OVERHEAD
ABSORPTION
Encyclopaedia of Accounting
OVERHEAD ABSORPTION
Some costs (Direct Costs) can be directly identified with a specific product or
service (Cost Unit). Other costs (Indirect Costs or Overheads) are related to a
range of products or services. Therefore the total cost of a cost unit is calculated
as follows:
Total Cost per unit = Direct Costs of unit + a proportion of Overheads
Total costs, calculated using this approach, are used for valuing stocks, calculating
profit and pricing but are not usually suitable for short-term decision-making. In
most organisations, only production overheads are absorbed into product costs
(ie.: not sales or general administration overheads).
The relevant proportion of overheads costs is calculated using the process known
as Absorption Costing. This process is also known as Full Costing.
There are two stages to the process of sharing out the indirect costs:
1. Allocate and apportion overhead costs to cost centres
2. Absorb overheads into the products processed in a cost centre
Allocation and Apportionment
Some overheads clearly belong to one cost centre (eg. The department manager’s
salary) and are allocated to it. For others (e.g.: rent) a single cost may need to
be divided (apportioned) between several departments.
The basis for such apportionment depends on the nature of the cost. For example,
rent may be divided in proportion to the floor area of the cost centres, insurance
may be based on equipment value, etc.
Example
A factory has two departments, X (4,000 sq. metres) and Y (6,000 sq. metres).
Total rental cost is £1,200,000 a year.
The rental cost is therefore
£1,200,000
= £120 per square metre per year
4,000 sqm + 6,000 sqm
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The rental cost is apportioned as follows:
Department A
£480,000
£120 x 4,000
Department B
£720,000
£120 x 6,000
Total
£1,200,000
Absorption
If a department produces only one product, the total overheads are simply divided
amongst the units produced.
Example
Total overheads in Department X in May = £150,000
Total number of units produced in May = 300,000
Overhead per product =
£150000
= £0.50
300000
This is known as the overhead absorption rate (OAR), or overhead recovery
rate.
When products are not identical, OAR needs to be calculated in a different way:
Estimated overhead costs for period
Estimated activity for the period
The level of activity may be measured in various ways, including:
 Direct Labour Hours:
OAR = £x per labour hr
 Machine Hours:
OAR = £x per machine hr
 Direct Labour Cost:
OAR = £x per £1 of labour
or y% of labour cost
 Direct Material Cost:
OAR = y% of material
 Selling price:
OAR = y% of selling price
An OAR of, say, £10 per labour hour implies that, whilst the production operative
is working on a product for one hour, the department as a whole has spent £10
on various services to support that production. The appropriate measure to use
depends on which one seems to divide the overheads amongst products in the
most sensible manner. Different measures may be appropriate for different cost
centres.
Absorption rates are usually determined at the beginning of a period, using
budget figures for overhead expenditure and cost centre volume. These are
known as predetermined overhead absorption rates.
Once the OAR has been established, the overhead per cost unit is calculated as:
OAR x amount of activity per cost unit
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Example
OAR = £10 per labour hour
Manufacture of Product A takes 2 hours
Overhead per unit = £10/hr x 2 hrs = £20
The total cost per unit can then be calculated, given that £5 of material is
required and that production staff cost £20/hour
£
Material
5
Labour (2hrs x £20/hr)
40
Overhead
20
Total cost
65
Non-Production (Service) Departments
For this to work, all overheads need to be charged to departments which generate
goods or services. If overhead costs are allocated or apportioned to nonproduction departments, then they need to be re-apportioned to production
departments in much the same way as other overheads are apportioned. For
example, the overheads of the maintenance department may be charged to other
departments based on the number of jobs they do for each department.
Sometimes, these service departments do work for other service departments. If
the re-apportionment is repeated several times (the reciprocal, or repeated
distribution method), the overhead costs attributed to service departments
become negligible.
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OVERHEADS
ALLOCATE
directly to
cost centres
APPORTION
on an equitable
basis
SERVICE COST
CENTRES
REAPPORTION
to production
cost centres
PRODUCTION
COST CENTRES
ABSORB into
product cost
PRODUCT
PRODUCT
PRODUCT
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Under/over Absorption
If actual overhead expenditure exceeds budget, then the predetermined amount
of overhead absorbed into the product cost is less than it needs to be. Any
calculations using the predetermined rate will under-absorb (under-recover) the
overhead (ie. Overstate profit).
The same effect will arise if the actual level of activity is smaller than budget.
Similarly, low actual expenditure or high actual activity lead to over-absorption
of overhead.
Example
Department M has an OAR of £1.72 per machine hour. Actual overhead
expenditure was £1,800,000 and actual machine hours were 800,000:
£
Actual overhead
1,800,000
Overhead costs based on predetermined rate
1,376,000
(800,000hrs x £1.72)
Under-absorption
424,000
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