Absorption Costing

IS ONE OF THE TRADITIONAL COSTING METHODS.

 Absorption costing
 It is important that the business is able to calculate what each
product or service has cost to make or provide.

The cost to make a product helps the business to fix a selling

price in order to recover the costs in operating the business and
to provide profits to ensure the survival of the business.

Absorption costing determines the total cost of production,

that is why sometimes it is called total costing.

The total costs incurred in the production of the product are

absorbed into the cost of production.
Example
Answer
Benefits of absorption
costing
 Limitations of
absorption costing
Overheads
Overheads
How to apportion overheads to
cost centres
Key terms

Cost centre: Any location, usually a department, in a business to which costs may be attributed. Is
usually a department or process, but may be an item of equipment (a machine) or even a person, for
example, a marketing manager.

Production cost centres: Locations which are directly involved in producing goods, for example,
moulding or shaping raw materials, assembling components, painting.

Service cost centres: Locations which are not involved in the production of goods, but provide services
for the production cost centres, for example, stores, building and plant maintenance, canteen etc.
Allocation and apportionment of
costs to production cost centres
Direct expenses and some overhead expenses, such as indirect labour or materials, can be identified
with specific cost centres and are allocated directly to them(allocation costs).

Allocation of costs: is the charging of costs directly to the costs centres which can be directly identified
with them.

Other overheads are incurred for the business generally and are apportioned to cost centres on suitable
bases (apportionment of costs).

Apportionment of costs: The process of charging costs to cost centres using a suitable basis. Such costs
cannot be directly identified with a single cost centre.
 Overhead Basis of apportionment
• Heating and lighting (when not separately • In proportion to the respective floor areas of the
metered to the cost centres) rent, insurance of departments.
buildings.
• Power (if metered separately to cost centres) • Actual consumption (this is allocation rather
than apportionment).
• Insurance of plant, machinery and other assets • On cost or replacement values of assets in each
department.
• Depreciation of non-current assets • On the cost or book value of assets in each
department.
Key terms to remember
Overhead allocation is used when the whole expense is directly related to one department.

Overhead apportionment is used when the overhead is related to more than one department .

A production department is one which is directly involved in manufacturing the products.

 A service department is one which is not directly involved in manufacturing the products but
provides support to other departments.
Example on
how to Activity 4, pages 510-511, Randall and
apportion Hopkins

overheads.
Transfer of service cost centre
costs to production cost centres.
Apportionment of service cost centre
overheads to production cost centres
Service cost centre Apportioned on
• Stores • Number or value of stores requisitions
raised by production cost centre.
• Canteen • Number of persons in each production
cost centre.
• Building maintenance • Area occupied by each production cost
centre*.
• Plant and machinery maintenance • Number or value of machines in each
cost centre.
 Once overheads have been apportioned to cost centres, the
next step is to calculate overhead absorption rates
(OARs).

How to The OARs are then used to calculate the amount of

overhead to be attributed to each cost unit as it passes

calculate
through each cost centre.
Cost units are units of production. For example:
overhead •A computer (computer manufacturer).

absorption •A garment (dress maker).

rates
•A thousand electric lamps (manufacturer of electric lamps).
•A barrel of oil (oil well)
•Passenger-mile (freight transport)
•A kilowatt-hour (electricity generation)
 Overhead absorption rates are calculated for future
periods because the cost of production must be known
in advance to enable selling prices to be fixed.
Calculations are based on planned volumes of output
and budgeted, or forecast, overhead expenditure.

The amount of overhead absorbed by a cost unit is

usually calculated by reference to the time taken to
produce it.
Direct
labour A process is labour intensive when it requires
the use of labour rather than machines, and the
overhead labour cost is greater than the cost of using

absorption machinery. The time is measured in direct

labour hours.
rate
Machine hour overhead
absorption rate
A cost centre is capital intensive when the operations carried out in the centre are mechanised and the
machinery running cost is greater than the direct labour cost. Overhead should then be absorbed on a
machine hour rate (machine hour OAR).
Example
REFER TO AUSTEN PAGE 234
The use of Once the OAR has been calculated, it is
the OAR possible to calculate the full cost of a cost unit.
Example
REFER TO AUSTEN PAGE 234
Under-/over-absorption of
overheads
OARs are calculated on planned levels of production and budgeted overhead expenditure. It is most
likely that the actual volume of goods produced and the actual overhead expenditure will turn out to
differ from the forecasts. The result will be that overhead expenditure will either be under-absorbed or
over-absorbed.

Under-absorption occurs when: Over-absorption occurs when:

• Actual expenditure is more than budget
expenditure.
• And/or production is less than the planned level.
In this case not enough overhead has been
charged to production.
• Actual expenditure is less than budget
expenditure.
• And/or actual production is more than the
planned level. In this case too much overhead has
been charged to production.
Under absorption or over
absorption
•The difference is recorded as an adjustment within the absorption
costing statement.

•Over absorption is credited to the income statement.

•Under absorption is debited to the income statement.

EXAMPLE
Refer to Austen page 235
Questions
Thank you.