The Overhead Absorption Puzzle at Dhaka Textiles
Dhaka Textiles Ltd produces two fabrics, Cotton and Blend, in a single department. Budgeted monthly data: machine hours 10,000; direct labour hours 4,000; fixed production overhead Tk 3,000,000. Cotton uses 6,000 machine hours and 1,000 labour hours; Blend uses 4,000 machine hours and 3,000 labour hours. Overhead is currently absorbed on direct labour hours. Actual fixed overhead for the month was Tk 3,240,000 and actual machine hours were 10,400. The sales manager complains that Cotton is being 'subsidised' and is losing tenders, while Blend looks profitable. The cost accountant proposes switching to machine hours as the absorption base.
1. Calculate the overhead absorbed by each product under both bases and quantify the distortion. Which base is more defensible and why?
Read the worked answer
Under labour hours (current): OAR = 3,000,000 / 4,000 = Tk 750 per labour hour. Cotton: 1,000 × 750 = Tk 750,000. Blend: 3,000 × 750 = Tk 2,250,000.
Under machine hours (proposed): OAR = 3,000,000 / 10,000 = Tk 300 per machine hour. Cotton: 6,000 × 300 = Tk 1,800,000. Blend: 4,000 × 300 = Tk 1,200,000.
Distortion: Cotton's absorbed overhead swings from Tk 750,000 to Tk 1,800,000 - an under-costing of Tk 1,050,000 under the current base. Blend is over-costed by the same amount. This fully explains the sales manager's complaint: Cotton is heavily machine-intensive but light on labour, so a labour-hour base assigns it almost none of the overhead it actually causes.
Which base? Machine hours. Overhead in a single department dominated by machine-driven production is driven by machine time, not labour time. The causal link between the cost driver and the overhead is the governing principle. The switch is defensible provided (a) machine hours are reliably recorded, and (b) the department is genuinely machine-paced - which the 10,000 vs 4,000 ratio supports.
Judgement point: the answer is not 'machine hours are better' in the abstract - it is that the current base has no causal relationship to the cost, and the evidence (losing tenders on the labour-light product) is the symptom of that.
2. Compute the fixed overhead expenditure and volume variances for the month under the machine-hour base, and state what each tells management.
Read the worked answer
Absorbed overhead (machine-hour base, actual hours): 10,400 × 300 = Tk 3,120,000.
Expenditure variance = Budgeted − Actual = 3,000,000 − 3,240,000 = Tk 240,000 adverse. This is a spending/control signal: RCL spent more than budgeted regardless of activity. Management should investigate what drove the overspend (price rises, idle maintenance, wastage).
Volume variance = Absorbed − Budgeted = 3,120,000 − 3,000,000 = Tk 120,000 favourable. Activity exceeded budget by 400 machine hours (4%), so more overhead was absorbed than budgeted. This is an activity/capacity signal, not a cost-control signal.
Check: total under/over-absorption = Absorbed − Actual = 3,120,000 − 3,240,000 = Tk 120,000 under-absorbed, which equals the net of the two variances (240,000 A + 120,000 F = 120,000 A).
What it tells management: the overspend is a genuine control issue (Tk 240,000 A), partially masked by higher activity. If the month had run at budgeted hours, the full Tk 240,000 would have hit the P&L as under-absorption. The two variances must be read together - a favourable volume variance does not excuse an adverse expenditure variance.