Overheads and absorption costing
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Overheads
• Overhead is the cost incurred in the course of making a
product, providing a service or running a department,
but which cannot be traced directly and fully to the
product, service or department.
• Overheads is actually the total of the following:– Indirect materials
– Indirect labour
– Indirect expenses
• In cost accounting there are two school of thoughts as
to the correct method of dealing with overheads:– Absorption costing
– Marginal costing
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Introduction to absorption costing
• The objective of absorption costing is to include in the
total cost of a product an appropriate share of the
organization's total overheads.
• An appropriate share is generally taken to mean an
amount which reflects the amount of time and effort
which has gone into producing a unit or completing a
job.
• The theoretical justification for using absorption costing
is that all production overhead are incurred in
production of output so each unit of the product
receives some benefits from these cost.
• Therefore each unit of output should be charged with
some of the overhead costs.
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Practical reasons for using absorption
costing- Inventory valuations
• Inventory in hand must be valued for two
reasons:• For the closing inventory figure in the
statement of financial position
• For the cost of sales figure in the statement
of comprehensive income
• In absorption costing, closing inventory is
valued at fully absorbed factory costs.
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Practical reasons for using absorption
costing- Pricing decisions
• Many companies attempt to fix selling
prices by calculating the full cost of
production or sales of each product, and
then adding a margin for profit.
• Without using absorption costing, a full cost
is difficult to ascertain.
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Practical reasons for using absorption costingEstablishing profitability of different products
• If a company sells more than one product, it
will be difficult to judge how profitable
each individual product is, unless overhead
costs are shared on a fair basis and charged
to the cost of sales of each product
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Absorption costing stages
• The three stages of absorption costing are:– Allocation
– Apportionment
– Absorption
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Overhead allocation
• Allocation is the process by which whole cost items are
charged direct to a cost unit or cost centre
• For example, the following cost will be charged to the
following cost centres via the process of allocation:– Direct labour will be charged to the production cost
centre
– The cost of warehouse security will be charged to the
warehouse cost centre
– Costs such as canteen are charged direct to the various
overhead cost centres.
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Example1-Overhead allocation
• Cost of company:– Wages of foreman of department A
Rs 200
– Wages of foreman of department B
Rs 150
– Indirect materials consumed in department A
Rs 50
– Rent of premises shared by department A and B Rs 300
• The accounting system might include three cost centres:– Cost centre 1 Department A
– Cost centre 2 Department B
– Cost centre 3 Rent
• Calculate the overhead costs of cost centres 1, 2 and 3
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Apportionment of overhead
• Apportionment of overhead is distribution of
overheads to more than one cost centre on some
equitable basis.
• When the indirect costs are common to different cost
centres, these are to be apportioned to the cost centres
on an equitable basis. For example, the expenditure on
general repair and maintenance pertaining to a
department can be allocated to that department but has
to be apportioned to various machines (Cost Centres)
in the department. If the department is involved in the
production of a single product, the whole repair &
maintenance of the department may be allocated to the10
product.
Bases of apportionment
• Overhead apportionment basis:-
Overhead to which basis
apply
Rent, rates, heating and light,
repairs and depreciation of
building
Deprecation and insurance of
equipment
Personnel, office, canteen,
welfare, wages and costs of
offices, first aid
Basis of apportionment
Floor area occupied by each
cost centre
Cost or book value of
equipment
Number of employees, or
labour hours worked in each
cost centre
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Basis of apportionment of service
cost centres
Service cost centre
Stores
Maintenance
Production planning
Possible basis of
apportionment
Number of cost value of
material requisitions
Hours of maintenance
work done for each cost
centre
Direct labour hours worked
in each production cost
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centre
Primary and Secondary Distribution of
Overheads
•
•
•
•
In case of multi-product environment, there are
common service cost centres which are providing
services to the various production cost centres and other
service cost centres.
The costs of services are required to be apportioned to
the relevant cost centres.
First step to be followed is to apportion the overheads to
different cost centres and then second step is to
apportion the costs of service cost centres to production
cost centres on an equitable basis.
The first step is termed as primary distribution and the
second step is termed as secondary distribution of
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overheads.
Absorption of overheads
• Absorption of overheads is charging of overheads
from cost centres to products or services by means of
absorption rates for each cost center which is
calculated as follows :
Overhead absorption Rate =
TOTAL OVERHEADS OF COST CENTRE
TOTAL QUANTUM OF BASE
• The base ( denominator) is selected on the basis of
type of the cost centre and its contribution to the
products or services, for example, machine hours,
labour hours, quantity produced etc.
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Example of overhead apportionmentPrimary Distribution of overheads
• Jazz PLC Part 1
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Apportionment of service
departments costs
•
The aim is to apportion all the service
department costs to the production departments,
in one of three ways:1. The direct method, where the service centre costs
are apportioned to production departments only
2. The step down method, where each service cost
centres’ are not only apportioned to production
departments but to some (but not all) of the other
service centres that make use of the services
provided
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Example 2- Simple distribution of
overheads
• JAZZ PLC Part 2
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Apportionment of service departments
costs- the reciprocal method
3. The repeated distribution (or reciprocal) method,
where service cost centres are apportioned to both
the production departments and services
department that use the services.
The service centre costs are then gradually
apportioned to the production departments.
This method is used only when service
departments use each other’s services
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The reciprocal method of distribution
Steps to be followed under this method are :
i.
The proportion at which the costs of a service cost
centres are to be distributed to production cost
centres and other service cost centres are determined.
ii. Costs of first service cost centres are to be
apportioned to production cost centres and service
cost centres in the proportion as determined in step
(i).
iii. Similarly, the cost of other service cost centres are to
be apportioned.
iv. This process as stated in (ii) and (iii) are to be
continued till the figures remaining undistributed in
the service cost centres are negligibly small. The
negligible small amount left with service centre may
be distributed to production cost centres.
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Example 3- Reciprocal method
• Jazz Plc Part 3
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The reciprocal (Algebraic)
method of apportionment
• Jazz Plc
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Overhead absorption
• Overhead absorption is the process whereby
overhead costs allocated and apportioned to
production cost centres are added to unit, job or
batch costs.
• Overhead absorption is sometimes known as
overhead recovery
• Therefore having allocated and/or apportioned all
overheads, the next stage is to add them to, or
absorb them into, cost units
• Overheads are usually added to costs units using a
predetermined overhead absorption rate, which is
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calculated using figures from the budget.
Calculation of overhead
absorption rate
• Estimate the overhead likely to be incurred
during the period
• Estimate the activity level for the period
• Divide the estimated overhead by the
budgeted activity level
• Absorb the overhead into the cost unit by
applying the calculated absorption rate
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Example- Calculation of
overhead absorption rate
• Gamma makes two products, crushers and
cements. Crushers take 2 labour hours each to
make and cement takes 5 labour hours. Gamma
estimates that total overheads will be Rs 50,000
and that a total of 100,000 direct labour hours will
be worked.
• What is the overhead cost per unit for Crushers
and cements respectively if overheads are
absorbed on the basis of labour hours.
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Choosing the appropriate
absorption base
•
•
•
•
•
•
•
•
A percentage of direct materials cost
A percentage of direct labour cost
A percentage of prime cost
A rate per machine hour
A rate per direct labour hour
A rate per unit
A percentage of factory cost (for admin overhead)
A percentage of sales or factory cost ( for selling
and distribution overhead)
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Activity
The budgeted production overheads and other budgeted
data of Nick are as below. Calculate the absorption rate
using the various bases of apportionment
Production
Production
Budget
department A
department B
Overhead cost
Direct materials cost
Direct labour cost
Machine hours
Direct labour hours
Unit of production
Rs 36,000
Rs 32,000
Rs 40,000
10,000
18,000
Rs 5,000
1,000
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Blanket absorption rate and departmental
absorption rate
• A blanket overhead absorption rate is an absorption rate
used throughout a factory and for all jobs and units of
output irrespective of the department in which they are
produced
• If a separate absorption rate is used for each department,
charging of overheads will be fair and the full cost of
production of items will represent the amount of effort and
resources put in making them
• Blanket overhead rates are not appropriate in the following
circumstances:– There is more than one department
– Jobs do not spend an equal amount of time in each
department
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Activity- Blanket and separate absorption rate
• A company has two production departments, for which the
following budgeted information is available:Calculate the rate of overhead recovery if a single factory
overhead absorption rate is applied
Calculate the rate of overhead recovery if a separate departmental
rate is applied
Budgeted
overheads
Dept A
Dept B
Total
Rs 360,000
Rs 200,000
Rs 560,000
40,000 hours
240,000
Budgeted
200,000 hours
direct labour
hours
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Activity (Cont…)- Blanket and separate
absorption rate
•
If the company undertakes two jobs, X and Y,
where Job X has a prime cost of Rs 100 and
takes 30 hours in dept B and does not involve
any work in dept A and job Y has a prime cost of
Rs 100, takes 28 hours in dept A and 2 hours in
dept B,
• What would be the factory cost of each job,
using the following rates of overhead recovery:(a) A single factory rate of overhead c\recovery
(b) Separate departmental rates of overhead
recovery
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Activity-Machine hour
absorption rate
• The following data relate to one year in a
department:Budgeted machine hours
25,000
Actual machine hours
21,875
Budgeted overheads
Rs 350,000
Actual overheads
Rs 350,000
• Based on the above data, what is the machine hour
absorption rate?
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Over and under absorption of
overheads
• The rate of overhead absorption is based on
estimates ( of both numerator and denominator)
and it is quite likely that either one or both of the
estimates will nit agree with what actually occurs
– Over absorption means that the overheads
charged to the cost of sales is more than the
overheads actually incurred
– Under absorption means that insufficient
overheads have been included in the cost of
sales
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The reasons for over/under absorbed
overheads
• The overhead absorption rate is predetermined
from budget estimates of overhead cost and the
expected volume of activity.
• Over or under recovery of overhead will occur in
the following circumstances:– Actual overhead costs are different from
budgeted overhead
– The actual activity level is different from the
budgeted activity level
– Actual overhead costs and actual activity level
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differ from the budgeted costs and levels
Example-over and under
absorption
The following data is given for a production
department:Budgeted overhead
Rs 80,000
Budgeted direct labour hours
40,000
Actual overhead
Rs 84,000
Actual direct labour hours
45,000
Calculate the under/over absorbed overheads
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Activity
•
Ref co has a budgeted production overhead of
Rs 50,000 and a budgeted activity of 25,000
direct labour hours.
• Calculate the under/over absorbed overheads
and give reasons for the under/over absorption in
the following circumstances:(a) Actual overheads cost Rs 47,000 and 25,000
direct labour hours are worked
(b) Actual overheads cost Rs 50,000 and 21,5000
direct labour hours are worked
(c) Actual overheads cost Rs 47,000 and 21,500
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direct labour hours are worked