 6. Value of direct materials.
7. Material handling charges 7. Weight of materials of each department
subject to any special factor affecting
handling costs.

Following can be taken as reasonable basis for apportionment of overheads of services

departments over different production departments.

Service Department Costs Basis of Apportionment

1. Maintenance department 1. Actual services utilised (if records are
maintained) or hours worked for each
department.
2. Pay roll or time-keeping department 2. Direct labour hours, machine hours,
Number of employees.
3. Personnel department 3. Rate of labour turnover, number of
employees.
4. Store-keeping department 4. Number of requisitions, quantity or value
of materials purchased.
5. Purchase department 5. Number of purchase orders, value of
material purchased.
6. Welfare department 6. Number of employees.
7. Internal transport service, overhead crane 7. Weight or value of the products, or weights
service. and distance covered.

Under Absorption and Over absorption of overheads

If the overheads absorbed are higher than the actual overheads incurred, it is called over
absorption. If the overhead absorbed is lower than the actual overheads incurred during the
accounting period, it is called under absorption.
The overheads are absorbed on the basis of predetermined overhead absorption rate according
to the actual production of goods throughout the accounting period or specific period.
Budgeted overheads and budgeted output are used to determine overhead rate. If
budgeted overhead and budgeted output differ from actual overhead and actual output, three
is a difference between predetermined overhead rate and actual overhead rate.
Reasons for Over or Under absorption of overhead
The reasons for over or under absorption of overheads are as follows.
(i) The actual hours worked is more or less than the budgeted hours.

19
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

(ii) The actual overhead costs are different from budgeted overheads.
(iii) Both actual overhead costs and actual activity level are different from the budgeted costs
and level.
(iv) The method of overhead absorption may be wrong.
(v) Unexpected expenses may be incurred during the accounting period.
(vi) Extra ordinary expenses might have been included in the calculation of overhead
absorption rate.
(vii) Major changes like replacement of manual labour with machines. This leads to increase
in capacity levels.
(viii) Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Over or Under absorbed overhead
The over or under absorbed overheads are treated in the cost accounts in any one of the
following ways.
(i) Application of Supplementary Rates
The supplementary rate is calculated by dividing the under or over absorbed amount by the
actual base. In case of over absorption, the over recovered amount will be adjusted by
applying the supplementary rate and vice versa.
(ii) Adjustment to Cost of Sales
The over absorbed or under absorbed overheads is closed and transfers the same to the cost of
sale account. This is done by the Cost Accountant at the end of every month or at the end of
accounting period. If the transfer is made at the end of the accounting period, the over/under-
absorbed overhead is carried forward from month to month treating it as deferred income if
over applied and as deferred charges, if under applied.
(iii) Write off to Costing Profit and Loss Account
If the over or under absorbed overhead is small, and then it will be written off by transferring
it to the costing profit and loss account. If so, the valuation of closing stock is over stated or
under stated.
(iv)Adjusted to Gross Profit
The under or over absorbed overhead balances are closed by making the adjustment in gross
profit.
(v) Carry Forward to Subsequent Year
The under or over absorbed overhead may be carried forward to the subsequent accounting
year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account.
This Overhead Suspense Account or Overhead Reserve Account will appear in the Balance
Sheet.
The debit and credit balances representing under/over absorbed overhead showing in the asset
side or liabilities side of the Balance Sheet. The basic idea is to offset the under absorbed
overhead in one year with over absorbed overhead in another year. But, many accountants
oppose this idea. The reason is that balances of under/over-absorbed overhead should not be
carried forward from one year to another year. This method is
otherwise called as use of reserve account.
Absorption of factory overheads
Absorption of factory overheads refers to charging of the factory overheads of a particular
production department to various products manufactured, or jobs completed, or orders
executed in that department. The method for absorption of these overheads may be put into
two categories:

20
 Chanderprabhu Jain College of Higher Studies
&
School of Law
An ISO 9001:2015 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi, Approved by AICTE &Bar Council of India)

(1) Percentage methods

(2) Hourly rate methods
As far as possible, the method applied should be equitable so that the absorbed overheads are
not in much difference with the actual overheads. Otherwise it will lead to excessive under or
over absorption, simply because of the adoption of a particular method.
(1) Percentage methods
(i) Direct material cost method
In this method the cost of direct materials use in the manufacture of a product is used as a
basis for allocation of factory overheads. The overhead rate is, therefore calculated on the
basis of the following formula:
Factory overhead rate = (Amount of factory overheads/Cost of direct material used) x 100
(ii) Direct labour cost method
The cost of direct labour incurred in the manufacture of the product is used as a base for
allocation of factory overheads in this method. The formula for calculating the factory
overhead rate based on labour can be put as follows:
Factory overhead rate = (Amount of factory overheads/Cost of direct labour) x 100
(iii) Prime cost method
The method considers both direct materials and direct labour for allocation of overheads. The
formula for calculating factory overhead rate, therefore, can be put as follows:
Factory overhead rate = (Amount of factory overheads/Prime cost) x 100
(2) Hourly rate methods
(i) Machine hour rate method
The machine hour rate method of allocation of factory overheads is used in those cases where
the processes of manufacture are carried out by machines and there is very little or practically
no manual labour.
Generally under machine hour rate method, the total number of working hours of a machine
during the whole of its effective life is estimated, and then, the cost of machine is divided by
the expected number of hours of useful life, this gives the rate per hour.
Overhead rate = Amount of factory overheads/Machine hours
(ii) Labour hour rate method
Under this method, overheads are charged to production on the basis of number of labour
hours of work put on every job. The overhead rate is calculated by dividing the total works
overheads for the shop or department for a given period by the total estimated direct labour
for the same period.
Overhead rate = Amount of overheads/Total number of direct labour hours
(iii) Dual hour rate method
Where in a shop both manual labour and machines play an equally important role
overheads are classified into two categories:
(a) Those which relate to manual work, such as proportionate charge for lighting and
foreman’s salary, employee’s insurance premium etc.;
(b) Those which relate to machine as depreciation, power, repairs, operator’s wage etc.
Note - Practical part of labour cost and overheads will be from the book. Few formats of
important topics are also there in the book.

21