allocate, apportion, absorb

This article focuses on production overhead absorption using, as an illustration, a question from the December 2005 CAT Scheme Paper 4 examination. It also considers the wider context of overhead allocation, apportionment, and absorption. The cost accounting for overheads (indirect costs) is an element in the CAT Paper 2 Study Guide. Sub-section 8(g) states that students are required to explain and illustrate the process of cost apportionment and absorption for indirect costs (excluding reciprocal services). This topic is explored further in CAT Scheme Paper 4, where two sections of the Study Guide are devoted to overhead allocation, apportionment and absorption, including Sub-section 9(a), which states that students are required to justify, calculate, and apply production cost centre overhead absorption rates using labour hour and machine hour methods. OVERHEAD COST SHARING Overheads are those costs that cannot be directly allocated to any of the products or services provided by a business to its customers. These costs, therefore, have to be shared out in some way among the various products or services in order to establish product/service costs. Overhead costs must be shared: as fairly as possible over the different cost centres and cost units that use the particular resources in question in ways that are administratively feasible so that the benefits from having and using the information (ideally) exceed the cost of its provision. 50 student accountant August 2006 PRODUCTION OVERHEAD ALLOCATION, APPORTIONMENT, AND ABSORPTION Production overheads are a popular topic in study materials and examination questions. At the very least, costs have to be shared among products in order to value work-in-progress and finished goods stocks. By refining what may otherwise be an arbitrary process, accountants can provide useful information that will help management in cost control and profitability analysis. An important part of such refinement involves the establishment of cost centres (both production cost centres and service cost centres) in order to: delegate management responsibility for costs incurred increase the accuracy of cost sharing by allocating costs at a lower level and sharing them on different bases. A further refinement is the use of budgets to facilitate cost control and the sharing of costs in advance. There are three main steps in the process of production overhead cost sharing: allocation, apportionment, and absorption. Allocation collection of costs by type allocation of as many costs as possible directly to cost centres. Apportionment apportionment to cost centres of establishment costs those costs that cannot be allocated directly to individual cost centres re-apportionment of service cost centre overheads to production cost centres. Products/services pick up overhead costs out of the production cost centres via overhead absorption, as production occurs. Absorption establishing an absorption rate for each production cost centre absorption of overheads into cost units. The key issue in establishing how to apportion, re-apportion, and absorb overheads is fairness. When considering cost apportionment/ re-apportionment for each overhead cost type (or service cost centre) that has to be shared, the important principle is to identify the key driver of the cost. In other words, what is the main cause of the cost incurred? The same general principle applies to overhead absorption. There are many different causes, and thus many drivers, that traditionally have been encapsulated (for each production cost centre) in a single basis for overhead absorption. Typically, this is achieved by using an activity measure based on direct labour hours or machine hours, because the production activity of each product can be measured in this way and used to absorb overheads. More than one basis could be used in each cost centre if there are clearly different drivers. If overhead cost budgets are prepared, then predetermined absorption rates can be established and used. This gives rise to production overhead over-absorption or under-absorption in each production cost centre resulting from the comparison of

technical

overhead absorption
relevant to CAT Scheme Papers 2 and 4

the actual overhead costs allocated and apportioned with the total costs absorbed. QUESTION Question 2(b), in Section B of the December 2005 Paper 4 examination, tested candidates ability to calculate and use predetermined production overhead absorption rates when the allocation and apportionment of the overheads had already taken place. Part (b) of the question was as follows: Overheads allocated, apportioned, and re-apportioned to the two production cost centres in a factory for a period were: Budget Actual

Production cost centre X Y 161,820 97,110 163,190 96,330

Production cost centre X Y Machine hours: Budget Actual Direct labour hours: Budget Actual 8,700 8,960 6,220 6,276 1,760 1,725 8,300 7,870

Overheads are absorbed using predetermined rates. A machine hour rate is used in production cost centre X and a direct labour hour rate in production cost centre Y. Machine and direct labour activity in each production cost centre is:

Required: Calculate for each production cost centre for the period: i the predetermined production overhead absorption rate ii the production overheads absorbed August 2006 student accountant 51

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Answer (with explanation) The first stage in production overhead absorption is to calculate absorption rates using budgeted data (ie predetermined rates). The question states that a machine hour rate is to be applied in production cost centre X, and a direct labour hour rate in production cost centre Y. Thus: Production cost centre X: 161,820 8,700 machine hours = 18.60 per machine hour Production cost centre Y: 97,110 8,300 direct labour hours = 11.70 per direct labour hour These predetermined rates are then used throughout the budget period to absorb overheads on the basis of actual hours worked; overheads are transferred (absorbed) from the production overhead accounts to the work-in-progress accounts on a regular basis. Over the whole period, the total of the production overhead absorbed from each cost centre is: Production cost centre X: 8,960 machine hours @ 18.60 per machine hour = 166,656 Production cost centre Y: 7,870 direct labour hours @ 11.70 per direct labour hour = 92,079 The amount of overheads have therefore been transferred into the cost of the different products manufactured (along with the allocated direct materials and direct labour costs), and subsequently into cost of sales when the products are sold. Ultimately, however, it is the actual production overhead costs incurred that are charged against sales, along with all the other actual costs, to determine profit. The final stage in the overhead absorption process is, therefore, to make a comparison between the actual costs incurred (debited to individual cost centres and, in total, to the production 52 student accountant August 2006

technical
the over/under-absorption of production overhead.

The key issue in establishing how to apportion, re-apportion, and absorb overheads is fairness. When considering cost apportionment/ re-apportionment for each overhead cost type (or service cost centre) that has to be shared, the important principle is to identify the key driver of the cost.
overhead control account) and the overheads absorbed into product costs in work-in-progress (credited to individual cost centres and, in total, to the production overhead control account). Any difference will be either an under-absorption or an over-absorption depending on whether more or less has been incurred than absorbed. So: Production cost centre X: actual 163,190 - absorbed 166,656 = 3,466 over-absorbed (less incurred than absorbed) Production cost centre Y: actual 96,330 - absorbed 92,079 = 4,251 under-absorbed (more incurred than absorbed) Any under-absorption is a further charge that reduces profit: any over-absorption is added back to increase profit. Examiners comments A number of candidates were well-prepared and scored full marks on this question. However, a serious lack of understanding of absorption costing was demonstrated by many. Candidates need to appreciate that overhead absorption rates are typically established in advance of a period on the basis of budgeted data. Overheads are then absorbed during the period using the predetermined rates but this time on the basis of actual activity. Over/under-absorption of overheads arises due to differences between overheads actually incurred in the period and those absorbed into the cost of work done in the period.

Many candidates were able to calculate the required overhead absorption rates in Part (i), although several calculated other rates as well (for example, labour hour rate and machine hour rate for each cost centre and/or on actual costs and hours). Apart from not answering the question, which clearly stated the basis for calculating the predetermined rate to be used in each of the cost centres, a lot of time was wasted on unnecessary calculations. This was often carried over to Parts (ii) and (iii) where further incorrect and unnecessary calculations were made. There were also many scripts where candidates added hours to or added labour hours and machine hours together. Where candidates calculated the correct rates in Part (i), and no further rates, they were frequently unable to apply the rates to answer Parts (ii) and (iii). Many, seemingly, could not calculate the overheads that would be absorbed in each cost centre. A common error in Part (ii) was the calculation of further absorption rates, this time on the actual data (costs and hours). A very common error to Part (iii) was the comparison of actual and budgeted costs. A few candidates even compared actual and budgeted hours. Not infrequently, candidates calculated absorption rates in answer to Part (i) using the actual figures, rather than the budgeted figures, and got an answer for each cost centre which they rounded. In answer to Part (ii), they then simply multiplied the actual absorption rate by the number of hours they had divided by in Part (i) the resulting number was inevitably very similar to the actual costs they had started with in Part (i). Finally, in Part (iii), candidates compared the two numbers (actual and absorbed) to produce a very small over/under-absorption due to the rounding in Part (i). It is disappointing that coverage of this topic in Paper 2, as well as Paper 4, did not produce good results in the Paper 4 exam. I hope that candidates now have a better idea about production overhead absorption and its role in the overhead allocation, apportionment and absorption process. Nigel Coulthurst is examiner for CAT Scheme Papers 2 and 4