Chapter 8 Absorption Costing

I. Product Costs and Service Costs

Commercial rog either sell products or provide services. They need to know what their

products or service cost. There are several reasons for wanting to know about product costs

and service costs.

- We need to know about costs in order to decide whether the products or services

are profitable

- In some cases, products or services might be priced by adding a profit mark-up on

cost

- In the case of products, closing inventory must be valued at its cost.

 Overhead: a term for indirect costs.

 A key issue with product costing and service costing is deciding what to do about

overhead costs.

 Absorption costing: is a method of costing in which the costs of an item (product or

service or activity) are built up as the sum of direct and a fair share of overhead costs

to obtain a full cost

1. Product costs and Absorption costing

When costs incurred, they can recorded as:

 Direct materials

 Direct labour

 Direct expense or

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  Overhead

Overhead costs are charged to a cost center which might represent:

 Production overheads

 Administration overheads

 Selling and distribution overheads

General overheads. However, general overheads are shared out between production,

administration, selling and distribution overheads.

Fully absorbed product costs can therefore be built up as follows:

Direct materials X

Direct labour X

Direct expense X

Total Direct cost X

production overhead X

Full production cost X

Administration overhead X

Selling and distribution overheads X

Full cost of sales X

Notes:

1. In the statement of financial position, closing inventory is valued at its full production

cost. This is consistent with the requirements for financial accounting. In any financial

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 statements that are produced for external users (such as suggest shareholders or the tax

authorities), absorption costing must be used. In management accounts, which can only

be used internally by the business managers, the business can choose any method of

stock valuation it wishes.

2. Absorption costing problems are concerned with building up the full production cost

and therefore concentrate on production overheads. Non-production overheads may be

charged as a period cost against profits or may be added to the full production cost

using a given percentage.

2. Service Costs and Absorption costing

Fully-absorbed service cost can be built up in the same way. A service business

must first of all decide what a unit of service should be. For example:

- For a telecommunications business, a unit of service might be a cost Patel phone

call per minute or the cost of communication link.

- For a private hospital, the cost might be a cost per patient day.

- For a electricity supply business, a unit cost might be a cost per unit of elasticity

supplied.

Service Cost might be established as follows:

Direct materials X

Direct labour X

Direct expense X

Total direct costs X

Operating overhead X

Full operating cost X

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 Administration overhead X

Selling and distribution overhead X

Full cost of sale X

3. Fixed and Variable Overhead

Overhead costs might be fixed or variable costs. In absorption costing, production

overheads, administration overheads and selling and distribution overheads might therefore be

separated into their fixed and variable cost components.

In absorption costing for products, the full production cost of a product might therefore

consist of direct materials, direct labour, direct expenses, variable production overhead and

fixed production overhead.

 Fixed overhead remain the same whatever the level of output or activity during the

period. It does not vary with the changes in output levels or activity, but remain

constant.

 Variable overhead are amounts of the indirect cost that vary with the level of output

or activity. As the level of output or activity rises then so does any variable overhead

cost.

4. Reason for Absorption costing:

The main reasons for wanting to calculate full costs are mainly to value inventories

of manufactured goods, and possibly also to calculate a selling price based on full costs.

- Inventory valuation

- Pricing at a mark-up over full cost

II. Treatment of Overheads in Absorption costing

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 In absorption costing, products, services or activities are charged with a fair share of

indirect costs. There is a three-stage process involved in charging overhead costs to products

or services:

- Overhead allocation

- Overhead apportionment

- Overhead absorption (overhead recovery)

In order to appreciate overhead allocation and overhead apportionment, it’s first of all

necessary to know something about the type of cost centers found in manufacturing org.

1. Cost centers and absorption costing:

A business can decide what its cost centers should be. Generally speaking, cost

center within a manufacturing org are likely to consist of:

- Production department: in which items of product are manufactured.

- Service department: not involved directly in the manufacture of product but they

provide service and support to production dpt. Examples: store dpt, a maintenance

and repairs dpt, a canteen dpt etc.

- Administration departments/costs

- Selling and distribution departments/costs

- General cost items: e.g. rental cots for a factory building, lighting and heating

costs, building security and maintenance costs etc.

In the description of absorption costing that follows, administration overheads

and selling and distribution are ignored, and the focus attention is on full production

costs. Cost centers will therefore be categorized as production departments, services

department and general costs

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 2. Overhead Allocation:

Overhead allocation is the first of the three stages in establishing a full cost for

product and service. Overhead allocation is the process of charging a whole item of cost to

a cost center.

3. Apportionment of overhead costs

Once overhead costs have been allocated to cost centers, general overheads must

be shared out, or apportioned. This may be to production or service cost centers. Overhead

apportionment is the process of sharing out overhead costs on fair basis. Apportionment

should be on a fair basis but there are no rules about what ‘fair’ means. An org should

establish, for each item of general cost, what this basis ought to be. For many costs, there

are two or more different bases that could be used.

4. Overhead Analysis Sheet

A record of the overheads allocated and apportioned can be set out on an overhead

analysis sheet.

i. Overhead Analysis sheet: Overhead apportionment:

The purpose of the analysis sheet is to show how the overhead costs are built

up for each production and services cost centre.

III. Service cost center re-apportionment

The aim of allocating and apportioning production overheads is to establish the total

overhead costs for each production cost center. In order to achieve this, the overhead costs that

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have been allocated and apportioned to service cost centers within production have to be re-

apportioned to the production cost centers.

There two main methods of service cost center re-apportionment:

- Direct method: used when service cost centers do no provide service for one

another.

- Step-down methods: used when at least one of the service cost centers provides

a service to another service cost center as well as to the production cost centers.

When service cost center overheads are re-apportioned, the end result is the same. All

overhead costs are charged to production dpt. However, the amount of overheads charged to

each production dpt will be different. In other words the direct method and step-down method

will share out the overhead costs in a different way.

1. Direct Method

2. Step-down method: (start by re-apportioning the overhead costs of the service cost

center that does work for other service cost center.)

IV. The Arbitrary Nature of overhead apportionments

At the end of the process of allocation and apportionment of production overheads, all

overhead costs have been charged to production cost centers. The process of apportionment

attempts to be fair but the selection of the bases for apportionment is based on judgement and

assumptions.

- General cost items can often be apportioned on any of two or more different bases

and depending on the basis chosen, the amount of cost charged to each cost center

will differ.

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 - Similarly, the basis for apportioning service department costs to production

departments can differ, depending on the assumptions made of point of view

taken.

- The decision about whether to allow for the work done by service departments for

other service departments is also significant. The assumption chosen will affect

amount of overheads charged from the service department s to each production

department.

Methods of apportioning overheads should be kept under review, to make sure that they

remain valid and sensible. If a basis of apportionment no longer appears valid, a change in the

apportionment basis should be proposed to management, giving the reasons for the proposed

change.

V. Overhead Absorption

Allocation and apportionment are the first two stages in process of charging overhead

costs to products services. The third stage in the absorption costing process is overhead

absorption. The third stage in the absorption costing process is overhead absorption, also called

overhead recovery.

Overhead absorption is the process of adding overhead costs to the cost of a product

or service. In order to build up a fully absorbed product cost or service cost.

As a result of overhead absorption, in theory at least, the total amount of overheads incurred

should absorbed into the costs of the products manufactured (or services provided) by the

business.

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 1. Basic of Absorption:

Production overhead costs are absorbed into product costs on a basis selected by organization.

The absorption basis should be appropriate for the particular products or services. The most

common bases of absorption are:

- An absorption rate per unit but only if the org produces a single product or several

standard products

- An absorption rate per direct labour hour worked

- An absorption rate per machine hour worked

- An absorption rate based on a percentage of direct labour costs

- An absorption rate based on a percentage of prime cost (a percentage of direct

materials, direct labour, and direct expense costs).

The only bases for absorption required for your syllabus are direct labour hours and

machine hours.

2. Absorption rates

𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠
𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠, 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠)

Absorption rate is the rate at which overheads are added to costs.

An org might have just one absorption rate for its entire production operations.

However, an org with more than one production department is likely to have a different

absorption rate for each department, so that separately calculated production overheads are

added to product costs for the work done in each department. The basis of an absorption

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 can differ between production departments and the absorption rate can differ between

departments.

3. Absorptions rate based on the budget

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠

It’s logical that overhead absorption rates should be based on the actual

overhead costs in a period and the actual volume of activity (direct labour hours or

machine hours worked or unit produced). In practice; however, overhead absorption

rates are based on budgeted overhead costs and the budgeted volume of activity.

There are several important reasons for using budgeted figures:

1. If we used actual costs, we’d have to wait until after the end of the period to

calculate the product costs.

2. As full product cost is often used as a basis to set prices, it needs to be known

in advance.

3. Overheads, by their nature, are often incurred unevenly.

4. The average cost calculated should recover all overhead costs and provides a

stable basis to establish prices.

By using absorption rates based on budgeted overhead spending and budgeted activity

volume, we can establish absorption rates in advance, and charge overhead costs to products

as soon as they are made (and to services as soon as they are performed.)

4. Overhead Absorption

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 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑏𝑠𝑜𝑟𝑏𝑒𝑑 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙 × 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑏𝑠𝑜𝑝𝑟𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

(overhead absorption or amount of overhead absorbed )

VI. Under- and Over- Absorption of Overheads

Overhead absorption rates are based on budgeted overhead costs and the budgeted

volume of activity; they are pre-determined. In practice, for each accounting period, it’s often

the case that:

- Actual overhead expenditure will differ from budgeted overhead expenditure, and

- The actual volume of activity will differ from the budgeted volume of activity.

Hence, the amount of overheads charged to product costs will differ from the actual

overhead expenditure.

 We might charge more overhead costs to production than the amount of overhead

expenditure actually incurred. If so, there is over-absorbed or over-recovered

overheads.

=> Over-absorbed overhead during a period is treated as an addition to profit

cuz it’s an adjustment to allow for the fact that too much overhead cost has been

charged to the items produced the period.

 We might charge less in overhead costs to production than the amount of overhead

expenditure actually incurred. If so, there is under-absorbed or under-recovered

overheads.

 Under-absorbed overhead during a period is treated as an reduction to profit

cuz it’s an adjustment to allow for the fact that the overhead cost charged to

the items produced in the period is less than the actual overhead incurred.

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VII. Causes of Under- or Over- Absorbed overhead:

The intention of absorbing production overhead is to share the costs of the overheads

among the various products manufactured or jobs worked on. Ideally the amount of overhead

absorbed should equal to the amount of overhead expenditure incurred.

There are several reasons why a large amount of under or over absorption of overhead

might occur:

- Actual overhead expenditure was much higher than budgeted, possibly due to poor

control over overhead spending

- Actual overhead expenditure was much less than budgeted, possibly due to good

control over overhead spending

- Actual overhead expenditure was much higher or lower than budgeted due to poor

budgeting of an overhead expenditure.

- The actual volume of activity was higher or lower than budgeted, for operational

reasons that the production manager should be able to explain.

- The actual volume of activity was high/lower than budgeted due to poor budgeting

of volume of activity.

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