One of the most important roles an accountant has is to help work out how much an organisation is spending in each area of the business.
For example, the costs of all the raw materials used to make a product can be added to the direct labour to provide the cost of making each item.
But what about costs like renting the building the product is made in? Or buying a piece of machinery to help make it? Accountants need to have a way of including some of these costs.
Absorption costing is used when management want to determine the full cost of one unit of output, including a proportion of the overheads.
This process is known as absorption costing because a proportion of the fixed cost is absorbed into the product cost.
There are three stages involved in absorption costing:
There are some costs incurred directly by one cost centre and we can therefore allocate those costs directly to the appropriate cost centre.
For example: A paint shop may have sole use of a paint spraying machine, therefore the associated costs are allocated to the paint shop’s cost centre.
A little more complex is apportionment, as this is where costs can relate to a number of cost centres. For example: the rent of the premises will relate to all cost centres within a factory. As such the organisation needs to find a way to apportion the cost in a fair and reasonable way.
Whichever basis of apportionment selected the calculation will be as follows:
Total cost / Total quantity x quantity related to cost centre
So, what will be the most appropriate method of apportionment for rent?
Answer: Area or Floor Space
Example: The factory rent for a company is £24,000 per annum. Within the factory there are 4 Cost centres occupying the following floor space.
This needs to be apportioned between the cost centres so the formula will be as follows:
Total cost of rent / Total area (SQ mtr) x Area in SQ mtr relating to the cost centre
Once we have allocated and apportioned overhead costs to the appropriate cost centres, the next stage is to find a mechanism to allow cost units passing through each cost centre to absorb overhead costs. The involves the OAR – Overhead Absorption Rate
OAR = Budgeted Production overhead / Budgeted Activity level
The two common examples will be based on
- Per labour hour (appropriate for labour-intensive production processes)
- Per machine hour (where production is controlled or dictated by machines)
An important aspect to note is that the OAR is calculated using budgeted values. We can then apply the OAR to the actual amount of work undertaken during the period to calculate the overheads that were actually absorbed.
Example Direct labour hours
Company A has two production departments. Once overhead costs are apportioned we have the following totals:
Production 1 total overheads: £90000, Production 2 total overheads: £72500. Now, our budgeted activity based on hours will be as follows.
If we apply the above formula our OAR based on labour hours will be as follows
Production 1: 90000 / 12200 = 7.38 per labour hour
Production 2: 72500 / 7320 = 9.90 per labour hour
Once we have calculated the OAR this then needs to be applied to the actual activity levels. At the end of the accounting period it was determined that the actual labour hours in Production 1 were 12,650 and Production 2 were 6,100.
The actual hours are then multiplied by the absorption rate which will provide us with the actual overheads absorbed.
Production 1: 7.38 x 12650 hours = £93357
Production 2: 9.90 x 6100 hours = £60390
Over and Under absorption of overheads
The company for Production 1 has calculated the OAR as 7.38 per direct labour hour. We know that the actual hours worked were 12650 and are now told that the actual overheads are £102,650.
Hopefully, you now have a solid understanding of absorption costing, and Overhead Absorption Rates, and are ready to start using them either in your studies or your workplace!
Adam Ruston-Shaw is a distance learning tutor at AVADO.