Absorption Costing

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Absorption Costing

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Overheads• Overheads are those costs that cannot be directly related to a product.

Examples of these can be factory rent, factory lighting, deprecation of machinery etc.

• In Cost Volume Profit Analysis (Marginal Costing) all overheads were lumped together and were treated separately.

• In Overhead Absorption overheads are studied in greater depth.• It will be seen that different overheads behave in different ways.• It is also arguable that the actual cost of a product should include an

appropriate element of overheads in addition to the variable costs.• Absorption Costing tries to include an appropriate amount of the

overheads to each and every product.• This is not always an easy task and there are several steps needed to

achieve this.

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The Road from Guildford to London is called the A3. You need to remember 3A’s for the process of involved

in Absorption Costing (Please remember the colour coding for the rest of the slides)

A LLOCATEPPORTIONBSORB

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Let us imagine that there are five departments in a factory – The Production departments are in green and the service departments are in red

1. Machining2. Finishing3. Packing4. Canteen5. Stores

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Given below is a picture of Cupid. According to Greek mythology Cupid finds an appropriate couple fires arrows at the hearts of the two individuals and

they fall in love and remain together forever!!

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Absorption Costing requires you to “Cupidify” (or interrelate)

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We shall first concentrate on the first of the thee A’s - ALLOCATE

• There are some overheads that belong exclusively to a production or service department.

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Can you “Cupidify” or ALLOCATE the following costs to the correct department?

1 Machining A Stock Requisition paper

2 Finishing B Food

3 Packing C Machine Oil

4 Canteen D Cardboard boxes

5 Stores E Quality Control

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Did you get them right?

1 Machining C Machine Oil

2 Finishing E Quality Control

3 Packing D Cardboard boxes

4 Canteen B Food

5 Stores A Stock Requisition paper

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The following stages are generally used to estimate the amount of overheads, (such as rent), that is absorbed into each product

1. The overheads are normally charged to the cost centres (normally departments) that use them

2. The departments then charge the overheads to the cost units (products) they work on.

overheads departments

departments

products

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Absorption costingStage 1 Overheads will be charged to cost centres/ departments. This process is known as allocating & apportioning

Rent (floor space)

Ordering costs (No. of orders)

Chef’s Wages

Production Dept. A

Production Dept. B

Canteen

Machinery depreciation

(Value of mach.)

Allocating

Apportioning

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Production Dept. A

Production Dept. B

Canteen

The departments then must charge their overheads to the products they work on.

The canteen does not work on any products because it is not a production department. It must recharge its overheads to the production departments

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ExampleThe annual overhead costs for a company which has two production centres and two service centres (Maintenance & Canteen) are as follows:

Dept. 1 Dept. 2 Maint. CanteenTotal£ £ £ £ £

Food & drink 4,000Rent & Rates 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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You are also given the following information:Dept. 1 Dept. 2 Maint. Canteen Total

Floor space (sq. m) 10,000 12,000 5,000 3,000 30,000Value of machinery (£) 150,000 120,000 20,000 10,000 300,000No. of employees 40 30 10 80

The canteen staff are outside contractors

The maintenance department provides 12,000 service hours to Department 1 and 10,000 hours to Department 2Dept. 1 is machine intensive and Dept. 2 is labour intensiveBudgeted machine hours for Dept.1 is 6,320 and budgeted labour hours for Dept. 2 is 7,850

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Basis Dept. 1 Dept. 2 Maint. CanteenTotal£ £ £ £ £

Food & drink 4,000Rent & Rates 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

The food and drink should be allocated to the canteen department


Food & drink Allocate 4,000 4,000Rent & Rates 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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Food & drink Allocate 4,000 4,000Rent & Rates 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

The rent & rates should be apportioned to all the departments, but how?The more floor space, each department occupies, the more rent it should be charged

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Food & drink 4,000 4,000Rent & Rates 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

e.g., rent & rates charged to Dept. 1 =

£18,000 x 10,000 sq. m / 30,000 sq. m = £6,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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Food & drink 4,000 4,000Rent & Rates floor space 6,000 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

rent & rates charged to Dept. 2 =

£18,000 x 12,000 sq. m / 30,000 sq. m = £7,200


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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rent & rates charged to Maintenance =

£18,000 x 5,000 sq. m / 30,000 sq. m = £3,000


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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rent & rates charged to Canteen =

£18,000 x 3,000 sq. m / 30,000 sq. m = £1,800


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000

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e.g., heating & lighting charged to Dept. 1 =

£12,000 x 10,000 sq. m / 30,000 sq. m = £4,000


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting 12,000Depreciation 30,000Supervision 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 12,000Depreciation 30,000Supervision 24,000

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£12,000 x 10,000 sq. m / 30,000 sq. m = £4,000


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 12,000Depreciation 30,000Supervision 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 12,000Depreciation 30,000Supervision 24,000

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£12,000 x 12,000 sq. m / 30,000 sq. m = £4,800




Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 12,000Depreciation 30,000Supervision 24,000

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e.g., heating & lighting charged to Maintenance =£12,000 x 5,000 sq. m / 30,000 sq. m = £2,000




Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 12,000Depreciation 30,000Supervision 24,000

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heating & lighting charged to Canteen =

£12,000 x3,000 sq. m / 30,000 sq. m = £1,200




Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation 30,000Supervision 24,000

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e.g., depreciation charged to Dept. 1 =

£30,000 x £150,000 / £300,000 = £15,000




Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation 30,000Supervision 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 30,000Supervision 24,000

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e.g., depreciation charged to Dept. 2 =

£30,000 x £120,000 / £300,000 = £12,000




Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 30,000Supervision 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 30,000Supervision 24,000

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e.g., depreciation charged to Maintenance =

£30,000 x £20,000 / £300,000 = £2,000






Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 30,000Supervision 24,000

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e.g., depreciation charged to Canteen =

£30,000 x £10,000 / £300,000 = £1,000






Food & drink Alocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision 24,000

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e.g., supervision charged to Dept. 1 =

£24,000 x 40 / 80 = £12,000




Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 24,000

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£24,000 x 40 / 80 = £12,000




Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 24,000


Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 24,000

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£24,000 x 30 / 80 = £9,000






Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 9,000 24,000

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e.g., supervision charged to Maintenance =

£24,000 x 10 / 80 = £3,000






Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 9,000 3,000 24,000

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e.g., supervision charged to Canteen =

£24,000 x 0 / 80 = £0






Food & drink Allocate 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 9,000 3,000 0 24,000

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All overheads have now been allocated or apportioned to the cost centres (departments)


Food & drink 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 9,000 3,000 0 24,000



37,000 33,000 10,000 8,000 88,000

The next stage would be for the centres to charge the overheads to the products they work on

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37,000 33,000 10,000 8,000 88,000

However, the service departments do not work on any of the products so cannot charge or absorb the overheadsThe service departments will have to reapportion their overheads to the production departments

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37,000 33,000 10,000 8,000 88,000Reapportion canteen employees (8,000)

The service departments’ overheads will be reapportioned on the basis of the amount of work done by the other departments

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37,000 33,000 10,000 8,000 88,000Reapportion canteen employees 4,000 3,000 1,000 (8,000) 0

The service departments’ overheads will be reapportioned on the basis of the amount of work done by the other departments

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11,000 0 11,000Reapportion main.

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11,000 0 11,000Reapportion main. 12:10 6,000 5,000 (11,000) 0

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Food & drink Allocating 4,000 4,000Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000Depreciation £machinery 15,000 12,000 2,000 1,000 30,000Supervision employees 12,000 9,000 3,000 0 24,000


11,000 0 11,000Reapportion main. 12:10 6,000 5,000 (11,000) 0

47,000 41,000 0 88,000

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Can you use the information in slides 13-14 to develop a spread sheet to automate the calculations?

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AbsorptionThe production departments must now charge (absorb) their overheads to the products they work on

To do this we need to calculate an absorption rate for each department. Always remember that Overhead Absorption Rate (OAR) is predetermined

overhead absorption rate

= budgeted expenditurebudgeted activity

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Dept. 1 Dept. 2£ £

Budgeted expenditure 47,000 41,000Budgeted machine hours 6,320Budgeted labour hours 7,850Absorption rate 7.44 5.22

per mhr per lhr

Dept. 1 Dept. 2£ £

Budgeted expenditure 47,000 41,000Budgeted machine hoursBudgeted labour hoursAbsorption rate

You are also told the time spent by each department on each product

Department 1 spends 2 machine hours on each Product X and 1.5 hours on each Product Y

Department 2 spends 3 labour hours on each Product X and 4 hours on each Product Y

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Now that each dept knows its absorption rate and the amount of work done (measured in hours) on each product, they can absorb (charge) the overhead to X and Y.

Absorption

X (£) Y (£)Department 1 (£7.44/m. hr)= £7.44 x 2 m.hrs

Department 2 (£5.22/l. hr)= £5.22 x 3 l.hrs

14.88

15.66

30.54Total absorbed

= £7.44 x 1.5 m.hrs 11.16

= £5.22 x 4 l.hrs 20.8832.04

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Absorption Costing

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