Absorption Costing

Example 1
A company is producing and selling 3,000 units of Product A on a monthly basis. Below are the
information related to this product.
Unit Cost $
Direct Material (1kg*$6 per kg) 6.00
Direct Labour (2hours*$4 per hour) 8.00
Direct Expenses 2.00

Heating and Lighting (monthly) 800

Rental (monthly) 1 700
Maintenance (monthly) 1 100

REQUIRED
a) Determine the overhead cost to be absorded by a unit of Product A.
b) Calculate the total cost per unit of Product A.

Unit costs
Prime cost $6 + $8 + $2 = $16

Overhead Analysis
To determine the overhead per unit for finished goods,

Absorption costing:
A method that absorbs overhead costs into the TOTAL PRODUCTION COST for each cost
unit produced.
 Considers all production costs, both fixed and variable.

Cohort 1803MA
Compiled by: Cheryl. TYX
 • Collection of Overheads
Step 1

• Identification of Cost Centres

• Production Cost Centre
Step 2 • Service Cost Centre

• Primary Distribution
• Allocation
Step 3 • Apportionment

• Secondary Distribution
Step 4 • Reapportionment

• Final distribution
• Absorption
Step 5 • Overheads Absorption Rate (OAR)

• Calculation of Overheads Per Unit (OH/Units)

Step 6

Cohort 1803MA
Compiled by: Cheryl. TYX
STEP 2
Cost Centres:
A production or service location whose costs may be attributed to costs units.
A department where costs are accumulated

Production department:
Where the products are manufactured

Service department:
Department that supports the other departments
Example: technical support, marketing

STEP 3
Allocation:
The process of charging costs that derived from a cost centre directly to the particular cost
centre.
Eg: direct costs allocated to relevant cost centre

Apportionment:
Many expenses of the business such as rent and rates are shared by a number of different cost
centres.
These joint expenses must be apportioned between cost centres on some suitable basis.
The process of charging overhead costs to a cost centre on a rational basis.

STEP 5
The total of each department is then absorbed into a cost unit using Overheads Absorption
Rate (OAR).

Overheads Absorption Rate (OAR):

An absorption rate which will absorb or include the overhead into the cost of each unit of
production.
The rate that is used to absorb the overheads into the cost unit.
 Usually rate per direct machine hour or the rate per direct hour.

The methods of absorption may be:

1. Direct labour hour rate
2. Direct machine hour rate
Most influential factor to the overhead

Could be more labour intensive or machine intensive (capital intensive)

Cohort 1803MA
Compiled by: Cheryl. TYX
 The Absorption of Overheads
The idea here with calculating an overhead absorption rate (OAR) is that we are using
𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅
= OAR
𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑩𝒂𝒔𝒆

1. Use direct labour hours = Labour intensive and there is little machinery used/ machine
costs are low.

2. Use the machine hour = Production methods are capital intensive or machinery costs are
relatively high.

3. Other suitable bases can also be direct labour cost rate, direct material cost rate, unit
produced rate and etc.

Overheads Absorption: Over/ Under Absorption of Overheads

 The actual overheads incurred will only be known or determined at the end of the
period.

However, evaluation of cost units (circulation of cost/unit) is an on-going process throughout the
period.
 Predetermined overhead absorption rates are required in advance of the period using
estimated or budgeted figures for overhead and for the number of units of the
absorption base.

Reason:
1. The total expected cost of production must be identified in advance
2. To enable selling prices to be calculated
3. Ensure that expected overhead costs are fully recovered.
4. Actual figures are not available

Cohort 1803MA
Compiled by: Cheryl. TYX
During the period:
Cost per unit:
$
Direct materials cost X
Direct labour cost X
Direct expense X
Prime Cost X

Production Overhead Absorbed X

Cost Per Unit (For Stock Valuation & Cost of Sales Calculation) X

PERIOD: PERIOD: PERIOD:

START DURING END

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑇𝑜𝑡𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝐴𝑏𝑠𝑜𝑟𝑏𝑒𝑑

𝑂𝐴𝑅 𝑥 Less
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐵𝑎𝑠𝑒
𝐴𝑐𝑡𝑢𝑎𝑙 𝐵𝑎𝑠𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑢𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝐼𝑛𝑐𝑢𝑟𝑟𝑒𝑑

Overhead Under/ Over Absorption

OAR
Absorbed of overheads

Step 1:
Budgeted Overhead
Budgeted Base
= OAR

Step 2:
OAR
x Actual Base
Overhead Absorbed

Step 3:
Overhead Absorbed
- Overhead Incurred (Actual)
Over/ (Under) Absorbed

Cohort 1803MA
Compiled by: Cheryl. TYX
Overhead absorption rate:
 Based on predictions of future levels of activity and budgeted levels of overhead
expenditure

Actual level = Budgeted level Expenditure on overheads

Actual overhead expenditure = budgeted expenditure will be recovered easily
Actual level of activity < budgeted level Under absorption of
Actual overhead expenditure = budgeted expenditure overheads
Actual level of activity = budgeted level Under absorption of
Actual overhead expenditure > budgeted expenditure overheads
Actual level of activity > budgeted level Over absorption of
Actual overhead expenditure = budgeted expenditure overheads
Actual level of activity = budgeted level Over absorption of
Actual overhead expenditure < budgeted expenditure overheads

Under absorption of overheads is debited to income statement.

Over absorption of overheads is credited to income statement.

A business provided the following information.

Budgeted overheads $20 000

Budgeted direct labour hours 2 000
Direct labour rate $20 per hour

A job used materials costing $45 and 6 hours of direct labour.

Overheads are charged on the basis of direct labour hours used.
What was the cost of the job before adding any profit?

A $165 B $175 C $180 D $225 √

Cohort 1803MA
Compiled by: Cheryl. TYX