Absorption Costing
Definition: Overheads are expenses other than direct expenses. They include indirect materials, indirect labour and other indirect expenses. The prime costs - direct wages cost and the cost of materials consumed can be easily ascertained and charged to a job or process. However, many costs are incurred so that the business can operate eg. rent, rates, depreciation, heat and light etc. The technique for charging overheads to products, jobs or processes is called absorption costing. Absorption costing is concerned with the type and nature of costs rather than cost behaviour.
There are two main purposes of absorption costing:
(1) to ascertain the cost of a product, job or process.
(2) to assist business with their pricing - a cost plus approach.
Cost analysis consists of the following components
| | Direct materials | X |
| + | Direct labour | X |
| + | Direct expense | X |
| | | -------- |
| | Prime cost | X |
| + | Production overheads | X |
| | | ------- |
| | Production cost | X |
| + | Selling & Distribution overheads | X |
| + | Administration overheads | X |
| | | -------- |
| | Total cost | X |
| | | --------- |
It is relatively easy to ascertain the prime cost as they are closely identified with the final product. However it is more difficult to relate the indirect costs - the overheads to the product. Absorption costing is an attempt to achieve this so that overheas can be charged to products.
There are three stages in the absorption costing process- allocation, apportionment and absorption.
Allocation is the process of locating overheads which can be identified with a particular cost centre in that cost centre. Overhead items which cannot be identified with a cost centre but are incurred for the benefit of the entire business must be shared out or apportioned across a number of cost centres. If there are overheads located in non-production or service cost centres they must be re-apportioned to production cost centres. Finally, when all the production overheads are located in production cost centres the final stage of absorbing or recovering the overheads and charging them to a product, job or process.
Example:
The following cost items have been identified in a company with two cost centres Depts. A & B. The floor area of Dept. A is 2,000 sq. ft. and Dept. B is 1,000 sq. ft. The value of machinery used in Dept. A is £1,000 and £4000 in Dept. B.
Salaries of supervisors in Dept. A £40,000
Indirect materials used in Dept. B £35,000
Rent & Rates £30,000
Light & Heat £15,000
Insurance of machinery £5,000
-----------
£125,000
-----------
| Overhead | Basis | Dept. A | Dept. B | Total |
| Salaries | Allocate | £40,000 | | £40,000 |
| Ind. materials | Allocate | | £35,000 | £35,000 |
| Rent & Rates | Floor area | £20,000 | £10,000 | £30,000 |
| Light & Heat | Floor area | £10,000 | £5,000 | £15,000 |
| Insurance | Value of Mach. | £1,000 | £4,000 | £5,000 |
| | | ---------- | ---------- | ----------- |
| | | £71,000 | £54,000 | £125,000 |
| | | ---------- | ---------- | ----------- |
In apportioning costs a suitable basis is used eg. floor area is used to divide the rent of the factory between the two cost centres. The following bases of apportionment is useful in dealing with certain overhead cost items.
| Overhead cost item | Basis |
| Rent & Rates, Light & Heating | Floor area of cost centre |
| Depreciation, insurance of machinery | Original cost or book value |
| Power costs | Horse power of machinery |
| Canteen expenses | Number of employees in cost centre |
| Maintenance costs for premises | Floor area |
Once overheads are allocated and apportioned among a number of cost centre if there are any overheads located in non-production cost centres these have to be removed and re-apportioned to the production departments.
Example:
A company has the following distribution of overheads in two production departments A and B and two service departments, a stores and a maintenance department. Requisitions from the stores by Depts. A and B are £1,000 and £500 respectively. The maintenance personnel spend three-quarters of their time in Dept. A and the remainder in Dept. B.
| Overhead | Dept. A | Dept. B | Stores | Canteen |
| | £ | £ | £ | £ |
| Allocated & Apportioned | 10,000 | 5,000 | 3,000 | 4,000 |
| Reapportion Stores costs | 2,000 | 1000 | --- | |
| Reapportion Maintenance costs | 3,000 | 1,000 | | --- |
| | --------- | -------- | -------- | ------- |
| | 15,000 | 7,000 | 0 | 0 |
| | -------- | ------- | ------- | ------- |
In the absorption stage an overhead recovery (absorption) rate (OAR) is calculated. The formula used is:
Budgeted Production Overheads
OAR = --------------------------------------------
Suitable basis
A number of bases can be used to compute an overhead rate eg. labour cost percentage, material cost percentage, prime cost percentage and cost units.
Generally, businesses use an activity rate to recover overheads. This rate is usually labour hours or if appropriate machine hours. Since many of the overheads arise as a consequence of the employment of labour or the use of mechanisation it appears reasonable to employ one or other of these bases.
Example:
Lets assume Dept. A is a mechanised operation and has 30,000 machine hours whereas Dept. B has only 4,000 machine hours. Labour hours in Dept. A is 5,000 and is 35,000 labour hours. Overheads in Dept. A is £15,000 and £7,000 in Dept.B.
Dept. A £15,000
OAR = ------------ = £0.50 per machine hr.
30,000 machine hrs.
Dept. B £7,000
OAR = ------------- = £0.20 per labour hr.
35,000 labour hrs.
Example: The company makes two products X and Y. The following information is available:
Product X Product Y
£ £
Direct materials 10 12
Direct labour 12 14
(Wage rate £2 per hr.)
Machine hours in
Dept. A 4 6
Required: Calculate the production cost of the two products.
Product X Product Y
£ £
Prime cost 22.00 26.00
+ Production overheads
Dept. A (4 hrs. x 0.50) 2.00 (6 hrs. x 0.50) 3.00
Dept. B (6 hrs. x 0.20) 1.20 (7 hrs. x 0.20) 1.40
--------- ----------
23.20 30.40
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