Cost Accounting: Wage Payment Systems and Overhead Absorption
1. Wage Payment Methods Discussion
An effective wage payment system is essential for improving labour productivity, controlling labour cost, and maintaining harmonious employer-employee relations. Wage payment refers to the method used for calculating compensation paid to workers in exchange for their labour services. The overall goal is to establish a system that is fair, motivational, economical, and efficient.
Wage payment methods are broadly classified into Time-Based Systems, Output-Based Systems, and Incentive/Bonus Systems.
I. Time-Based Wage Systems
In this system, workers are paid according to the time spent at work, irrespective of output.
1. Time Rate System
Workers are paid a fixed rate per hour, day, or month.
Formula:
Wages = Time worked × Rate per hour
Advantages
- Easy to implement and simple to compute.
- Ensures quality output because workers are not rushed.
- Reduces worker fatigue and health risks.
- Suitable for highly skilled work, repair work, and supervisory jobs.
Disadvantages
- No incentive to increase productivity.
- May lead to time wastage.
- Labour cost per unit may increase.
2. Time Rate with Guaranteed Minimum
A minimum wage is assured, protecting workers against low earnings due to machine delays or lack of work.
Useful in industries with fluctuating workload.
II. Output-Based (Piece Rate) Wage Systems
Here, wages depend on the number of units produced, creating a direct incentive for higher productivity.
1. Straight Piece Rate
Wages = Units produced × Rate per unit
Payment is directly linked to worker efficiency.
Advantages
- Encourages higher output.
- Labour cost per unit remains constant.
- Simplifies cost control.
Disadvantages
- May compromise quality.
- Excessive fatigue and safety concerns.
- Requires close supervision to prevent defective production.
2. Differential Piece Rate System
Designed to reward efficient workers and penalize inefficient ones.
(a) Taylor Differential System
- Workers below standard output receive a lower piece rate.
- Workers achieving above standard receive a higher piece rate.
This creates a strong performance incentive.
(b) Merrick Differential System
Three piece rates based on efficiency:
- 83 percent efficiency
- 100 percent efficiency
- Above 100 percent efficiency
Provides progressive motivation without discouraging low performers.
III. Incentive Wage Systems (Premium Bonus Plans)
These systems incorporate both time and output to offer fair and motivating compensation.
1. Halsey Premium Plan
Worker gets time wages plus bonus on time saved.
Bonus = 50 percent of (Time saved × Time rate)
Merits
- Encourages workers to save time.
- Rewards productivity but also protects employer’s interest.
2. Rowan Plan
Bonus = Time saved × (Time saved / Standard time) × Rate
This proportional method prevents excessive bonuses and safeguards quality.
3. Gantt Task and Bonus System
- Guaranteed minimum wages.
- If standard is achieved: 20 percent bonus.
- If standard is exceeded: higher bonus.
This system combines stability with strong incentives.
Conclusion
No single wage system suits all industries. The optimal method depends on the nature of work, measurability of output, worker skill, quality requirements, and organizational goals. A well-designed wage system enhances labour morale, reduces labour turnover, and contributes directly to cost efficiency and productivity.
Idle Time: Meaning, Causes, and Cost Effect
(Nov 2023 Q4b)
Meaning
Idle time refers to the period during which workers are paid but cannot perform productive work due to factors beyond their control. It represents the gap between paid time and actual working time.
Formula:
Idle Time = Normal paid time – Actual work time
Causes of Idle Time
A. Productive (Normal) Causes
These are unavoidable and inherent to production:
- Machine setup and adjustment
- Waiting for materials
- Regular tea/lunch breaks
- Maintenance and lubrication
- Normal machine downtime
Normal idle time is included in production overhead.
B. Unproductive (Abnormal) Causes
Arise due to inefficiencies:
- Power failure
- Machine breakdowns
- Poor supervision
- Shortage of materials
- Labour strike or lockout
- Poor planning or scheduling
Abnormal idle time is charged to the Costing Profit and Loss Account.
Effects on Production Cost
- Increase in Cost per Unit
Idle time increases labour cost without increasing output. - Higher Overhead Allocation
Unproductive time raises overhead absorption rates. - Reduced Productivity
Efficiency ratios fall, causing adverse variance. - Distorted Cost Data
Abnormal idle time must be isolated to avoid inflated cost figures. - Impact on Pricing
Higher costs may force upward revision of product pricing.
3. Normal Wastage, Abnormal Wastage, and Abnormal Effectiveness
Material losses are inevitable in the production cycle, but their proper classification ensures accurate cost allocation and effective control. Material losses are mostly grouped into normal wastage, abnormal wastage, and abnormal effectiveness (gain).
I. Normal Wastage
Normal wastage refers to the unavoidable, expected, and inherent loss that occurs even under efficient operating conditions.
Examples:
- Evaporation of liquids
- Breakage of fragile items
- Trimming of cloth or metal sheets
- Chemical reactions causing weight loss
Characteristics:
- Cannot be eliminated
- Considered a part of standard cost
- Predictable and measurable
Treatment:
- The cost of normal wastage is absorbed by the good units.
- This increases the per-unit cost because the same total cost is spread over fewer units.
II. Abnormal Wastage
Abnormal wastage is the excess loss over normal wastage. It arises due to inefficiencies or unexpected conditions.
Causes:
- Poor quality of raw materials
- Careless handling
- Machine malfunction
- Human negligence
- Poor supervision
- Accidents, fire, theft
Treatment:
- Abnormal loss is debited to the Costing Profit & Loss Account.
- It is excluded from product cost to prevent misleading costing.
III. Abnormal Effectiveness (Abnormal Gain)
Abnormal gain occurs when actual loss is less than normal loss, resulting in extra good units.
Reasons:
- Use of superior quality raw materials
- Higher worker efficiency
- Improved process controls
- Better machinery
- Favorable operational environment
Treatment:
- The value of abnormal gain is credited to the Costing Profit & Loss Account.
- It represents an improvement in production efficiency.
Effect on Production Cost
1. Normal Wastage
- Increases cost per unit.
- Considered part of efficient operations.
- Included in process or production cost.
2. Abnormal Wastage
- Should not enter product cost.
- Charged directly to costing P&L.
- Signals inefficiency requiring managerial attention.
3. Abnormal Effectiveness
- Reduces cost of production.
- Indicates operational improvement.
- Excess output is treated as a gain.
Conclusion
Proper identification and classification of wastage ensures that product costing reflects true efficiency. Normal wastage is unavoidable, abnormal wastage is controllable and must be minimized, and abnormal effectiveness reflects superior performance. Effective wastage control improves profitability and strengthens operational discipline.
4. Overhead Expenses and Absorption Methods
Overheads are an essential part of total manufacturing cost. An understanding of their nature and absorption methods is vital for determining accurate product cost.
Definition of Overhead Expenses
Overheads are indirect costs that cannot be traced directly to a specific product, job, or process.
They include:
- Indirect materials (lubricants, cleaning supplies)
- Indirect labour (supervisor salaries, watchmen)
- Indirect expenses (rent, depreciation, insurance, electricity)
Overheads are necessary to run the production system efficiently but require scientific allocation to ensure accurate costing.
Methods of Absorbing Overheads
Overhead absorption refers to charging a fair share of overheads to products using suitable bases. The principal methods include:
1. Direct Labour Hour Rate
Overheads absorbed based on labour hours.
Rate = Factory overhead / Total labour hours
Suitable for: Labour-intensive production.
2. Direct Labour Cost Percentage
Rate = Overheads / Direct labour cost × 100
Useful when labour cost forms a major portion of total cost.
3. Machine Hour Rate Method
Rate = Machine overhead / Machine hours
Best for automated manufacturing.
Advantages:
- Scientific and accurate
- Reflects real consumption of machine resources
- Useful for budgeting and cost control
4. Prime Cost Percentage Method
Rate = Overheads / Prime cost × 100
Prime cost = Direct material + Direct labour
Useful in industries where material and labour both vary across products.
5. Production Unit Method
Rate = Overheads / Units produced
Suitable where all units are identical (cement, bricks, sugar).
6. Material Cost Percentage Method
Rate = Overheads / Material cost × 100
Useful when material cost is the major cost component (e.g., metal industries).
7. Departmental Overhead Rate
Overheads first allocated to departments (cost centers) and then absorbed based on departmental bases such as:
- Labour hours
- Machine hours
- Floor area
- Value of equipment
Provides the highest accuracy.
Conclusion
Overhead absorption plays a vital role in arriving at true product cost. Using a scientific and appropriate method ensures equitable distribution of costs, helps in pricing decisions, budgeting, profitability analysis, and supports effective cost control.