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Fundamentals Of Management Accounting

Overheads & Absorption Costing

Fundamentals of Management Accounting
Class Slides Ian Wilson

Learning Aims (CIMA)





Consider what overheads are, how they

are allocated to product unit costs & the
methods employed
Calculate Overhead Absorption
Prepare cost statements for allocation &
apportionment of overheads, including
reciprocal departments
Calculate direct, variable & full costs of
products, services & activities using
overhead absorption rates
Apply information to pricing decisions

Context & Link to Session

We have seen that business costs can be, and
need to be classified by type & behaviour.
Direct Materials
Direct Labour
Direct Expenses
= Prime Cost
Production Overheads (OAR)
= Total Production (Absorbed Cost)
Non-Production Overheads
= Total Cost

Context & Link to Session

Costs behave in a variety of ways:
The classifications are:
Variable Costs
Semi-Variable Costs
Step Costs
Fixed Costs
Once costs types & behaviour is known,
what happens next?
Why did we collect this information?

Context & Link to Session

Key Emphasis in 4 areas of use:
1. Stock Valuations, what is the value/cost of
2. Planning, future forecasts
3. Control, actual against planned
4. Decision Making, the right outcome in
terms of cost/profit for the business

Context & Link to Session

Direct Costs are easy to deal with, they
relate to cost units
But what about indirect costs or
By their very nature, they cannot be traced
DIRECTLY to a cost unit.
We have to find a way to charge theses
indirect costs to a cost unit.

Context & Link to Session

The method Accountants used to charge
indirect costs to cost unit is called
CIMA definition of an Overhead:
An overhead is expenditure on labour,
materials, or services that cannot be
economically identified with a specific
saleable cost unit

Overhead Costing & Absorption

Absorption Costing is a method of sharing
Overheads (Indirect Costs/Expenses)
between a number of different Finished
Products on a Fair basis.
You will have to consider the 3 As:
1. Allocation
2. Apportionment (& re-apportionment)
3. Absorption
4. Point 3 leads to Over/Under Absorption

Absorption Cost Diagram

It may be useful to sketch out how costs are

allocated, apportioned and finally absorbed
into a single product cost per unit.

This is a useful summary I always use to

give you a map to follow & remember

Make sure you note this down:

Allocation &
A Company will have a Total Production
Overhead spend in mind, say 500K.
If it has 2 Departments, Cutting & Finishing,
how much does it charge to each of these
Dividing up Overheads is a critical process
as they will drive Absorption rates as we
have already seen
We follow a 3 stage process:

Allocation &


. You

must be able to tackle all 3:

Allocation &
Charging cost centres with Overheads that
are incurred solely in that centre.

eg: a salary of a supervisor in a particular

cost centre

Allocation &
Some costs relate to a business as a whole
Splitting shared Overheads between cost
centres using some form of fair basis.
eg: using floor area for rent & rates

: using number of employees for canteen


: using value of assets for Depreciation


Allocation &
Re-splitting Overheads from service cost
centres to production cost centres.
eg: moving service costs for say Canteen &
Maintenance centres to production cost
centres based on benefit & use of those
service centres

Allocation &

Exercise 1 page 36
We can complete this exercise to practice
the theory, first lets get our details right.
Indirect Wages & Materials have already
been ALLOCATED to the various cost centres
Machining - Production
Assembly - Production
Finishing - Production
Maintenance Service
Lets calculate an answer:

Secondary Apportionment
Not all departments are PRODUCTION
Some departments provide Services to
production departments.
These departments are called SERVICE
Secondary apportionment is therefore
apportioning service centre costs to
production cost centres.

Reciprocal Servicing
What happens when service centres provide
services for each other?
This is service to service
There are 2 ways to deal with this issue:
1. Elimination
2. Repeated Distribution

. Examples

2 & 3 provides the answer.

Overhead Absorption Rates

Having allocated/apportioned our overheads
to a Cost centre, we need to add them to, or
absorb, these costs in to the Cost of Sales.
Production Overheads are added to the
Prime Cost seen earlier in the course.
The OAR (Overhead Absorption Rate) can be
seen as a charge out rate for Overheads.
Authors also call this BOAR
Budgeted Overhead Absorption Rate

There are 3 common ways to achieve this:
1. A Rate per Unit (identical units)
2. A Rate per Labour Hour (human time
3. A Rate per Machine Hour (machine time
All of the above are set at a pre-determined
rate, using Budgets or expected estimates of
production costs (BOAR).

Rates of Overhead HAVE to be available at
the START of the production period.
The business CANNOT wait until the end of
the accounting period to see what the
ACTUAL production overhead costs were.
The BUDGET figures for Overheads are used

OAR = Budgeted Overheads for Production

Budgeted Level of Activity

OAR Blanket &

We will work out Exercises 4 & 5
Make sure you practice this at home
It is vital for ALL CIMA Management
Accounting papers you take!
Note: OAR Rates can be:
1. Blanketor
2. Departmental
. See page 39 of your notes.

Try Exercise 6 Page 41
This is a typical exam style question.
You are given 4 answers!.
Which is correct?

Over & Under Absorption

The OAR is based on estimates. This
estimate is quantified in the BUDGET.
Overhead Costs & Output Activity Levels are
estimated/Budgeted for a given period.
One or both estimates may be different to
what ACTUALLY takes place
Actual Overheads are likely to be greater or
less than the overheads absorbed into the
cost of production & production may differ
in volume also

Over & under Absorption

In Simple Terms:

Over Absorbed:
Absorbed Overhead > Actual Overhead

Under Absorbed:
Absorbed Overhead < Actual Overhead

Under & Over Absorption

A possible layout for your calculation:
I call this the 3 Box approach you need 3
Absorbed Overhead:
(Actual activity x OAR)

Actual Overhead:


Under/Over Absorption:


Exercise 7

Aurricula Ltd. Page 42

We can practice over/under absorption

calculations for this problem.

Try & use the layout I suggested for this

question. Remember the 3 box approach

We have seen that Costs can be used for:
1. Valuing Stock
2. Planning
3. Decision making
4. Control
. What else will product/service costs be used

As a Management Accountant, you will be
asked to price products based on their cost
value. This means setting the Sales Price.
You will have to consider:
1. Mark-up (profit expressed as a % of cost)
2. Margin (profit expressed as a % of price)

Try the example Exercise 5, page 52 of your


Marginal Costing
What is Marginal Costing?
This takes place where Overhead Costs are
written off in full to the period in which they
Production Overheads under this method
are NOT added to Prime Cost as is the case
with Absorption Costing

Absorption Costing
Direct Materials
Direct Labour
Variable Costs
Direct Expenses
= Prime Cost
Production Overheads - Fixed Costs via OAR

= Total Production (Absorbed Cost)

Non-production Overheads
= Total Cost

Marginal Costing template

Direct Materials
Direct Labour
Variable Costs
Direct Expenses
= Prime Cost
Production Overheads Fixed Costs
Non-production Overheads - Fixed Costs
= Total Cost

Absorption Costing
Less Production Costs
= Gross Profit
Gross Profit
Less Expenses (Non-Production)
= Net Profit

Marginal Costing template

Less Variable Costs (Prime)
= Contribution
Less Fixed Costs:
Fixed Production Costs
Fixed Non-Production Costs
= Net Profit

Marginal Costing Example


Write down the data I have, we can practice

Marginal AND Absorption Costing techniques:
Sales Price: 20
Direct Materials 6
Direct Labour 3
Variable overheads 4
All above are PER UNIT
Fixed Overheads 20,000 Budgeted each
Budgeted Production 20,000 units

Marginal Costing Example

Actual Production & sales was 20,000 Units
in a particular month:
1. Contribution per Unit
2. Total Contribution for the month
3. Total Profit for the Month ALL using
4. Profit for the month using Absorption

Marginal Costing Example

In this exercise, the Profits achieved were
the same under Marginal & Absorption
Because SALES = PRODUCTION, both
volumes are 20,000 Units
IF Sales & Production quantities differ, the
profits WILL DIFFER!.
Accountants expect this & need to reconcile
the difference.

Marginal Costing
The reconciliation can be made simpler by
working to a method:
This is an exam favourite topic
Learn the next slide well:
AC = Absorption Costing Profit
MC = Marginal Costing Profit
A business can have opening & closing stocks
Stock levels MAY differ
We can then tackle a second question:

Absorption & Marginal


If Op Stock > Close Stock

MC Profit > AC Profit

If Op Stock = Close Stock

MC Profit = AC Profit

If Op Stock < Close Stock

MC Profit < AC Profit

These are KEY Rules: remember them

Exercise 2
Sales Price 10
Direct Materials 3
Direct Labour 2
Variable overheads 1
Fixed Overheads 10,000 per month
Budgeted Production 5000 units per month
Actual Production & Sales = 4800 units
Work out Marginal & Absorption Profits

Exercise 3
Fixed overhead & Stock Effect
Re-work Exercise 2
Make the following adjustment:
Actual Production = 6,000 Units
Actual Sales = 4,800 units
Calculate the Absorption & Marginal Profit
Then, Reconcile the difference in profits: