ABSORPTION COSTING
In Absorption costing, we gather all the direct and indirect costs to get the ‘Full (Production) Cost’ of a product.
The aim of absorption costing is to establish Full (production) cost /unit. ‘Full Cost’ does not mean total cost. Full cost means all costs that can be attached to production unit. We try to link all the cost to the product.
1. How much it cost to produce something.
2. How much it cost to provide a service.
Full Production Cost is established:
1. for pricing (adding mark up / margin to the full production cost to set price)
2. Product Profitability (if another method is used for pricing, then we want to know profitability from that product)
3. Valuation for statutory reporting (i.e. valuation of closing stock)
Absorption costing is the accounting for overheads. It is concerned with Indirect Cost (overheads). As, the indirect cost cannot not be charged directly to the cost unit therefore we need cost centre for this purpose and we transfer that cost from cost centre to unit cost.
OVERHEAD APPORTIONMENT OF COST CENTRE
Some costs relate to the business as a whole. These costs then have to be shared between the various departments or cost centres. This is done by ‘apportioning the costs’. The apportionment is made on the basis nature of the cost centre. E.g. area, headcount, capital value etc. These are estimated bases for apportionment.
Cost of service cost centre is reapportioned to production cost centre to get the ‘Full Production Cost’ of unit. The charging of cost of service cost centres to production cost centres is known as absorbing of cost.
Steps Involved in Overheads Apportionment
Overheads are apportioned to Cost Centre in following order.
1. Allocation of Cost
2. Apportionment of Cost
3. Reapportionment of Cost
4. Absorbing of Cost
1. ALLOCATION OF COST – Accurately linking / charging of overheads to its relevant department (cost centre).
Cost of directly charged to production department
2. APPORTIONMENT OF COST – Apportionment is based on guess work / estimated basis. Apportionment is made for those costs which are not exactly related to a certain production cost centre. They are basically combine costs of all or some cost centres. Therefore, they are spread over different department on some fair basis.
Combined cost is spread over relevant service department and production department.
Example of Apportionment of Cost
ABC is preparing its departmental budgets and product cost estimates for the year ended 31 December 19X5. The company has three manufacturing departments – Machining, Assembly, and Finishing – together with a production maintenance department.
The following costs and related data have been estimated for the year to 31 December 19X5:
| | Machining | Assembly | Finishing | Maint | Total |
| Costs: | £’000 | £’000 | £’000 | £’000 | £’000 |
| Indirect wages | 10 | 6 | 8 | 30 | 54 |
| Indirect materials | 15 | 4 | 8 | 20 | 47 |
| Power | | | | | 102 |
| Light and heat | | | | | 10 |
| Depreciation | | | | | 7 |
| Rent and rates | | | | | 25 |
| Personnel | | | | | 63 |
| | | | | | |
| Other data: | | | | | |
| Direct labour hours | 12,000 | 8,000 | 16,000 | 6,000 | 42,000 |
| Machine hours | 40,000 | 5,000 | 6,000 | - | 51,000 |
| Employees | 6 | 4 | 8 | 3 | 21 |
| Floor area (m2) | 1,000 | 400 | 300 | 300 | 2,000 |
| Net book value of fixed assets | 20,000 | 8,000 | 3,000 | 4,000 | 35,000 |
The maintenance department is expected to spend 60% of its time working for the machining department with the remainder of its time being shared equally between assembly and finishing.
Required:
Prepare an overhead analysis sheet for ABC Ltd for its year ended 31 December
19X5.
Solution:
| | Basis | Machining | Assembly | Finishing | Maint | Total |
| Costs: | | £’000 | £’000 | £’000 | £’000 | £’000 |
| Indirect wages | | 10 | 6 | 8 | 30 | 54 |
| Indirect materials | | 15 | 4 | 8 | 20 | 47 |
| Power | Machine Hr | 80 | 10 | 12 | - | 102 |
| Light and heat | Floor area | 5 | 2 | 1.5 | 1.5 | 10 |
| Depreciation | N. book value | 4 | 1.6 | 0.6 | 0.8 | 7 |
| Rent and rates | Floor area | 12.5 | 5 | 3.75 | 3.75 | 25 |
| Personnel | Employees | 18 | 12 | 24 | 9 | 63 |
| Total | 144.5 | 40.6 | 57.85 | 65.05 | 308 | |
3. REAPPORTIONMENT OF COST (Secondary Apportionment) – Cost of service cost centre is apportioned onto the production cost centres as well as other service cost. Therefore, the cost of service cost centre must be reapportioned to production cost centre. Reapportionment is made because they have already received some cost in apportionment stage.
Again cost of service department is spread over production department.
There are three methods of reapportionment:
1. Elimination
2. Repeated distribution
3. Algebraic
3.1. Elimination
In this method, we have service departments and production departments. We need to charge the cost of service departments to production departments on given percentage basis.
We will use here elimination method. We will charge the cost of that service department first which is to be apportioned to more departments. By doing so, we eliminate this department from apportionment and then we will move to next and so on.
Example for Elimination
The ABC washing machine Co. produces a standard washing machine in three production departments (Machining, Assembly, and Finishing) and two service departments (Materials handling and Production control).
Costs for last year, when 2,000 machines were produced were as follows:
| | Production departments | Service | |||
| Dept: | Machining | Assembly | Finishing | Materials Handling | Production Control |
| Indirect materials | | | | £4,000 | |
| Indirect wage | | | | £8,000 | £11,200 |
| Other indirect costs | £41,920 | £12,960 | £7,920 | £8,000 | £2,400 |
| % use of Materials handling | 60% | 30% | 10% | | |
| % use of Production Control | 40% | 30% | 20% | 10% | |
| | | | | | |
Required:
Prepare a statement showing the overhead allocated and apportioned to each of the production departments.
Solution:
| | Production departments | Service | | |||
| Dept: | Machining | Assembly | Finishing | Materials Handling | Production Control | Total |
| Indirect materials | | | | £4,000 | | |
| Indirect wage | | | | £8,000 | £11,200 | |
| Other indirect costs | £41,920 | £12,960 | £7,920 | £8,000 | £2,400 | |
| Total | 41,920 | 12960 | 7,920 | 20,000 | £13,600.00 | £96,400.00 |
| % use of Production Control (B) | 5,440 | 4,080 | 2,720 | 1,360 | (13,600) | |
| Total C (A+B) | 47,360 | 17,040 | 10,640 | 21,360 | | |
| % use of Materials handling D | 12,816 | 6,408 | 2,136 | (21,360) | | |
| Total C + D | 60,176 | 23,448 | 12,776 | | | 96,400 |
3.2. Repeated Distribution (Reciprocal Servicing)
We will face problem here when we have more than one service departments and costs of service departments is also charged to each other as well as to the production department.
Example for Repeated distributions
| | Production departments | Service | |||
| Dept | A | B | C | P | Q |
| Costs | £3,000 | £4,000 | £2,000 | £2,500 | £2,700 |
| % of P used | 20% | 30% | 25% | - | 25% |
| % of Q used | 25% | 25% | 30% | 20% | - |
Required:
Reapportion the service centre costs to the production centres using:
(A) Repeated distribution method.
Solution:
| A | B | C | P | Q | |
| 3,000 | 4,000 | 2,000 | 2,500 | 2,700 | |
| P% | 20% | 30% | 25% | 25% | |
| Q% | 25% | 25% | 30% | 20% | |
| A | B | C | P | Q | |
| 3,000.00 | 4,000.00 | 2,000.00 | 2,500.00 | 2,700.00 | |
| P | 500.00 | 750.00 | 625.00 | -2,500.00 | 625.00 |
| Q | 831.25 | 831.25 | 997.50 | 665.00 | -3,325.00 |
| P | 133.00 | 199.50 | 166.25 | -665.00 | 166.25 |
| Q | 41.56 | 41.56 | 49.88 | 33.25 | -166.25 |
| P | 6.65 | 9.98 | 8.31 | -33.25 | 8.31 |
| Q | 2.08 | 2.08 | 2.49 | 1.66 | -8.31 |
| P | 0.33 | 0.50 | 0.42 | -1.66 | 0.42 |
| Q | 0.10 | 0.10 | 0.12 | 0.08 | -0.42 |
| P | 0.02 | 0.02 | 0.02 | -0.08 | 0.02 |
| Q | 0.01 | 0.01 | 0.01 | 0.00 | -0.02 |
| Total | 4,515.00 | 5,835.00 | 3,850.00 | - | - |
3.3. Algebraic Method for Apportionment
In case, we have more than one service departments and costs of service departments is also charged to each other as well as to the production department. We can use Algebraic method for apportionment of cost.
Example for Algebraic Method
| | Production departments | Service | |||
| Dept | A | B | C | P | Q |
| Costs | £3,000 | £4,000 | £2,000 | £2,500 | £2,700 |
| % of P used | 20% | 30% | 25% | - | 25% |
| % of Q used | 25% | 25% | 30% | 20% | - |
Required:
Reapportion the service centre costs to the production centres using:
(A) Algebraic method.
Solution:
P = 2,500 + 20%Q
Q = 2,700 + 25%P
By putting value of Q into P, we get
P = 2,500 + 20% (2,700 + 25%P)
P = 2,500 + (0.20 x 2,700 + 0.20 x 0.25P)
P = 2,500 + (540+0.05P)
P = 3,040 + 0.05P
P – 0.05P = 3,040
0.95P = 3,040
P = 3,040 /0.95
P = 3,200
Putting value of P into Q
Q = 2,700 + 25%P
Q = 2,700 + 25% x 3,200
Q = 2,700 + 800
Q = 3,500
4. Absorbing of Cost – Now cost that is gathered in production department is charged / absorbed into cost unit.
Cost of production department goes to Cost Unit
Absorption Costing represents the whole system of absorbing cost into Cost Unit whereas
Absorbing of Cost is single step in the whole system.
OVERHEAD ABSORPTION RATE (OAR)
OAR is used to link cost from cost centre to the Cost Unit. Because of indirect nature of indirect cost, it is difficult to charge accurately to specific Cost unit. Therefore, we set a standard rate of absorbing cost.
Overhead Absorption Rate (OAR) = Budgeted Overhead Cost
Budgeted level of Activity
Basis for Level of Activity (LoA) for OAR
1. Time Basis (Hours) – majority of the overhead are time based i.e. they are fixed like insurance, rent, depreciation etc
> Labour Hours
> Machine Hours
| Note: If Labour or Machine hours are given in question always use them unless it is told to use otherwise. |
2. Units (Output) – It makes sense when each unit of output use same amount of overhead or if they are identical.
3. Cost Basis – Cost may be used as basis for level of activity.
> Cost (%) of Direct material
> Cost (%) of Direct Labour
> Cost (%) of Total Prime Cost
Example (Blanket / Single Overhead Absorption Rates)
Blanket / Single OAR is a rate generally used for all departments
Tulip Ltd makes a single product, the Bulb. Each Bulb has a prime cost of £20.00, takes 2 labour hours and 3 machine hours. The following budgeted information is available for the factory.
Budgeted Overhead £100,000
Budgeted Output 20,000 units
Budgeted Labour Hours 50,000 hours
Budgeted Machine Hours 100,000 hours
Solution:
What is the absorption rate per unit?
OAR = £100,000 / 20,000 hours = £5
What is the absorption rate per labour hour?
OAR = £100,000 / 50,000 hours = £2
What is the absorption rate per machine hour?
OAR = £100,000 / 100,000 hours = £1
What is the total production cost using the unit based absorption rate?
Prime Cost x OAR = £20 + £5 = £25
What is the total production cost using the labour hour absorption rate?
Prime Cost + (OAR x 2 hours) = £20 + (£2 x 2 hours) = £24
What is the total production cost using the machine hour absorption?
Prime Cost + (OAR x 3 hours) = £20 + (£1 x 3 hours) = £23
Example (Departmental Overhead Absorption Rates)
Departmental OAR is separate rate for each department
It may be more accurate to calculate separate absorption rates for different departments. Would it be fair or meaningful to use labour hours, for instance, to charge out overheads in a machine intensive department?
A company has the following information available:
Cutting Finishing
Budgeted
Overheads £100,000 £50,000
Machine Hours 50,000 3,000
Labour Hours 20,000 12,500
Actual
Overheads £132,000 £38,000
Machine Hours 40,000 4,200
Labour Hours 28,000 12,000
The following information is also available about one of the company's products:
Cutting hrs Finishing hrs
Machine Hours 6 1
Labour Hours 2 4
Solution:
What is an appropriate absorption rate for the Cutting Department?
OAR for Cutting = £100,000 / 50,000 Machine hours = £2/Machine hours
What is an appropriate absorption rate for the Finishing Department?
OAR for Cutting = £50,000 / 12,500 Labour hours = £4/Labour hours
What is the total overhead cost per unit of product?
6 Machine hours x £2 per machine hour + 4 Labour hour x £4 per labour hours = £28/unit
There are more machine hours in cutting department, therefore, it is machine intensive.
There are more labour hours in finishing department, therefore, it is labour intensive.
UNDER / OVER ABSORPTION OF OVERHEAD
We use OAR to value our goods because if we want to value our goods in advance. Afterwards when actual overheads are known, we adjust them to correct Cost of Sale in Financial statements.
Continued from previous example ……..
Cutting Finishing
£ £
Overhead Absorbed
(OAR x Actual Activity)
£2 x 40,000 80,000
£4 x 12,000 48,000
Overhead Incurred 132,000 38,000
(Under)/Over absorbed 52,000 10,000
PRICING – (COST PLUS PRICING)
Cost Basis (for Setting Price of a product)
1. Full Production Cost
2. Full Cost (include expenses)
Expenses = Administrative and / or selling expenses
In full cost, expenses are absorbed in the cost of the product.
3. Marginal Cost
Methods for determining Pricing
1. Mark-up
2. Margin
| | | Mark-up | | Margin |
| | | Based on Cost | | Based on Price |
| Full Cost | 100% | £20 | 80% | £20 |
| %age | 20% | £4 | 20% | £5 |
| Price | 120% | £24 | 100% | £25 |
