Chapter 3

Overhead costs – absorption costing

• Overhead allocation
• The first step in absorption costing is allocation. Allocation is the process by which whole cost items are charged direct to a cost
unit or cost center.
• Allocation is 'to assign a whole item of cost, or of revenue, to a single cost unit, center, account or time period'.
Cost centers may be one of the following types.
(a) A production department, to which production overheads are charged.
(b) A production area service department, to which production overheads are charged.
(c) An administrative department, to which administration overheads are charged.
(d) A selling or a distribution department, to which sales and distribution overheads are charged.
(e) An overhead cost center, to which items of expense which are shared by a number of departments, such as rent and rates, heat
and light and the canteen, are charged.

1.1 Example: overhead allocation

Consider the following costs of a company.
Wages of the supervisor of department A $200
Wages of the supervisor of department B $150
Indirect materials consumed in department A $50
Rent of the premises shared by departments A and B $300
The cost accounting system might include three cost centers.
Cost center: 101 Department A
102 Department B
201 Rent
2 Overhead apportionment
• The second step in absorption costing is overhead apportionment. This involves apportioning
general overheads to cost centers and then reapportioning the costs of service cost centers to
production departments.
• Apportion is 'to spread indirect revenues or costs over two or more cost units, centers, accounts
or time periods'.
2.1 First stage: apportioning general overheads

The first stage of overhead apportionment is to identify all overhead costs as production
department, production service department, administration or selling and distribution overhead.
This means that the costs for heat and light, rent and rates, the canteen and so on (that is, costs
which have been allocated to general overhead cost centers) must be shared out between the
other cost centers.
2.1.1 Bases of apportionment
2.2 Second stage: service cost center cost apportionment
• The second stage of overhead apportionment concerns the treatment of service cost centers. A
factory is divided into several production departments and also a number of service departments,
but only the production departments are directly involved in the manufacture of the units. In
order to be able to add production overheads to unit costs, it is necessary to have all the
overheads charged to (or located in) the production departments. The next stage in absorption
costing is, therefore, to apportion the costs of service cost centers to the production cost centers.
Examples of possible apportionment bases are as follows.

There are two main methods of reapportioning (Re-apportion is 'the re-spread of costs apportioned to
service departments to production departments) the service department overheads to production
departments.
• Direct method (ignores inter-service department work)
• Repeated distribution method (recognizes inter-service department work)
2.2.1 Example: service center cost apportionment
• A company has two production and two service departments (stores and maintenance). The
following information about activity in the recent costing period is available.
3 Overhead absorption
Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add them to, or
absorb them into, the cost of production or sales.
Production overheads are added to the prime cost (direct materials, labor and expenses), the total of the two
being the factory cost, or full cost of production.
Production overheads are therefore included in the value of inventories of finished goods.

3.2 Predetermined absorption rates

In absorption costing, it is usual to add overheads into product costs by applying a predetermined overhead
absorption rate. The predetermined rate is set annually, in the budget.

3.3 Calculating predetermined overhead absorption rates

The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of activity. For
production overheads the level of activity is often budgeted direct labor hours or budgeted machine hours.
Overhead absorption rates are therefore predetermined as follows.
(a) The overhead likely to be incurred during the coming period is estimated.
(b) The total hours, units, or direct costs on which the overhead absorption rates are to be based (activity
level) are estimated.
(c) The estimated overhead is divided by the budgeted activity level to arrive at an absorption rate for the
forthcoming period.
3.4 Selecting the appropriate absorption base

• Management should try to establish an absorption rate that provides a reasonably 'accurate' estimate of
overhead costs for jobs, products or services.

• There are a number of different bases of absorption (or 'overhead recovery rates') which can be used.
Examples are as follows.
• A percentage of direct materials cost
• A rate per machine hour
• A percentage of direct labor cost
• A rate per direct labor hour
• A percentage of prime cost
• A rate per unit
The choice of an absorption basis is a matter of judgement and common sense. There are no strict rules or
formulae involved, although factors which should be taken into account are set out below. What is required is
an absorption basis which realistically reflects the characteristics of a given cost center and which avoids undue
anomalies
• Many factories use a direct labor hour rate or machine hour rate in
preference to a rate based on a percentage of direct materials cost, wages or
prime cost.
(a) A direct labor hour basis is most appropriate in a labor intensive
environment.
(b) A machine hour rate would be used in departments where production is
controlled or dictated by machines. This basis is becoming more appropriate as
factories become more heavily automated.
(c) In a standard costing environment, both of these time-based methods would
use standard hours as the absorption basis. We will return to study standard
labor hour and standard machine hour absorption rates when we learn about
standard costing.
3.5 Example: overhead absorption bases
3.6 The impact of different absorption bases
• The choice of the basis of absorption is significant in determining the cost of individual units, or
jobs, produced.
• Using the previous example, suppose that an individual product has a material cost of $80, a labor
cost of $85, and requires 36 labor 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.
4 Blanket absorption rates and departmental absorption rates
• A blanket or single factory 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 were
produced.
• For example, if total overheads were $500,000 and there were 250,000 direct machine hours
during the period, the blanket overhead rate would be $2 per direct machine hour and all units
of output passing through the factory would be charged at that rate.
4.3 Example: separate absorption rates Using a single factory overhead absorption rate, both
products would cost the same.
However, since product A is done entirely within
department 2 where overhead costs are relatively higher,
whereas product B is done mostly within department 1,
where overhead costs are relatively lower, it is arguable
that product A should cost more than product B.
This will occur if separate departmental overhead
recovery rates are used to reflect the work done on each
job in each department separately.
5 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 not agree with what actually occurs.
• Actual overheads incurred will probably be either greater than or less than overheads absorbed
into the cost of production.
(a) Over absorption means that the overheads charged to the cost of production are greater than
the overheads actually incurred.
(b) Under absorption means that insufficient overheads have been included in the cost of
production.
5.2 The reasons for under-/over-absorbed overhead
The overhead absorption rate is predetermined from budget estimates of overhead cost and the
expected volume of activity. Under or over recovery of overhead will occur in the following
circumstances.
• Actual overhead costs are different from budgeted overheads.
• The actual activity level is different from the budgeted activity level.
• Both actual overhead costs and actual activity level are different from budget.
5.3 Example: under and over absorption of overheads
6 Activity based costing
• Activity based costing (ABC) is an alternative approach to absorption costing. It involves the identification
of the factors (cost drivers) which cause the costs of an organization's major activities.
• 6.1.1 In the past
• Most organizations used to produce only a few products. Direct labor costs and direct material costs
accounted for the largest proportion of total costs and so it was these variable costs that needed to be
controlled.
• Overhead costs were only a very small fraction of total costs and so it did not particularly matter what
absorption costing bases were used to apportion overheads to products.
• 6.1.2 Nowadays
• Manufacturing is capital and machine intensive rather than labor intensive and so direct labor might
account for as little as 5% of a product's cost. For example, furniture is no longer made by skilled workers.
Instead complicated expensive machines are programmed with the necessary skills and workers become
machine minders.
• Advanced manufacturing technology (such as robotics) has had a significant impact on the level of
overheads. For example, the marginal cost of producing a piece of computer software might be just a few
kq but the fixed (initial) cost of the software development might run into millions of pounds.
• Many resources are used in support activities such as setting-up, production scheduling, first item
inspection and data processing. These support activities help with the manufacture of a wide range of
products and are not, in general, affected by changes in production volume. They tend to vary instead in
the long term according to the range and complexity of the products manufactured.
6.2 ABC and using it to calculate product costs

6.2.2 Cost drivers

A cost driver is 'a factor influencing the level of cost'.

ABC uses volume-related cost drivers such as labor hours or machine hours. The cost of oil used as a lubricant on machines
would therefore be added to products on the basis of the number of machine hours, since oil would have to be used for each
hour the machine ran.
For costs that vary with some other activity and not volume of production, ABC uses transaction-related cost drivers
such as the number of production runs for the production scheduling activity.
6.2.3 Calculating product costs using ABC