Managerial Accounting

Prof. Dr. Varadraj Bapat

Department School of Management
Indian Institute of Technology, Bombay
Lecture - 21 & 21 B
Cost Allocation, Absorption
Dear students in our last session, we have discussed the steps of Cost Allocation. We will
today do some practical problems. So, that you can actually see how the steps are used?
But, I will just take a brief recap. See you have the total costs at one end and you
ultimately want to calculate the cost of the product. Now, this cannot be directly done,
because in a particular company or in a particular production setup, you may have
hundred type of products.
So, it is impossible to link the total cost to the cost to the products. And we also want
detailed analysis of the cost, cost center wise or department wise. So, what is done is, the
total cost is first linked to two cost centers. And through cost centers, it is charged to
products. Now, the question which may come is what is a cost center, which we have
discussed last time. But, I will just repeat it again.
That cost center could be a location or it could be an equipment or it could be a person or
group of combination of these for which, the cost is accumulated. So, at one end you
have the cost. You link them to cost centers. And through cost centers, you charge them
to products. Now, what is a product? Product is any cost unit. Though, I am using the
term product, it could also be a service. But, what you are ultimately delivering to
customer is a product. In that sense, I am using the term.
So, you want to essentially cost the particular product or a service. So, the total cost first
are linked to cost center. Now, what are the steps for this linking? For this linking, the
first step is cost allocation. So, what can be charged directly? It charged directly, that is
called allocation. So, all exclusive costs are linked to cost centers. Remaining cost or
indirect costs are known as over rates. And so the step number one is allocation.
Step number two is apportionment. So, the common pool of cost or the over heads are
apportioned on some logical basis to cost centers. That is called as apportionment. The
third step is known as absorption. So, now from cost, they are allocated to cost centers,

allocated or apportioned to cost centers. From cost centers, you want to take them to
product. Now, how it is done? Let us say that, in a particular cost center 10,000 identical
units of x are made.
And the total cost of the cost center is 10 lakhs. How much will be the cost per product?
10 lakhs is a cost of a cost center. Let us say C 1, cost center 1. And you are making
10,000 units of x. How much will be the product, cost of x? Very simple, because you
can divide 10 lakhs by 10,000. This is nothing but, absorption. I think, now it will be
clear to you. So, your total cost you divide it by some base. The base in this case was
number of unit.
So, you could get the cost per unit of product x. Now, take another scenario. The cost of
cost center 2, C 2 is also 10 lakhs. But, it is not serving only one cost center or one
product. It makes product x, y and z. Now, what will you do? Now, you cannot divide
the total units of x plus y plus z, because they are not identical. So, you have to take
some other base. Now, what could be some other base? Number of units, you cannot take
now.
So, what could be the other base? The other base could be number of machine hours. So,
in cost center C 2, if 5000 hours of work is done, what will be the cost per machine hour?
10 lakhs is a total cost. 5000 hours of work is done. What will be the cost per machine
hour? You are going to divide 10 lakhs by 5000. So, you know that, cost per hour is 200.
Now, you will find out how much hours are consumed by x, y and z and accordingly
charge the cost. Are you getting?
What we are discussing now is known as absorption. So, the base for absorption could be
one, number of units. Second, number of machine hours. Can you think of any other
base? Sometimes, neither units are known. Neither, it is very easy to know the number of
machine hours. So, the base could be percentage of direct cost. Say in a service industry
like software, there is nothing like machining hours. There is nothing like units.
They may use the development cost, which is a direct cost. And other cost maybe
charged as a percentage of development cost. So, point is different basis are used. So, at
one side, you have got the total accumulator at a cost center. And then that is being
charged to products using some logical basis. That step is known as absorption. Now, let

us look at some practical problem. So, that whatever we are discussing could be more
clear to you.
(Refer Slide Time: 06:11)

Now, let us look at this case number one. This is a very simple one, where you have to
actually go into next steps. So, first step is to identify direct and indirect. What this step
is known as? Can you name this step? This step is known as cost allocation. This is the
first important step. Now, material costs are 27,000. So, how what will be? Will it be
direct or indirect? Mostly, direct nothing more is given. But, usually all material costs are
treated as direct costs.
So, let us put D here. Factory rent cannot be for one product. It is common in nature. So,
we will consider it as indirect. Wages, again we do not know. But, generally wages are
direct in nature. Depreciation, usually it is indirect, because it is not for one product. It is
for the facilities which are common in nature. So, it is indirect. Salaries generally
indirect, because they are for maintenance, for supervising, admin and so on.
Direct expenses as the name suggests, it is direct Insurance, usually indirect. So, is it
clear? This is step number one, where costs are identified as direct or indirect.

(Refer Slide Time: 07:44)

Now, let us go to the second sum. Here, some data is given about the machine. You
know, generally machine is treated as a cost center in production type of setups. So,
machine is treated as a cost center. You have been asked to calculate machine hour rate,
which is an absorption rate for charging the machining cost to the products. So, different
data is given about the machine. You can have a look, cost of the machine, expected life,
scrap value, repairs cost, lighting cost. Everything is given about the machine.
And it is also given that, the machine occupies one fourth of the area of the factory. And
it has 2 light points of the total 10 points. And foreman typically devotes one sixth of his
time for the machine. Now, we have been asked to calculate machine hour rate. That is a
cost per hour of machine consumption. Now, how to calculate? From where will you
start?
First, we will have to accumulate the total cost of the machine for a particular period. Let
us say 1 year. And we will divide by number of machine hours to get the machine hour
rate. So, we will try to calculate the cost of machine operation. Will you include the cost
of the machine in that? No, because it is a long term cost. Expected life of the machine is
10 years. So, I will ignore that. Scrap value, scrap value is also one time information.
But, using this three data, that is the cost of the machine, expected life and scrap value, I
can calculate depreciation of the machine per year. That will be considered as a
machining cost. How much will be the depreciation can you calculate orally? 2 lakh is a

cost of the machine. Life is 10 years. Scrap value is 10,000. So, 2 lakhs minus 10,000
1,90,000 divided by 10. So, 190 is the total cost for 10 years. We divide by 10. So, each
year it is 19,000.
Next is repairs. Throughout the life, can you consider it? I cannot consider the whole
amount. But, I can divide it by 10. So, repairs throughout the life are estimated to be
30,000 divided by 10. So, again you get 3000 per year. Can you tell me, instead of giving
repairs for the year? Why throughout the life repairs are estimated? Because, many times
what happens is, repairs may not be much repairs in the beginning.
But, you will require lot of repairs towards the end. That is towards 7th, 8th, 9th year or
10th year of the machine. Now, it is illogical to charge the repairs, only at that time. It is
more appropriate, if you estimate the total repairs and charge them, throughout the life of
the year, because we want to get a better estimate for the whole life. Not just for that
particular year. That is why the total repairs are given and a proportionate amount will be
charged.
Next is total usage in hours, which is 950. So, how much will be for a particular year,
950 upon 10? So, 95 hours. That will be our base. We will see it later. Next is electricity
consumption. Units per hour are given. So, again you will have to calculate it, to know
the cost per year. Let us look at the solution, because I think we have discussed too many
things.
(Refer Slide Time: 11:38)

So, if we try to solve to it, you can see how depreciation can be calculated? The cost of
the machine minus scrap value upon life, I think we have already done it. It is 19,000.
So, cost of the machine is depreciation. I mean machine cost per annum depreciation. So,
depreciation per year is 19,000. Next which we just discuss is repairs, which is the total
repairs upon life which comes to 30,000. Now, how will you calculate electricity?
Electricity charge per unit is given. Total units per hour is also given, multiplied by total
hours. So, you can see here ((Refer Time: 12:19)). Electricity consumption is 15. Rate is
0.5 and we know that about 95 hours of consumption use takes place per year. So, you
have 95 into 15 plus into 0.5. So, you have got 7125. Next, ((Refer Time: 12:53))
monthly rent of the department is 5000.
How much will be charged to the machine? In the footnote, you can see that machine
occupies one fourth of the area of the department. So, what will be the charge for the
machine of the rent? Total rent per month is 5000, first multiplied by 12. So, 60,000
becomes rent for the whole year. And again, it is divided by 4. Because, one forth area is
used by this machine. So, let us look at rent calculation. So, rent into 12 into percentage
area occupied. I think there is some problem. I will try to recalculate.
So, you know 5000 into 12 upon 4. So, 15,000 is a cost of the rent. Lighting charges are
given to be 8000 ((Refer Time: 13:49)). And it has two light points out of total of 10
light points. So, how much is a cost for the machine? So, you can see these light charges
into light points for the machine upon total light points. That is 2 by 10. So, it is 1600.
Next is monthly salary of the foreman, ((Refer Time: 14:11)) which is 10,000. How
much will be chargeable for the machine? It is given that, the foreman devotes about one
sixth of his time. So, foreman salary into 12 upon 16. So, you get 20,000. Anything else?
Miscellaneous expenses per month is given to be 500. So, miscellaneous expenses 500
into 12. So, you get 6000 ((Refer Time: 14:38)).
Last item, insurance premium is 1 percent. So, how much premium will be charged? So,
it is 1 percent generally of the cost of the machine. You know the cost of the machine is
2 lakhs. So, 1 percent of 2 lakhs means 2000. Is it right? So, I think we will recheck the
calculation of electricity charges. ((Refer Time: 15:07)) Electricity charges are how
much?

Consumption is 15 and rate is 0.5 per unit. So, 15 into 0.5 into the number of hours per
annum, which should be 95. So, you can go back and check ((Refer Time: 15:30)). It is
given that the total usage in hours, in the whole of lifetime is 950. So, per year it is 95.
So, you get 712.5. So, the operating cost of the machine comes to 67312 divided by It
is not 950. We will take it 95, because you are doing the yearly calculation.
So, machine hour rate that is, total cost of the machine operation upon the machine hours
comes to 708.55. Is it clear to you, how it is calculated? Now, where you can use it?
What is the use of this calculation of the machine hour? Now, you may possessing a
number of products using this machine. Suppose product A is processed for 3 hours.
Then, we can charge 3 into 708. Or suppose customer ask for a quotation and the work of
the customer requires 2 hours of time on this machine.
We can immediately add 708 into 2 as the cost of usage of this machine. I am not saying
the total job of the customer. But, for this machine cost is 2. So, like that on any product
or any service, we will add the cost of the required machining. And that will become the
total production cost. Are you getting? So, this is how machine hour calculation helps us
to calculate the cost of any product or any service.
(Refer Slide Time: 17:09)

Now, let us look at slightly more complicated problem. So, here we will try to look at all
the steps, which we have discussed so far. So, here company has three departments. You

can see it as department A B C. And there is also one service department. Certain costs
are given, which are common in nature or over rate cost.
(Refer Slide Time: 17:34)

And certain information about various factors is also available. And technical assessment
says that, service department essentially devotes this much of benefit for other
departments, which is 30 25 and 45. ((Refer Time: 17:52)) Using all these data, we are
required to calculate the per hour cost for these departments. My cost only indirect cost,
because we are not considering, material and labor now. We are focusing on overhead
cost, which are listed here.
Now, how to go about? Can you think of? So, here you have got time keeping and
accounts cost. How to link it, perhaps difficult? Let us take the next. Power, how to link
it? Look at the data below and try to link the factor to the cost. Is it possible to link?
There is a information given about horse power of the machine. So, that is a good proxy
to charge the power cost, assuming that the consumption is more or less similar.
So, you have got the information about horse power capacity of the departments. That
will be used as a base for charging power cost. What about canteen? Generally, the
canteen will be based on the number of workers. So, number of workers could be a base
for canteen cost. Stores, below you can see it is clearly says the value of store
requisitions. So, that is a cost driver. That can be used for store cost. Depreciation capital
cost in lakhs is given.

So, that could be used as a proxy for depreciation. Rents, floor space is given. Indirect
wages are very difficult to lean, because they are indirect in nature. But, the best way is
direct wages. So, I think now it is clear to you, a cost and the cost related factor or a cost
driver.
(Refer Slide Time: 19:44)

Now, let us see how the calculation can be done. So, this is how it is done. So, time
keeping and accounting cost again, generally depend on number of workers. So, you
know the number of workers in each. And you can find out the total which is 40. Just add
the total column for more clarity. So, total hours are 40 and total time keeping cost you
know is 30,000. So, based on the number of hours the allocation has been done, like this.
I think, it is clear to you. Power as we have just now discussed, depending on the horse
power of the machine. The total horse power of the machines comes to 15,000 and the
total cost is 80,000. So, in the ratio of horse powers, it has been divided. Then, canteen
on the number of hours, stores on the value of store requisitions. Depreciation on the
capital cost. Rent is on the floors space. Indirect wages are as a proportion of direct
wages.
So, here all the calculations have been done. Now, at this stage one problem may come is
we want to also charge the store cost to the production cost, because in the first level all
cost got charged to A B C plus service department. But, service department itself is not
producing anything. It is just providing service to A B C. That is why?

(Refer Slide Time: 21:17)

This is the second stage or you can say sub stage of apportionment which is known as
reapportionment. So, in reapportionment each of the costs of service department are
charged to A B C. So, the technical estimation was given to us ((Refer Time: 21:35))
that, approximately it is 30 percent 25 percent and 45 percent of the benefit from service
department to this three departments. So, same ratios are used for charging.
But, service department cost which are common in nature to production department cost,
which is A B C. So, here the costs are charged. Now, we get the total cost for A, which
includes its apportion cost 7500 plus that part of service cost which is charged, which is
1125. So, you get 8625. Is it clear? Same way, you can see power. So, the power cost for
A was 29867 to this ((Refer Time: 22:21)). It is also burden with 1600 from service
department, so 29867 plus 1600.
So, the total cost is 31461 and so on. So, like this the cost of each of the individual costs
are charged to A B C. And at this stage if we take a sum, we will get the total cost which
is charged to A B and C. Is it clear? So, which steps we have done now, up till this level?
We have done apportionment, which was done in the first table. Then, we have done
reapportionment of service department 2, A B C. And now, we are taken total. So, what
is the next step now?
Next step is absorption, because now the costs are collected at A B C. But, we want to
charge them to the products. Now, for absorption again we have to see, what is a base

((Refer Time: 23:29))? So, you can see some information is available about number of
workers and so on. So, what could be the base for absorption of cost to the products? Can
you think of what will be the base? May be here, you can see the data more clearly
((Refer Time: 23:44)).
Are the numbers of machine hours given? No, many times when machine hours are
given, we can calculate machine hour rate as it was there in the last sum. So, here can
you think of any other logical base? This department A BC may not be doing a particular
machining. So, it may be tough to calculate machine hour rate or getting the total
machine hours. So, amongst the given options, what will be the most suitable for
absorption?
Just think of over it. It is very logical. By absorption, what I mean is we are going to
charge to the customers or to the products. So, how will you charge? Can you use
number of workers or floor space? No, because they are for internal consumption. So, the
total cost of the rent of the factory is getting charged to A B C using floor space. But,
that cannot be the base for charging the customer. For charging the customer, either it
could be number of units.
If units are homogeneous or it could be machine hours, it could be what else it could be.
You can see, one of them you can identify. Or it could be direct wages. So, based on
direct wages, you can charge the customers. Sometimes, it could be sale value of the
product. But, right now amongst the available data, we will try to pick up the direct
wages. Now, we will not worry about service department. We are going to charge only to
A B C.

(Refer Slide Time: 25:19)

So, direct wages if it is taken as a base, what will be the cost per department? So, here
what we are trying to find is, percentage of direct labor. This is the absorption rate, we
have calculated. I hope, it is clear to you. Now, how will you use this rate in practical
circumstances? So, suppose customer makes a query and for that work, we require 5
hours of work in department A. How much will you charge the customer?
So, you will calculate the direct labor for that 5 hours plus, you will charge the 0.86 of
the cost of the direct labor as an overhead cost. Most of the service industries like in
software or in consulting, they fix up a proportion of charge of the direct labor. So,
hourly rate is first charged. And then on that hourly rate something extra is charged to
cover up the overhead cost. So, that is the rate we have calculated.
You can see the rate is much higher for department A. It is 0.86, 0.37 in B and 0.48 in C.
It may vary depending on the nature of the cost consumed by each of the departments. Is
it clear to you? So, here we have tried to look at all the stages, starting from
apportionment, reapportionment and absorption. Now, one more step is left. That step is
known as under or over absorption.
Thank you.
So, we have been discussing about, how overhead expenses are accounted for? Now, we
will look at the next step. Before that, a brief recap of the earlier steps. So, in the first

level, it is costs are allocated. That is, you segregate the cost into direct and indirect.
Direct are charged directly. Indirect are charged to some cost center. Next level is
apportionment. So, indirect costs are essentially a common pool.
So, you are required to apportion it on some logical basis. The next one is
reapportionment. So, the costs which are charged to service cost centers are again
allocated to production cost centers. Next one is absorption, which is very important.
And the one which we are talking now, the fifth step is based on this fourth step. So, in
the fourth step absorption, what we have done is
The costs which are accumulated at a cost center level are being charged to products or
cost units, as they are technically known as. For example, if the cost of a cutting cost
center is 1 lakh rupees. And the working there on is 1000 hours. Then, we can say that
the cost is approximately 100 per hour. So, any job which is done in the cutting unit for 1
hour will be charged for 100 rupees and so on.
So, the objective of absorption is the cost, which are accumulated at the cost center level
should get charged to the product or service, which is being delivered to the customer.
Now, one thing we should remember is, this 100 rupee calculation was itself based on
approximation, because it is done using a budgeted cost of 1 lakh and a budgeted activity
of 1000. So, both are estimated. And hundred which is calculated is known as
predetermined absorption rate.
It is called predetermined, because a prior we do not know, what will be the actual cost?
But, we cannot wait till the whole accounting is done and the correct figures, come. That
is why in advance, a rate is calculated that is 100 rupees which is a predetermined rate
and the products are charged at 100 rupees as and when they are produced. Naturally
what happens is, at the end of the period if the actual do not match with the figures which
are estimated, there will be some difference.
For example, we are charging 100 rupees per hour. For assumption, that there will be
1000 hours and the total cost is 1 lakh. Suppose, the hour remains same, that is 1000.
But, the actual cost becomes, instead of 1 lakh 1,05,000. Now, what will happen? At the
rate of 100 rupees for 1000 hours, we will charge 1 lakh. But, the cost is 105000. So,
there will be a difference of 5000, which will be called as under absorption.

I hope you are getting me. So, 105000 is a cost. Actual cost as we will call it. But, the
absorbed overheads are 1 lakh. So, there is a difference of 5000. In this case, it is a under
absorption, because the actual cost is not fully absorbed. Sometimes, other way around
may happen. That more costs get absorbed, actual cost is less. It will be a situation of
over absorption. So, at the end of the period, the fifth step will be to calculate the under
and over absorption and to account for this differences. Now, let us look at it. Exactly,
what is to be done?
(Refer Slide Time: 31:57)

So, here we have defined the over and under absorption. So, through the use of
predetermined overhead rates, they are charged on actual as I have explained you. And
the predetermined rates itself are expected or budgeted costs. So, they cannot match with
the actual.

(Refer Slide Time: 31:18)

Leading to differences, which are known as under and over absorption. Here is a
definition. So, if the overhead absorbed are higher than the actual incurred, it will be
called as over absorption. And exactly opposite, when the overhead absorbed are less
than the actual. It is called as under absorption.
(Refer Slide Time: 32:37)

Let us also look at the example to make it more clear to you.

(Refer Slide Time: 32:43)

So, please have a look at this example 4. So, as you can see here, the budgeted overhead
cost is 3,60,000. Budgeted machine hour rate is 1,80,000 and budgeted direct labor cost
is 3,96,000. It is given that the predetermined absorption rate is based on machine hour.
And then these are the figures for the whole year 2012, based on the annual budget.
Below this, the actual cost for 2 months April and May are given.
So, once the month over, the accounting system will provide us the actual data, which
has come for 2 months, which shows that the actual overhead cost in April is 23,000.
Actual machine hours in that month is 15,000 and the actual labor cost is 28,000. And we
have been asked to compute under and over absorption and also show the calculation, if
this under and over absorption is based on direct labor hour rate.
Basically, to begin with we will start with machine hours. Now, can you think of what
will be the under and over absorption? How will you calculate? Just give a thought, how
it can be calculated? First of all, before calculating under or over absorption you should
calculate how much is absorbed? Because actuals are given for the month of April but,
how much is absorbed is not given. Now, how will you calculate that how much is
absorbed?
Even before that, we need to know the rate of absorption. It is given that predetermined
rate is based on machine hours. So, we have to calculate based on machine hours, what
will be the rate of absorption? So, just think of what will be the rate? I think, it is very

simple, you can even do it without using computer, calculator and so on. Just by
observing, you can calculate how much will be the cost per machine hour, which is the
rate of absorption?
So, can you calculate how much will be the cost? If you look at the budget, the budgeted
overheads are 360 and budgeted machine hours are 180. So, how much is a cost per
machine hour? Let us look at the solution. I hope, you have calculated it orally.
(Refer Slide Time: 35:10)

So, the step number 1 is calculation of machine hour rate as it is known as. So, 360 upon
180, we get 2 rupees per machine hour. This 2 rupee means is known as predetermined
overhead absorption rate. So, it is based on budget. So, we call it predetermined. We do
not know, what will happen in April, May, June, etcetera? But, we have calculated that
the overhead cost is going to be about 2 rupees per hour.

(Refer Slide Time: 35:50)

Now, let us see what happen in the month of April? So, in the month of April, actual
overhead cost is 23. Actual machine hours as you can see are 15. So, if you absorb at 2
rupees per machine hour, you will absorb 30,000. Now, 23 is actual, 30 is absorbed. So,
it leads to over absorption to the tune of 7000. I hope, it is very simple and very clear to
you. Now, check it for the month of May. In the month of May, you will observe that the
actual cost has been shot up.
It has 41. Actual machine hours are also increased. But, they have become 20. So, at 2
rupees rate, the absorption becomes 40, 20 into 2. But, the actual is 41. So, there is a
difference of 1000, which is known as under absorption. So, you are not able to absorb
the full 41. You have absorbed 40. Actual is 41. So, there is a under absorption to the
tune of 1000. Is it clear both? Now, let us do the same thing. But, taking direct labor cost
as the basis ((Refer Time: 37:05)).
So, here we are back to the problem again. Now, think of the calculation if direct labor
cost is to be the basis. Now, how will you calculate? There are three stages. Just tell me,
what will be the three stages? So, stage number 1 is calculate the absorption rate based
on the direct labor cost. That is item number 1. Second one, calculate the amount
absorbed for the month for a particular month. That is month of April and May. And then
compare the actuals with the absorbed amount.

(Refer Slide Time: 37:50)

So, let us look at the calculations. So, what is a rate? Budgeted cost is 360 and budgeted
overhead cost is 360. Budgeted labor cost is 396. So, 360 upon 396 means 91 percent of
direct labor cost is our predetermined overhead rate. Earlier, we calculated 2 per machine
hour. Here, it is calculated as a percentage of direct labor cost. We have discussed in the
last session that, various basis can be used. So, one of the popular basis is machine hour.
The second one is one, which we are using now. That is as a percentage of labor cost.
Sometimes, it is based on direct labor hour. In very few cases but, it can be also based on
percentage of a material cost and so on. So, in this case it is 91 percent of direct labor
cost.

(Refer Slide Time: 38:47)

Now, let us look at the actual for the month of April. So, for the month of April, the
actual cost the actual overhead cost is 23. Actual labor cost is 28. So, if we absorb on the
basis of 28 at 91 percent, 25480 is the absorbed overheads. So, there is an over
absorption to the tune of two four eight 2480. If you look at the month of May, the actual
is 41. The actual labor cost is 35. So, you are able to absorb only 31,850.
So, there is an under absorption to the tune of 9150. So, is it clear to you now? Please
also see the comparison of two methods. Though both the methods, I mean are
alternatives. This or that can be used. You can see, how much big difference is there in
the calculation ((Refer Time: 39:52)). Are you getting? So, here in the month of May, the
under absorption was only 1000. Now, the under absorption is as high as 9150.
And there was a over absorption of 7 but, here there is an over absorption of 2480. So,
the base of absorption becomes very important. And the cost accounting data can change
completely by the base of absorption. That is why, when you do the product costing then
you say that product x cost mean, say 5000. It is very important to know, what methods
or what assumptions have gone into calculating that 5000?
Because, if you have used labor hour rate instead of say machine hour, the cost can be
different. There can be vast differences in the cost. As if there are more and more
products and more complexity, the differences can even be higher. So, management has
to be very, very particular in using an appropriate rate of absorption. Now, what will

happen if you do not use the suitable rate for absorption? Say machine hour is better.
But, you use labor cost.
What will happen? What happens is, in case of multiple products. You may have product
A B C D E F. One product gets charged more; the other product gets charged less. So,
what will happen? Let us say, product A is consistently being over burdened. It is being
charged more. Then, our product will lose its competitiveness in the market, because
product A is costed on higher side, competitors may supply it at a lower price.
So, we lose the advantage in the market. Whereas product B, we are charging less.
Definitely, it will be sold more. But, we are selling it at a loss, which we do not know.
We feel, we are selling it covering the full cost. But, actually we are covering less than
the appropriate cost. That is why management has to be careful in choosing the correct
rate of absorption. Not only that, they should also keep a track on regular basis.
So, in this sum you can see that, the calculation was done for the whole year based on the
annual budget. And now, we are calculating it month wise. So, in the month of April,
May, June, if you in first 2 3 months, you find lot of variation. You can perhaps change
the rate to ensure that, the correct costs are getting absorbed. Is it clear? Let us look at
one more case to make our point even more clear.
(Refer Slide Time: 42:33)

Now, here we have been given data about two companies. Have a look at it. I would not
tell you many things now. So, here you have two companies DEE and BEE. DEE does
not use in direct labor cost. BEE does not use in machine hours. The data is given for
budgeted overhead as well as the appropriate basis. And you have been asked to
calculate the under or over absorption. So, at the end of the whole year, now the data is
available.
So, DEE you can see 3 lakhs was the budgeted overhead cost. Whereas the actual
overhead cost has become 4 lakhs. So, how much will be under or over absorption? Are
you able to calculate? Can we say that, there is a under absorption of 1 lakh, because
actual is 4, budget is 3. Does it mean, there is a under absorption of 1 lakh? No, it is a
wrong calculation, because it is not. We have not yet calculated the amount, which is
absorbed.
So, using the budgeted figures, first of all calculate the absorption rate. Then, using that
absorption rate and the actual that is 5 lakhs, calculate the overhead absorbed. And then
we will get under or over absorption. So, think over now. Try to calculate it to yourself. I
think, this is also simple, you can do it orally. So, how much will be the rate?
(Refer Slide Time: 44:13)

So, 3 lakhs is a budgeted overhead, 4 lakhs is a labor cost. So, it comes to 0.75 or in
other words we can say, it is 75 percent of direct labor cost. It is a rate of absorption for
company DEE. So, how much will be now the amount absorbed?

(Refer Slide Time: 44:35)

So, you can see the actuals are 4 lakhs. Actual labor cost is 5 lakhs. So, 5 lakhs into 75
percent, that means 375 has been absorbed. But, since the actual is 4, the under
absorption is to the tune of 25,000. Is it clear? Now, do for the other company, company
BEE. So, for company BEE how much is over or under absorption? Now, look at the
budgeted rate 5 lakhs, for machine hours 2 lakhs. So, how much will be the absorption
rate?
5 lakhs upon 2 lakhs means 2.5 is the rate predetermined overhead absorption rate, as we
call is 2 per machine hour. So, how much amount will be absorbed in the concern year?
It is 3 lakhs, so 3 into 2.5. Let us look at the solution. So, 5 lakhs upon 2 lakhs, as we
were discussing 2.5 per hour is a rate. So, now for 3 lakhs at 2.5, we are absorbing
7,50,000. 5 lakhs is actual, 750 is absorbed. So, there is over absorption to the tune of
2,50,000 getting. So, I hope the concept of under and over absorption is clear to you
now.

(Refer Slide Time: 46:15)

Now, what are the reasons? The reasons for over absorption could be the actual hours
work can be more or less than estimate. Then, the actual labor cost maybe different. So,
either the numerator or denominator can be different.
(Refer Slide Time: 46:36)

The application method may not be correct. Extraordinary expenses or there could be
seasonal variations.

(Refer Slide Time: 46:41)

Sometimes, some major changes have been made in the either plant layout or the
machines, mechanization and so on which are not accounted in calculating the rates. So,
it is very important that, over and under absorption is calculated regularly. And it is also
suitably adjusted. So, I hope now all the five steps, that is starting with allocation,
apportionment, reapportionment, absorption and over and under absorption are fairly
clear to you.
Thank you so much. We will be continuing in the next session.