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Absorption costing requires managers to gather information on the direct costs, such as materials,
and also the indirect costs or overheads such as admin costs. This method enables us to calculate
the cost of production as precisely as possible. If the cost of meeting an order is underestimated,
then the business might set the price too low, and make a loss on the order. Or, vice versa, the cost
could be too high, and then the business might lose the order to a competitor.
Cost centres and cost units
We must firstly collect and record the production costs and overheads of running a business. A
cost centre is a particular area or point of a business for which costs are collected.
In the case of manufacturing businesses, there are two main types of cost centre:
When we have collected and recorded costs into cost centres, the process of absorption costing
involves calculating the cost of each unit of production or Cost Unit.
What is absorption costing?
It is also known as full or total costing. The key point is that all overheads (indirect costs) are
absorbed into cost units. Therefore, all costs are included when calculating the cost of
producing particular items.
The main difficulty of absorption costing is deciding how to divide the cost of overheads
(indirect) between these cost centres (more on this later).
There are 5 main stages in the absorption costing process:
1.) The first stage is the ALLOCATION of those overhead costs that are directly incurred by
particular cost centres (remember the above explanation of what a cost centre is), for
example, we might be able to pinpoint depreciation of a machine to the production
department.
2.) The second stage is to APPORTION, i.e. divide all shared overheads between the
production and service cost centres. (For example, sharing the rent of a building between
several cost centres contained within that building).
3.) The third stage is to apportion or reapportion all service cost centre overheads to the
production cost centres. This is also called secondary apportionment (an example might be
splitting the cost of running a canteen (service cost centre) up amongst several production
cost centres. The reason is that it is only the production cost centres that are directly
associated with the manufacture of the cost units.
4.) The fourth stage is to ABSORB the allocated and apportioned overheads into the costs of
production of cost units.
5.) Finally include direct costs, which can easily be attributed to individual products (cost units).
This stage may have been completed in stage one, so could be ignored depending on the
question.
Stage 1 ALLOCATION
We must include the direct and indirect costs of production. Most exam questions provide direct
costs associated with particular products or cost units, so can easily be charged to the relevant cost
centre. For example, wages paid to assembly line workers can be allocated directly to the
production department. Note: Sometimes this part is left until the end of the calculation.
Some indirect costs that are wholly associated with a particular cost centre can also be charged
directly to that cost centre. Examples might include the wages of an assembly line supervisor,
or depreciation of an assembly line machine. They can be allocated directly to the production
department.
Not all indirect costs can be charged to production departments. For example, the rent of a sales
office might be charged directly to the sales department (service cost centre).
Example: Consider Dentons Ltd, a clothing manufacturer.
directly
allocated costs
Cutting
(production)
8,500
Assembly
(production)
10,500
Canteen
(service)
4,400
Maintenance
(service)
6,600
Total
30,000
It is important to apportion the overheads fairly because businesses will want to determine as
accurately as possible the true cost of operating each cost centre. If they are not apportioned fairly,
the business might charge an inappropriate price to its customers.
Also, managers (who are responsible for cost centres) might be demotivated, if their centres are
charged an unrealistic share of overheads, as it would suggest they are running an expensive
department, and seem perhaps inefficient.
Example: Consider Dentons Ltd, a clothing manufacturer. They have three overheads, 10,000 for
heating, 40,000 in wages for 2 supervisors and 20,000 for insuring equipment. The
business is divided into 4 cost centres.
Some further information about Dentons Ltd is provided in the table below.
Floor area
Staff employed
Book value of
equipment
Total
400m2
50
200,000
We must now apportion the 3 overheads, to the cost centres. The earlier table gave examples of
how this can be done.
Heating: The heating costs of 10,000 can be apportioned according to the proportion of total
floor space each that each cost centre occupies.
Cost to be apportioned
So:
Cutting
25m2
Assembly
_____
400m2
10,000
Canteen
_____
400m2
10,000
Maintenance =
_____
400m2
Supervision: The supervisory costs of 40,000 can be apportioned according to the proportion of
total staff employed in each cost centre.
Cost to be apportioned = number of staff employed by cost centre * total supervisor cost
Total number of staff
So:
Cutting
__
40,000
Assembly
__
50
Canteen
__
40,000
50
Maintenance =
__
50
40,000
Insurance: The insurance costs of 20,000 can be apportioned according to the total book value
of equipment (fixed assets) used in each cost centre.
Costs to be apportioned = book value of equipment in cost centre * total insurance cost
Total book value
So:
Cutting
=
_______
*
20,000
=
200,000
Assembly
_______
200,000
Canteen
______
200,000
20,000
Maintenance =
_____
200,000
20,000
The following table shows the share of overheads apportioned to each cost centre. Sometimes
more than one basis for apportionment could be used. For example buildings insurance could be
apportioned according to the size of the floor area of each cost centre, OR to the book value of the
buildings of each cost centre. It is therefore a subjective judgement. However, it should always
be made clear which basis is chosen, and the decision should be consistent and appropriate.
Basis of
apportionment
Heating
Supervisory
Insurance
Total
Floor area
No.of employees
Book value
Cutting
Assembly
Canteen
Maintenance Total
625
12,000
5,000
17,625
5,000
24,000
13,500
42,500
2,500
1,600
1,000
5,100
1,875
2,400
500
4,775
10,000
40,000
20,000
70,000
Stores
We can now illustrate how overheads are apportioned to production cost centres. Firstly we will
consider each cost centre as it stands now, and then reapportion the service cost centre
overheads to the production cost centres.
directly
allocated costs
Apportioned
costs
Total
Cutting
(production)
8,500
Assembly
(production)
10,500
Canteen
(service)
4,400
Maintenance
(service)
6,600
Total
17,625
42,500
5,100
4,775
70,000
26,125
53,000
9,500
11,375
100,000
30,000
The directly allocated costs are those costs such as depreciation of a specific machine that
can be associated straight away with a particular cost centre (stage 1).
The apportioned costs are taken from the workings on the previous page (stage 2). They are
those costs which needed apportioning to different cost centres.
We now need to reapportion the service cost centre (canteen and maintenance) costs in the
following ways:
Canteen: according to the number of meals served to staff in each cost centre
Maintenance: according to the number of hours that maintenance staff work in each cost
centre.
Canteen: No of
meals
(as a % of total)
Maintenance:
No. of hours
(as a % of total)
Cutting
3,750
Assembly
7,500
Canteen
-
Maintenance
1,250
Total
12,500
30%
3,000
60%
3,000
10%
-
100%
6,000
50%
50%
100%
The total number of meals served is 12,500. These are split up amongst the three
departments. This example presumes that no canteen staff have meals.
The 6,000 maintenance hours are split equally between the cutting and assembly
departments.
Cutting
26,125
Assembly
53,000
Canteen
9,500
Maintenance Total
11,375
100,000
2,850
5,700
(9,500)
950
28,975
6,162.50
58,700
6,162.50
12,325
(12,325)
100,000
35,137.50
64,862.50
100,000
The 9,500 canteen overheads need to be reapportioned to the two production cost centres.
Remember that the Cutting department used 30% of meals so = _______ (30% of 9,500)
The Assembly department used 60% of the meals so = _______ (60% of 9,500)
The Maintenance department used 10% of the meals so = _____ (10% of 9,500)
We can now reapportion the Maintenance overheads to the two production cost centres.
Remember the Maintenance overheads now include some reapportioned Canteen overheads.
Remember that both the Cutting, and Assembly cost centres used 50% of the Maintenance
hours. Therefore we can split the 12,325 Maintenance overheads equally, which = 6,162.50.
Imagine that in a machining department, the total annual overheads are estimated to be 250,000.
The budgeted annual total of machine hours in this cost centre is 10,000 hours.
Machine hour OAR
______
If a particular cost unit takes 6 hours to produce in the machining department then 150 (6 *
___) overheads will be absorbed to the production of that single unit.
Direct labour hour overhead absorption rate:
This method is most suitable when production is labour intensive, i.e. when direct labour costs
are high relative to capital costs.
Direct labour hour OAR
For example, a packaging department has total annual overheads estimated to be 60,000. The
budgeted annual total labour hours is 20,000 hours.
Direct labour hour OAR
______
If it takes hour to pack a cost unit, then 1.50 (0.5 * __) overheads will be absorbed to each
unit.
Step 5: Calculating the total cost unit
Firstly add together each production cost centre from step 4. e.g. 25 + 3 = 28.
The final step is to consider any direct costs (materials, labour etc) which would be provided in
the exam question (if these have not been dealt with in stage 1). We do not have to do any
working out with these direct costs, apart from perhaps working out the direct costs per unit
(if only a total is given). We can then add these direct costs to the first bullet point and we
have the total cost per unit!!!
Body shop produces the fibre glass parts that are needed to construct the boat.
Sub-assembly assembles the bought-in components.
Production
Packing and dispatch packs and dispatches the kits to customers.
Cost centres
Quality control This department overseas quality control in the 3 production cost centres.
This is therefore a service cost centre.
Body shop
8,000m2
600,000
Sub-assembly Packing
4,000m2
2,000m2
200,000
200,000
Quality control
2,000m2
-
Total
16,000m2
1,000,000
10
40
20
10
80
2,000
8,000
4,000
14,000
1,600,000
400,000
200,000
800,000
3,000,000
500
2,500
50,000
40,000
20,000
Sub-assembly
Packing
15 hours
8 hours
Body Shop
Subassembly
Packing
Quality
Control
Rent
Heat & Light
Depreciation
Administration
Total
Total
1,600,000
400,000
200,000
800,000
3,000,000
Step 2: Reapportion the overheads of the service department to the production departments.
In this example, the quality control department is a service cost centre, so needs to be
reapportioned to the other 3 production cost centres. The basis for reapportionment in this
case is the number of hours the quality control department works for each other department.
Body shop
Sub-assembly Packing
Quality control
Total
overheads
Quality control
reapportioned
Total
Total
3,000,000
3,000,000
Step 3: When all the overheads have been apportioned to the production cost centres, the next
step is to calculate the overhead absorption rates. (Remember either the machine or direct
labour hour OAR can be used).
In the exam, if you are not sure which OAR to use, then just decide if the department in question is
capital or labour intensive, and this will tell you which OAR to use!
The body shop uses the machine hour OAR.
The sub-assembly department uses the direct labour OAR.
The packing department uses the direct labour OAR.
Therefore:
Body shop:
Sub-assembly dept:
Packing dept:
Step 4: We can now calculate the number of overheads that can be charged to each cost unit,
i.e. boat. We just multiply the relevant OAR by the length of time it takes to process a single
cost unit in each department.
Department
OAR
Multiplied by
Number of hours
Cost per unit
Body shop
*
Sub-assembly
*
Packing
*
Total
917.50
Step 5: The final step is to calculate the total cost of each boat (cost unit) by adding the total
overheads (917.50 from above) charged per cost unit to the direct costs per unit (labour and
materials provided in the question).
3,917.50
Key definitions:
Allocation
Apportionment
Reapportionment
Absorption