Suppose that a company makes and sells 100 units of a product each week. The
prime cost per unit is $6 and the unit sales price is $10. Production overhead costs
$200 per week and administration, selling and distribution overhead costs $150 per
week. The weekly profit could be calculated as follows:
Sales (100 units x $10)
Prime costs (100 x $6)
Production overheads
Administration, selling and distribution costs
Profit
$1,000
$600
$200
$150
$950
$50
In absorption costing, overhead costs will be added to each unit of product
manufactured and sold.
Prime Cost per unit
Production overhead ($200 per week for 100 units)
Full Factory Cost
$ Per Unit
6
2
8
The weekly profit would be calculated as follows:
Sales
Less: Factory cost of sales
Gross Profit
Less: Administration, selling and distribution costs
Net Profit
$1,000
$800
$200
$150
$50
Sometimes, but not always, the overhead costs of administration, selling and
distribution are also added to unit costs, to obtain a full cost of sales:
Prime Cost per unit
Factory overhead cost per unit
Administration, selling and distribution costs
Full Cost of Sales
$ Per Unit
6.00
2.00
1.50
9.50
The weekly profit would be calculated as follows:
Sales
Less: Full cost of sales
Net Profit
$1,000
$950
$50
It may already be apparent that the weekly profit is $50 no matter how the figures
have been presented. So, how does absorption costing serve any useful purpose in
accounting?
1
A company has two production departments (A and B) and two service departments
(maintenance and stores). Details of next year's budgeted overheads are shown
below:
Heat and Light
Repair Cost
Machinery Depreciation
$19,200
$9,600
$54,000
Rent and Rate
Canteen
Machinery Insurance
$38,400
$9,000
$25,000
Details of each department are as follows:
(m2)
Floor area
Machinery book value ($)
Number of employees
Allocated overheads ($)
A
6,000
48,000
50
15,000
B
4,000
20,000
40
20,000
Maintenance
3,000
8,000
20
12,000
Stores
2,000
4,000
10
5,000
Total
15,000
80,000
120
52,000
Service departments’ services were used as follows:
Maintenance hours worked
Number of stores requisitions
Required: How
departments?
overheads
A
5,000
3,000
B
4,000
1,000
should
be
Maintenance
1,000
apportioned
Stores
1,000
-
between
Total
10,000
5,000
the
four
Stage 1: Apportioning general overheads
Item of Cost
Heat and Light
Repair costs
Machinery
Depreciation
Rent and Rate
Canteen
Machine
Insurance
Total
Allocated
overheads
Grand Total
Basis of
Apportionment
Floor area (W1)
Floor area (W1)
Machinery value
(W2)
Floor area (W1)
Number of
employees (W3)
Machinery value
(W2)
A ($)
B ($)
Stores
($)
2,560
1,280
2,700
Total ($)
5,120
2,560
13,500
Mainten
ance ($)
3,840
1,920
5,400
7,680
3,840
32,400
15,360
3,750
10,240
3,000
7,680
1,500
5,120
750
38,400
9,000
15,000
6,250
2,500
1,250
25,000
78,030
15,000
40,670
20,000
22,840
12,000
13,660
5,000
155,200
52,000
93,030
60,670
34,840
18,660
207,200
19,200
9,600
54,000
Workings:
1. Overhead apportioned by floor area
2
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
𝐹𝑙𝑜𝑜𝑟 𝑎𝑟𝑒𝑎 𝑜𝑐𝑐𝑢𝑝𝑖𝑒𝑑 𝑏𝑦 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
=
𝑥𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑇𝑜𝑡𝑎𝑙 𝑓𝑙𝑜𝑜𝑟 𝑎𝑟𝑒𝑎
For example:
6,000
𝐻𝑒𝑎𝑡 𝑎𝑛𝑑 𝐿𝑖𝑔ℎ𝑡 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐴 =
𝑥19,200 = $7,680
15,000
2. Overhead apportioned by machinery value
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡𝑠 ′ 𝑚𝑎𝑐ℎ𝑖𝑛𝑒𝑟𝑦
=
𝑥𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑒𝑟𝑦
For example:
48,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐴 =
𝑥54,000 = $32,400
80,000
3. Overhead apportioned by number of employees
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑖𝑛 𝑑𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
=
𝑥𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠
For example:
50
𝐶𝑎𝑛𝑡𝑒𝑒𝑛 𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐴 =
𝑥9,000 = $3,750
120
Stage 2: Reapportionment of service department costs
1. Direct method of reapportionment (ignores inter-service department work)
Allocated costs (given already)
General cost (calculated earlier)
Maintenance hours worked
Number of stores requisitions
Service department
Maintenance
Stores
Previously allocated costs
Total overhead
A ($)
B ($)
15,000
78,030
93,030
20,000
40,670
60,670
A
5,000
3,000
B
4,000
1,000
Basis of
apportionment
Maintenance
hours (W1)
Number of
requisitions (W2)
Maintenance Stores ($)
($)
12,000
5,000
22,840
13,660
34,840
18,660
Maintenance
1,000
Stores
1,000
-
Total
10,000
5,000
Total cost ($)
Dept. A
Dept. B
34,840
19,356
15,484
18,660
13,995
4,665
53,500
153,700
207,200
33,351
93,030
126,381
20,149
60,670
80,819
3
Workings:
1. Maintenance department overheads reapportioned as follows:
Total hours worked in Dep A and B = 5,000 + 4,000 = 9,000 hours
5,000
𝑥 $34,840 = $19,356
9,000
4,000
𝑟𝑒𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐵 =
𝑥 $34,840 = $15,484
9,000
𝑟𝑒𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐴 =
2. Stores department overheads reapportioned as follows:
Total number of stores requisitions Dep A and B = 3,000 + 1,000 = 4,000
3,000
𝑥 $18,660 = $13,995
4,000
1,000
𝑟𝑒𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐵 =
𝑥 $18,660 = $4,665
4,000
𝑟𝑒𝑎𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑 𝑡𝑜 𝐷𝑒𝑝 𝐴 =
2. Step down method of reapportionment
Allocated costs (given already)
General cost (calculated earlier)
A ($)
B ($)
15,000
78,030
93,030
20,000
40,670
60,670
Maintenance Stores ($)
($)
12,000
5,000
22,840
13,660
34,840
18,660
Service department’s services were used as follows:
Maintenance
used
Number
of
requisitions
A
hours 5,000
(50%)*
stores 3,000
(60%)**
B
4,000
(40%)*
1,000
(20%)**
Maintenance
1,000
(20%)**
Stores
1,000
(10%)*
-
Total
10,000
(100%)
5,000
(100%)
* 5,000/10,000 × 100% = 50%, 4,000/10,000 = 40%, 1,000/10,000 = 10%
** 3,000/5,000 × 100% = 60%, 1,000/5,000 = 20%, 1,000/5,000 = 20%
A ($)
B ($)
Overhead costs (allocated &
general)
Apportion stores (60%/20%/20%)
93,030
60,670
11,196
3,732
Apportion maintenance (5/9 / 4/9)
21,429
125,655
17,143
81,545
Maintenance Stores ($)
($)
34,840
18,660
3,732
38,572
(38,572)
NIL
(18,660)
NIL
4
If the first apportionment had been the maintenance department, then the overheads
of $34,840 would have been apportioned as follows:
Overhead costs
general)
Apportion
(50%/40%/10%)
A ($)
B ($)
&
93,030
60,670
maintenance
17,420
13,936
(34,840)
3,484
16,608
127,058
5,536
80,142
NIL
22,144
(22,144)
NIL
(allocated
Apportion stores (3/4 / 1/4)
Maintenance Stores ($)
($)
34,840
18,660
Note: Notice how the final results differ, depending on whether the stores
department or the maintenance department is apportioned first.
If one service cost centre, compared with the other(s), has higher overhead costs
and carries out a bigger proportion of work for the other service cost centre(s), then
the overheads of this service centre should be reapportioned first.
3. The repeated distribution (or reciprocal) method of reapportionment
Allocated costs (given already)
General cost (calculated earlier)
Maintenance hours worked
Number of stores requisitions
A ($)
B ($)
15,000
78,030
93,030
20,000
40,670
60,670
A
5,000
3,000
B
4,000
1,000
Maintenance Stores ($)
($)
12,000
5,000
22,840
13,660
34,840
18,660
Maintenance
1,000
Stores
1,000
-
Total
10,000
5,000
Show how the maintenance and stores departments' overheads would be
apportioned to the two production departments and calculate total overheads for
each of the production departments.
Note: To apportion both the general and allocated overheads. The bases of
apportionment for maintenance and stores are the same as for the above examples
(that is, maintenance hours worked and number of stores requisitions).
A ($)
B ($)
Overhead costs (allocated &
general)
Apportion maintenance (note A)
93,030
60,670
17,420
13,936
Apportion stores (note B)
13,286
4,429
Apportion maintenance
Apportion stores (note C)
2,215
332
126,283
1,772
110
80,919
Maintenance Stores ($)
($)
34,840
18,660
(34,840)
NIL
4,429
4,429
(4,429)
NIL
-
3,484
22,144
(22,144)
NIL
442
(442)
NIL
5
Notes:
A. It does not matter which department you choose to apportion first.
Apportionment is as follows:
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 ℎ𝑜𝑢𝑟𝑠 𝑤𝑜𝑟𝑘𝑒𝑑 𝑖𝑛 𝐷𝑒𝑝
𝑥34,840
𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 ℎ𝑜𝑢𝑟𝑠 𝑤𝑜𝑟𝑘𝑒𝑑
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑝 𝐴 =
5,000
𝑥34,840 = $17,420
10,000
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑝 𝐵 =
4,000
𝑥34,840 = $13,936
10,000
𝑆𝑡𝑜𝑟𝑒𝑠 =
1,000
𝑥34,840 = $3,484
10,000
B. Stores overheads apportionment are as follows:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑟𝑒𝑠 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠 𝑓𝑜𝑟 𝐷𝑒𝑝
𝑥22,144
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑟𝑒𝑠 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑝 𝐴 =
3,000
𝑥22,144 = $13,286
5,000
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑝 𝐵 =
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 =
1,000
𝑥22,144 = $4,429
5,000
1,000
𝑥22,144 = $4,429
5,000
C.
The problem with the repeated distribution method is that you can keep performing
the same calculations many times.
When you are dealing with a small number (such as $442 above) you can take the
decision to apportion the figure between the production departments only.
In this case, we ignore the stores requisitions for maintenance and base the
apportionment on the total stores requisitions for the production departments (that is,
4,000). The amount apportioned to production departments A and B is calculated as
follows:
𝑆𝑡𝑜𝑟𝑒𝑠 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠 𝑓𝑜𝑟 𝐴
3,000
𝑥𝑆𝑡𝑜𝑟𝑒 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 =
𝑥$442 = $332
𝑇𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑟𝑒 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠 (𝐴 + 𝐵)
4,000
𝑆𝑡𝑜𝑟𝑒𝑠 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠 𝑓𝑜𝑟 𝐵
1,000
𝑥𝑆𝑡𝑜𝑟𝑒 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 =
𝑥$442 = $110
𝑇𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑟𝑒 𝑟𝑒𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠 (𝐴 + 𝐵)
4,000
4. The reciprocal (Algebraic) method of reapportionment
6
The results of the reciprocal method of apportionment may also be obtained using
algebra and simultaneous equations.
Whenever you are using equations you must define each variable first.
Let
M = total overheads for the maintenance department
S = total overheads for the stores department
Remember that total overheads for the maintenance department consist of general
overheads apportioned, allocated overheads and the share of stores overheads
(20%).
Similarly, total overheads for stores will be the total of general overheads
apportioned, allocated overheads and the 10% share of maintenance overheads.
Therefore,
𝑀 = 0.2𝑆 + $34,840 (1)
𝑆 = 0.1𝑀 + $18,660 (2)
Solve the equations now
Multiplying equation (1) by 5 will give us
5𝑀 = 𝑆 + $174,200 (3)
It can be rearranged as
𝑆 = 5𝑀 − $174,200 (4)
Subtract equation (2) from equation (4)
𝑆 = 5𝑀 − $174,200 (4) − 𝑆 = 0.1𝑀 + $18,660 (2)
We get
0 = 4.9𝑀 − $192,860
4.9𝑀 = $192,860
𝑀=
192,860
= $39,359
4.9
Substitute M = 39,359 into equation (2)
𝑆 = 0.1 𝑥 39,359 + $18,660 = 22,596
These overheads can now be apportioned to the production departments using the
proportions above.
A ($)
B ($)
Maintenance Stores ($)
($)
7
Overhead costs (A & G)
Apportion
maintenance
(50%/40%/10%)
Apportion
stores
(60%/20%/20%))
Total
93,030
19,680
60,670
15,743
34,840
(39,359)
18,660
3,936
13,558
4,519
4,519
(22,596)
126,268
80,932
NIL
NIL
Example: The Basics of Absorption Costing
Anila & Co makes two products, Slippers and Shoes. Slippers take two labour hours
each to make and Shoes take five labour hours. What is the overhead cost per unit
for Slippers and Shoes respectively, if overheads are absorbed on the basis of
labour hours?
Solution:
Step 1: Estimate the overhead likely to be incurred during the coming period.
Anila & Co estimates that the total overhead will be $50,000.
Step 2: Estimate the activity level for the period. This could be total hours,
units, or direct costs or whatever it is upon which the overhead absorption
rates are to be based.
Anila & Co estimates that a total of 100,000 direct labour hours will be worked.
Step 3: Divide the estimated overhead by the budgeted activity level. This
produces the overhead absorption rate.
𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
$50,000
= $0.50 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
100,000 ℎ𝑟𝑠
Step 4: Absorb the overhead into the cost unit by applying the calculated
absorption rate.
Labour hours per unit
Absorption rate per labour hours
Overhead absorbed per unit
Slippers
2
$0.50
$1.00
Shoes
5
$0.50
$2.50
It should be obvious to you that, even if a company is trying to be 'fair', there is a
great lack of precision about the way an absorption base is chosen. This
arbitrariness is one of the main criticisms of absorption costing, and if absorption
costing is to be used (because of its other virtues) then it is important that the
methods used are kept under regular review. Changes in working conditions should,
if necessary, lead to changes in the way in which work is accounted for. For
example, a labour-intensive department may become mechanised. If a direct labour
hour rate of absorption had been used previous to the mechanisation, it would
probably now be more appropriate to change to the use of a machine hour rate.
8
Example: Overhead Absorption
The budgeted production overheads and other budget data of Bridge Cottage Co are
as follows:
Budget
Overhead cost
Direct materials cost
Direct labour cost
Machine hours
Direct labour hours
Units of production
Production
Dep A
$36,000
$32,000
$40,000
10,000
18,000
Production
Dep B
$5,000
1,000
Calculate the absorption rate using the various bases of apportionment?
Solution:
Department A
$36,000
1. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 = $32,000 𝑥100% = 112.50%
$36,000
2. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡 = $40,000 𝑥100% = 90%
$36,000
3. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑝𝑟𝑖𝑚𝑒 𝑐𝑜𝑠𝑡 = $72,000 𝑥100% = 50%
$36,000
4. 𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 = 10,000 ℎ𝑟𝑠 = $3.60 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟
$36,000
5. 𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟 = 18,000 ℎ𝑟𝑠 = $2 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
Department B
The department B absorption rate will be based on units of output.
𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 =
$5,000
= $5 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
1,000 𝑢𝑛𝑖𝑡𝑠
Bases of Absorption:
The choice of the bases of absorption is significant in determining the cost of
individual units, or jobs, produced.
Using the above example, suppose that an individual product has a material
cost of $80, a labour cost of $85, and requires 36 labour hours and 23 machine
hours to complete.
The overhead cost of the product would vary, depending on the basis of absorption
used by the company for overhead recovery.
In theory, each basis of absorption would be possible, but the company should
choose a basis for its own costs which seems to be 'fairest'.
9
Example: Separate absorption rates
The Old Grammar School has two production departments, for which the following
budgeted information is available:
Budgeted overheads
Budgeted direct labour hours
Dep A
$360,000
200,000 Hrs
Dep B
$200,000
40,000 Hrs
Total
$560,000
240,000 Hrs
If a single factory overhead absorption rate is applied, the rate of overhead recovery
would be:
$560,000
= $2.33 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
240,000
If separate departmental rates are applied, these would be:
𝐷𝑒𝑝 𝐴 =
$360,000
= $1.80 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
200,000 ℎ𝑜𝑢𝑟𝑠
𝐷𝑒𝑝 𝐵 =
$200,000
= $5 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
40,000 ℎ𝑜𝑢𝑟𝑠
Dep. B has a higher overhead rate of cost per hour worked than Dep. A.
Now let us consider two separate jobs:
Job X has a prime cost of $100, takes 30 hours in department B and does not
involve any work in department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in
department B.
What would be the factory cost of each job, using the following rates of overhead
recovery?
(a) A single factory rate of overhead recovery
(b) Separate departmental rates of overhead recovery
Solution:
(a)
Single Factory Rate
Prime Cost
Factory overhead (30 x $2.33)
Factory cost
Job X
$
100
70
170
Job Y
$
100
70
170
(b)
10
Single Factory Rate
Prime Cost
Factory overhead:
Dep A
Dep B
Factory cost
Job X
$
100
(30 x $5)
0
150
250
Job Y
$
100
(28 x $1.80)
(2 x $5)
50.40
10.00
160.40
Using a single factory overhead absorption rate, both jobs would cost the same.
However, since job X is done entirely within department B where overhead costs are
relatively higher, whereas job Y is done mostly within department A where overhead
costs are relatively lower, it is arguable that job X should cost more than job Y.
This will occur if separate departmental overhead recovery rates are used to reflect
the work done on each job in each department separately.
If all jobs do not spend approximately the same time in each department then, to
ensure that all jobs are charged with their fair share of overheads, it is necessary to
establish separate overhead rates for each department.
Example: Over and under absorption
Suppose that the budgeted overhead in a production department is $80,000 and the
budgeted activity is 40,000 direct labour hours. The overhead recovery rate (using a
direct labour hour basis) would be $2 per direct labour hour.
Actual overheads in the period are, say, $84,000 and 45,000 direct labour hours are
worked.
Overhead incurred (actual)
Overhead absorbed (45,000 x $2)
Over absorption of overhead
$
84,000
90,000
6,000
In this example, the cost of production includes $6,000 more of overhead than was
actually incurred. An adjustment to reconcile the overheads charged to the actual
overhead is necessary and the over-absorbed overhead will be credited to the profit
and loss account at the end of the accounting period.
Example: Reasons for under-/over-absorbed overhead
Pembridge Co has a budgeted production overhead of $50,000 and a budgeted
activity of 25,000 direct labour hours and therefore a recovery rate of $2 per direct
labour hour.
Calculate the under-/over-absorbed overhead, and the reasons for the under/over
absorption, in the following circumstances.
(a) Actual overheads cost $47,000 and 25,000 direct labour hours are worked.
(b) Actual overheads cost $50,000 and 21,500 direct labour hours are worked.
(c) Actual overheads cost $47,000 and 21,500 direct labour hours are worked.
11
Solution:
(a)
$
47,000
50,000
3,000
Overhead incurred (actual)
Overhead absorbed (25,000 x $2)
Over absorption of overhead
The reason for the over absorption is that, although the actual and budgeted direct
labour hours are the same, actual overheads cost is less than expected.
(b)
$
50,000
43,000
7,000
Overhead incurred (actual)
Overhead absorbed (21,500 x $2)
Under absorption of overhead
The reason for the under absorption is that, although budgeted and actual overhead
costs were the same, fewer direct labour hours were worked than expected.
(c)
$
47,000
43,000
4,000
Overhead incurred (actual)
Overhead absorbed (21,500 x $2)
Under absorption of overhead
The reason for the under absorption is a combination of the reasons in (a) and (b).
The distinction between overheads incurred (actual overheads) and an overhead
absorbed is an important one which you must learn and understand. The difference
between them is known as under- absorbed or over-absorbed overheads.
Ledger Entries Relating to Overheads
Example: The under-/over-absorbed overhead account
Mariott's Motorcycles absorbs production overheads at the rate of $0.50 per
operating hour and administration overheads at 20% of the production cost of sales.
Actual data for one month was as follows:
Administration overheads
Production overheads
Operating hours
Production cost of sales
$32,000
$46,500
90,000
$180,000
What entries need to be made for overheads in the ledgers?
12
Solution:
Journal entries:
Production overheads (W.I.P)
(90,000 x $0.50)
Production overheads (Under-absorption)
Cash
$45,000
$1,500
$46,500
Admin overheads (To Cost of Sales $180,000 x $0.20)
Cash
Admin overheads (Over-absorption)
$36,000
$32,000
$4,000
Ledger entries:
Cash
Cash
Over-absorbed overhead
Production overheads A/C
$46,500 Absorbed into (W.I.P)
Under-absorbed overhead
$46,500
Admin overheads A/C
$32,000 Absorbed into Cost of Sales
$4,000
$36,000
UNDER-/OVER-ABSORBED OVERHEADS A/C
Production overhead
$1,500
Administration overhead
Balance to P&L account
$2,500
$4,000
$45,000
$1,500
$46,500
$36,000
$36,000
$4,000
$4,000
Less production overhead has been absorbed than has been spent so there is
under-absorbed overhead of $1,500. More administration overhead has been
absorbed (into cost of sales, note, not into WIP) and so there is over-absorbed
overhead of $4,000. The net over-absorbed overhead of $2,500 is a credit in the
statement of profit or loss.
13