Absorption Costing
Absorption costing requires managers to gather information on the direct costs, such as materials,
and also the indirect costs or overheads such as admin costs. This method enables us to calculate
the cost of production as precisely as possible. If the cost of meeting an order is underestimated,
then the business might set the price too low, and make a loss on the order. Or, vice versa, the cost
could be too high, and then the business might lose the order to a competitor.
Cost centres and cost units

We must firstly collect and record the production costs and overheads of running a business.
A cost centre is a particular area or point of a business for which costs are collected.
In the case of manufacturing businesses, there are two main types of cost centre:


Production cost centres (e.g. production departments such as machining or assembly)
Service cost centres (e.g. admin or canteen)
When we have collected and recorded costs into cost centres, the process of absorption costing
involves calculating the cost of each unit of production or Cost Unit.
What is absorption costing?
It is also known as full or total costing. The key point is that all overheads (indirect costs) are
‘absorbed’ into cost units. Therefore, all costs are included when calculating the cost of
producing particular items.
The main difficulty of absorption costing is deciding how to divide the cost of overheads
(indirect) between these cost centres (more on this later).
There are 5 main stages in the absorption costing process:
1.) The first stage is the ALLOCATION of those overhead costs that are ‘directly’ incurred by
particular cost centres (remember the above explanation of what a cost centre is), for
example, we might be able to pinpoint depreciation of a machine to the production
department.
2.) The second stage is to APPORTION, i.e. divide all shared overheads between the
production and service cost centres. (For example, sharing the rent of a building between
several cost centres contained within that building).
3.) The third stage is to apportion or ‘reapportion’ all service cost centre overheads to the
production cost centres. This is also called secondary apportionment (an example might be
splitting the cost of running a canteen (service cost centre) up amongst several production
cost centres. The reason is that it is only the production cost centres that are directly
associated with the manufacture of the cost units.
4.) The fourth stage is to ABSORB the allocated and apportioned overheads into the costs of
production of cost units.
5.) Finally include direct costs, which can easily be attributed to individual products (cost units).
This stage may have been completed in stage one, so could be ignored depending on the
question.
Miss Hunter – Absorption Costing
Stage 1 – ALLOCATION
We must include the direct and indirect costs of production. Most exam questions provide direct
costs associated with particular products or cost units, so can easily be charged to the relevant cost
centre. For example, wages paid to assembly line workers can be allocated directly to the
production department. Note: Sometimes this part is left until the end of the calculation.
Some indirect costs that are wholly associated with a particular cost centre can also be charged
‘directly’ to that cost centre. Examples might include the wages of an assembly line supervisor,
or depreciation of an assembly line machine. They can be allocated directly to the production
department.
Not all indirect costs can be charged to production departments. For example, the rent of a sales
office might be charged directly to the sales department (service cost centre).
Example: Consider Dentons Ltd, a clothing manufacturer.
‘directly’
allocated costs
Cutting
(production)
£
8,500
Assembly
(production)
£
10,500
Canteen
(service)
£
4,400
Maintenance
(service)
£
6,600
Total
£
30,000
Stage 2 – Apportionment of overheads to cost centres
Sometimes overheads are shared between several cost centres. For example, the cost of heating
and insurance on a building might be shared amongst several production and service departments.
A number of methods can be used to apportion overheads, as shown in the table below. There are
no set guidelines to follow, but the basis must be equitable, which means that a fair share of the
overheads should be apportioned to the relevant cost centre.
Overhead
Rent and rates
Heating and lighting
Personnel costs
Buildings insurance
Machinery and equipment insurance
Depreciation
Maintenance
Supervisory costs
Staff canteen
Administration
Possible basis of apportionment
Floor area of cost centres
Floor area, or volume of space of cost centres
Number of staff employed by each cost centre
Floor area, or book value of buildings in each cost centre
Book value of machinery/equipment in each cost centre
Book value of assets in each cost centre
Book value of assets in each cost centre
No.of staff, or hours worked by supervisor, in each cost centre
No.of staff employed in each cost centre
No.of staff employed in each cost centre
It is important to apportion the overheads fairly because businesses will want to determine as
accurately as possible the true cost of operating each cost centre. If they are not apportioned fairly,
the business might charge an inappropriate price to its customers.
Also, managers (who are responsible for cost centres) might be demotivated, if their centres are
charged an unrealistic share of overheads, as it would suggest they are running an expensive
department, and seem perhaps inefficient.
Miss Hunter – Absorption Costing
Example: Consider Dentons Ltd, a clothing manufacturer. They have three overheads, £10,000
for heating, £40,000 in wages for 2 supervisors and £20,000 for insuring equipment. The business
is divided into 4 cost centres.
Some further information about Dentons Ltd is provided in the table below.
Floor area
Staff employed
Book value of
equipment
Production cost centres
Cutting
Assembly
25m2
200m2
15
30
£50,000
£135,000
Service cost centres
Canteen
Maintenance
100m2
75m2
2
3
£10,000
£5,000
Total
400m2
50
£200,000
We must now apportion the 3 overheads, to the cost centres. The earlier table gave examples of
how this can be done.
Heating: The heating costs of £10,000 can be apportioned according to the proportion of total
floor space each that each cost centre occupies.
Cost to be apportioned
= floor space occupied by cost centre
Total floor space
*
total heating cost
So:
Cutting
=
25m2
*
£
=
Assembly
=
_____
400m2
*
£10,000
=
£
Canteen
=
_____
400m2
*
£10,000
=
£
Maintenance =
_____
400m2
*
£
=
£
Supervision: The supervisory costs of £40,000 can be apportioned according to the proportion of
total staff employed in each cost centre.
Cost to be apportioned = number of staff employed by cost centre * total supervisor cost
Total number of staff
So:
Cutting
=
__
*
£40,000
=
£
Assembly
=
__
50
*
£
=
£
Canteen
=
__
50
*
£40,000
=
£
Maintenance =
__
50
*
£40,000
=
£
Miss Hunter – Absorption Costing
Insurance: The insurance costs of £20,000 can be apportioned according to the total book value
of equipment (fixed assets) used in each cost centre.
Costs to be apportioned = book value of equipment in cost centre * total insurance cost
Total book value
So:
Cutting
=
_______
*
£20,000
=
£
200,000
Assembly
=
_______
200,000
*
£
=
£
Canteen
=
______
200,000
*
£20,000
=
£
Maintenance =
_____
200,000
*
£20,000
=
£
The following table shows the share of overheads apportioned to each cost centre. Sometimes
more than one basis for apportionment could be used. For example buildings insurance could be
apportioned according to the size of the floor area of each cost centre, OR to the book value of the
buildings of each cost centre. It is therefore a subjective judgement. However, it should always
be made clear which basis is chosen, and the decision should be consistent and appropriate.
Basis of
apportionment
Heating
Supervisory
Insurance
Total
Floor area
No.of employees
Book value
Cutting
Assembly
Canteen
Maintenance Total
£
625
12,000
5,000
17,625
£
5,000
24,000
13,500
42,500
£
2,500
1,600
1,000
5,100
£
1,875
2,400
500
4,775
£
10,000
40,000
20,000
70,000
Stage 3 – Reapportionment of service centre overheads
We now must apportion the service cost centre overheads to the production cost centres. This is
called reapportionment or secondary apportionment. Therefore, the costs involved in running
service cost centres, such as canteen and maintenance (other examples might include stores and
planning), must be shared between the production departments.
The reason for this, is that it is only the production cost centres that are directly associated with
the manufacture of the cost units.
Service cost centre
Canteen
Maintenance
Planning
Stores
Miss Hunter – Absorption Costing
Possible basis for reapportionment
Number of staff or meals served to each cost centre
Hours of maintenance work carried out for each cost centre
Number of hours worked in each cost centre
Number of times that materials are requested by each cost
centre.
We can now illustrate how overheads are apportioned to production cost centres. Firstly we will
consider each cost centre as it stands now, and then reapportion the service cost centre
overheads to the production cost centres.
‘directly’
allocated costs
Apportioned
costs
Total


Cutting
(production)
£
8,500
Assembly
(production)
£
10,500
Canteen
(service)
£
4,400
Maintenance
(service)
£
6,600
Total
17,625
42,500
5,100
4,775
70,000
26,125
53,000
9,500
11,375
100,000
£
30,000
The ‘directly’ allocated costs are those costs such as depreciation of a specific machine that
can be associated straight away with a particular cost centre (stage 1).
The apportioned costs are taken from the workings on the previous page (stage 2). They are
those costs which needed apportioning to different cost centres.
We now need to reapportion the service cost centre (canteen and maintenance) costs in the
following ways:
 Canteen: according to the number of meals served to staff in each cost centre
 Maintenance: according to the number of hours that maintenance staff work in each cost
centre.
Canteen: No of
meals
(as a % of total)
Maintenance:
No. of hours
(as a % of total)


Cutting
3,750
Assembly
7,500
Canteen
-
Maintenance
1,250
Total
12,500
30%
3,000
60%
3,000
-
10%
-
100%
6,000
50%
50%
-
-
100%
The total number of meals served is 12,500. These are split up amongst the three
departments. This example presumes that no canteen staff have meals.
The 6,000 maintenance hours are split equally between the cutting and assembly
departments.
Total overheads (from
above table)
Canteen overheads
reapportioned
Sub-total
Maintenance overheads
reapportioned
Total overheads
apportioned



Cutting
£
26,125
Assembly
£
53,000
Canteen
£
9,500
Maintenance Total
£
£
11,375
100,000
2,850
5,700
(9,500)
950
28,975
6,162.50
58,700
6,162.50
-
12,325
(12,325)
100,000
35,137.50
64,862.50
-
-
100,000
The £9,500 canteen overheads need to be reapportioned to the two production cost centres.
Remember that the Cutting department used 30% of meals so = £_______ (30% of £9,500)
The Assembly department used 60% of the meals so = £_______ (60% of £9,500)
Miss Hunter – Absorption Costing

The Maintenance department used 10% of the meals so = £_____ (10% of £9,500)

We can now reapportion the Maintenance overheads to the two production cost centres.
Remember the Maintenance overheads now include some reapportioned Canteen
overheads.
Remember that both the Cutting, and Assembly cost centres used 50% of the Maintenance
hours. Therefore we can split the £12,325 Maintenance overheads equally, which = £6,162.50.

Stage 4 – ABSORPTION of the allocated and apportioned (and reapportioned!) overheads
into the cost units
This will ensure that all costs are taken into account when calculating the cost of producing the
goods that are to be sold. The rate at which the overheads are charged to cost units is called the
overhead absorption rate (OAR). There are several methods available, but we must know only
2 methods for the exam (note: the book has 3 methods, ignore the 3rd!)
Machine hour overhead absorption rate:
This method is most suitable when production is capital intensive (large investment in fixed
assets like machinery compared to labour). Therefore, most of the overheads are related to the
cost of using the machinery. They include, for example depreciation, power, insurance,
maintenance etc.
Machine hour OAR =
Total cost centre overheads =
Number of machine hours
rate per machine hour
Imagine that in a machining department, the total annual overheads are estimated to be £250,000.
The budgeted annual total of machine hours in this cost centre is 10,000 hours.
Machine hour OAR
=
£______
=
£___ per machine hour
If a particular cost unit takes 6 hours to produce in the machining department then £150 (6 *
£___) overheads will be absorbed to the production of that single unit.
Direct labour hour overhead absorption rate:
This method is most suitable when production is labour intensive, i.e. when direct labour costs
are high relative to capital costs.
Direct labour hour OAR
=
Total cost centre overheads = rate per direct labour hour
Total direct labour hours
For example, a packaging department has total annual overheads estimated to be £60,000. The
budgeted annual total labour hours is 20,000 hours.
Direct labour hour OAR
=
£______
=
£__ per direct labour hour
If it takes ½ hour to pack a cost unit, then £1.50 (0.5 * £__) overheads will be absorbed to each
unit.
Miss Hunter – Absorption Costing
Step 5: Calculating the total cost unit


Firstly add together each production cost centre – from step 4. e.g. £25 + £3 = £28.
The final step is to consider any direct costs (materials, labour etc) which would be provided in
the exam question (if these have not been dealt with in stage 1). We do not have to do any
working out with these direct costs, apart from perhaps working out the direct costs per unit
(if only a total is given). We can then add these direct costs to the first bullet point and we
have the total cost per unit!!!
Example of calculating unit costs using absorption costing:
Consider Wrights Ltd, a manufacturer of sailing boats. The business is divided into 4 cost centres:




Body shop – produces the fibre glass parts that are needed to construct the boat.
Sub-assembly – assembles the bought-in components.
Production
Packing and dispatch – packs and dispatches the kits to customers.
Cost centres
Quality control – This department overseas quality control in the 3 production cost centres.
This is therefore a service cost centre.
 A machine hours OAR is used in the body shop to charge overheads.
 A direct labour hours OAR is used in the other 2 production departments.
Floor space
Book value of
assets
No. of
employees
Quality control
hours
Overheads
Rent
Heat & light
Depreciation
Administration
Total
Body shop
8,000m2
£600,000
Sub-assembly Packing
4,000m2
2,000m2
£200,000
£200,000
Quality control
2,000m2
-
Total
16,000m2
£1,000,000
10
40
20
10
80
2,000
8,000
4,000
-
14,000
£
1,600,000
400,000
200,000
800,000
3,000,000
Annual budgeted machine hours in the body shop
Annual budgeted direct labour hours in the sub-assembly dept
Annual budgeted direct labour hours in the packing department
Cost of direct materials per boat
Cost of direct labour per boat
£500
£2,500
Time taken to produce one boat kit in each department
Body shop
10 hours
Sub-assembly
15 hours
Packing
8 hours
Miss Hunter – Absorption Costing
50,000
40,000
20,000
We now need to calculate the cost of producing one boat:
Step 1: Firstly we must apportion the £3m overheads to the 4 cost centres.
Basis for
apportionment
Body Shop
£
Subassembly
£
Packing
£
Quality
Control
£
Rent
Heat & Light
Depreciation
Administration
Total
Total
£
1,600,000
400,000
200,000
800,000
3,000,000
Step 2: Reapportion the overheads of the service department to the production departments.
In this example, the quality control department is a service cost centre, so needs to be
reapportioned to the other 3 production cost centres. The basis for reapportionment in this
case is the number of hours the quality control department works for each other department.
Body shop
£
Sub-assembly Packing
£
£
Quality control
£
Total
overheads
Quality control
reapportioned
Total
Total
£
3,000,000
3,000,000
Step 3: When all the overheads have been apportioned to the production cost centres, the next
step is to calculate the overhead absorption rates. (Remember either the machine or direct
labour hour OAR can be used).
In the exam, if you are not sure which OAR to use, then just decide if the department in question is
capital or labour intensive, and this will tell you which OAR to use!
 The body shop uses the machine hour OAR.
 The sub-assembly department uses the direct labour OAR.
 The packing department uses the direct labour OAR.
Therefore:
Body shop:
Machine hour OAR
=
=
Sub-assembly dept:
Direct labour hour OAR
=
=
Packing dept:
Direct labour hour OAR
=
=
Step 4: We can now calculate the number of overheads that can be charged to each cost unit,
i.e. boat. We just multiply the relevant OAR by the length of time it takes to process a single
cost unit in each department.
Department
OAR
Multiplied by
Number of hours
Cost per unit
Miss Hunter – Absorption Costing
£
£
*
*
*
Body shop
Sub-assembly
Packing
Total
917.50
Step 5: The final step is to calculate the total cost of each boat (cost unit) by adding the total
overheads (£917.50 from above) charged per cost unit to the direct costs per unit (labour and
materials – provided in the question).
£
Direct material cost per unit
Direct labour cost per unit
Overheads per cost unit
Total
3,917.50
And the selling price should be?
Now that we have worked out that the cost of the boat is £3,917.50 we can decide the selling price
accurately. Obviously it needs to be higher than this figure, so that the business can make money.
And if the calculations are inaccurate?
Obviously, all these calculations are budgeted figures. They are just predictions, usually based on
historical data, which might not accurately reflect the future. If they are inaccurate, then the
selling price might be set too high, or too low. This could either put off customers, or result in
less profit being made, than was perhaps possible.
Advantages of absorption costing



Ensures all costs are fully covered so is a widely used method.
Business will cover their costs (assuming actual costs are similar to budgeted costs)
Conforms to SSAP9 Valuing stocks. SSAP9 states that absorption costing should be used,
rather than marginal costing. This is because absorption costing reflects all costs involved,
including fixed costs.
Disadvantages of absorption costing



Is based on budgeted figures, which may prove inaccurate.
If they are inaccurate then businesses might set the selling price too high or too low.
It is a complex, time consuming and expensive process.
Key definitions:
Allocation
Apportionment
Reapportionment
Absorption
Costs assigned to one individual cost centre
Costs assigned to two or more cost centres
Charging all service cost centre overheads to production cost centres. This
is because at the end of the day it is the production cost centres that are
directly associated with the finished products (cost units)
The allocation of all production direct and indirect expenses to cost units
Miss Hunter – Absorption Costing