Computation of overhead absorption rates should be based on:

Correct option is D

Overhead absorption rates should be computed based on normal capacity because it reflects the average level of activity a business expects over a period, considering regular business operations, normal losses, maintenance, and anticipated interruptions. Normal capacity represents a practical and realistic benchmark, ensuring that overheads are neither over-absorbed (which would understate cost) nor under-absorbed (which would overstate cost).

It serves as a stable base to determine the predetermined overhead absorption rate (POAR) and ensures that costs are allocated consistently across products or services, thus supporting more accurate product costing and profitability analysis.

If absorption is based on maximum capacity, it may lead to under-absorption because actual activity levels seldom reach maximum capacity. Similarly, practical capacity does not consider demand constraints, and idle capacity cannot be a reliable base as it doesn’t contribute to production.

Information Booster:

• Normal Capacity is the expected average activity level over several periods under normal circumstances.

• It includes adjustments for seasonal fluctuations, regular downtime, and maintenance.

• It avoids extreme over- or under-absorption of overheads.

• Recommended by Accounting Standards like AS 2 and Cost Accounting Standards (CAS) for allocating fixed overheads.

• It provides a more stable base than actual or theoretical capacities.

• It is useful in both standard costing and budgeting processes.

• Enhances the accuracy of cost control and variance analysis.

Additional Knowledge:

(a) Maximum Capacity:
Refers to the theoretical maximum output without any stoppages or downtime. It's unrealistic and rarely achieved in practice. If used, it would result in under-absorption of overheads due to lower actual activity levels.

(b) Practical Capacity:
Represents the capacity after deducting unavoidable downtimes (like maintenance), but it still doesn’t consider market demand or sales constraints. Using it may lead to overhead under-recovery when demand is less than practical capacity.

(c) Idle Capacity:
It is the unused portion of production capacity. It's not a base for overhead absorption, but rather a result of inefficiencies or low demand. Overhead should not be spread over idle capacity, as it would distort product cost.