ACCA F2 Management Accounting - 2010 - Study text - Emile Woolf Publishing
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Paper F2
Management Accounting
CHAPTER
6
Accounting for overheads
Contents
1 Definitionandpurposeofabsorptioncosting
2 Stagesinabsorptioncosting
3 Overheadapportionment
4 Apportionmentofservice departmentcosts
5 Overheadabsorption
6 Underabsorbedandoverabsorbedoverheads
7 Fixedandvariableoverheads
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Definition and purpose of absorption costing
Introduction to absorption costing
The treatment of direct and indirect expenses
Definition of absorption costing
The purpose of absorption costing
1 Definition and purpose of absorption costing
1.1 Introduction to absorption costing
This chapter describes the basic principles and methods of absorption costing.
Absorption costing is a method of costing in which overhead costs are added to the
cost of cost units, and a ‘full cost’ is calculated. The full cost of an item is the prime
cost plus a share of overhead costs.
The absorption costing method can be used in either manufacturing industries or
service industries, but it is more commonly associated with costing for
manufacturing. This is because in manufacturing there are usually large quantities
of inventory, and work-in-progress and finished goods are normally valued (or
‘costed’) to include some production overhead costs.
The absorption costing method therefore focuses mainly on production costs and
the treatment of production overheads.
1.2 The treatment of direct and indirect expenses
In cost accounting, direct and indirect costs are treated differently.
Direct costs are charged directly to the cost of production. They are directly
identified with cost units, batches of production, a production process or a job or
a contract.
Overheads are indirect costs, and cannot be identified directly with specific cost
units, jobs or processes etc. They are therefore recorded as overhead costs, and a
distinction is made between production overheads, administration overheads
and sales and distribution (marketing) overheads.
Overhead costs can then be treated in either of two ways.
Method 1 – Marginal costing. They might be treated as period costs, and
charged as an expense against the period in which they are incurred, without
any attempt to add a share of the overhead costs to the cost of units of
production.
Method 2 – Absorption costing. They might be shared out between cost units or
processes. Overhead costs might be charged to cost units in addition to direct
costs, so that the cost of goods sold (the cost of cost units) includes a fair share of
overhead costs.
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$ per unit
Direct material costs A
Direct production labour cost B
Production overheads C
Full production cost
(A + B + C) = D
Administration overhead E
Sales and distribution overhead F
Full cost of sale
D + E + F
This chapter deals with absorption costing. In absorption costing, a share of
overhead costs is added to direct costs, to obtain a ‘full cost’ or a ‘fully absorbed
cost’ for cost units. This chapter explains the methods that are used to calculate the
amount of overhead costs to add to unit costs in order to obtain a full cost per unit.
Marginal costing is explained in a later chapter.
1.3 Definition of absorption costing
Absorption costing is based on the idea that the cost of a product or a service should
be:
its direct costs (direct materials, direct labour and sometimes direct expenses)
plus a share of overhead costs.
Absorption costing is therefore a system of costing in which a share of overhead
costs is added to direct costs, to obtain a full cost. This might be:
a full production cost, or
a full cost of sale.
An absorption costing system might be used to decide the full production cost of
the product, so that only a share of production overheads is added to product costs.
Administration overheads and selling and distribution overheads are simply
charged as an expense to the period in which they occur.
Income statement: absorption costing
$000 $000 $000
Sales 950
Cost of inventory at the beginning of the period 80
Production cost of items manufactured in the period:
Direct materials 280
Direct labour 120
Direct expenses (if any) 0
Production overhead added to cost (‘absorbed’) 240
640
720
Less: Cost of inventory at the end of the period (120)
Production cost of items sold 600
Gross profit 350
Administration overhead 100
Selling and distribution overhead 200
300
Net operating profit 50
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Inventory valuation is an important feature of absorption costing, because the cost
of production in any period depends partly on the valuation of opening and closing
inventory, including work-in-progress and finished goods inventory.
In some costing systems, a share of administration overhead and selling and
distribution overhead might be added to the full production cost, to obtain a full
cost of sale. However, it is not common practice to calculate a full cost of sale,
because it has only limited value as management information.
1.4 The purpose of absorption costing
There are several reasons why absorption costing is sometimes used, and
production overhead costs are added to direct costs to calculate the full production
cost of products (or services).
There is a view that inventory should include a fair share of production
overhead cost. This view is applied in financial accounting and financial
reporting. It can therefore be argued that inventory should be valued in a similar
way in the cost accounting system. (However, inventory valuations may differ
between the cost accounts and the financial accounts.)
There is also a view that in order to assess the profitability of products or
services, it is appropriate to charge products and services with a fair share of
overhead costs. Unless products contribute sufficiently to covering indirect costs,
its ‘profitability’ might be too low, and the business as a whole might not be
profitable.
Criticisms of absorption costing
There are criticisms of absorption costing. The main criticisms are as follows:
Absorption costing does not provide reliable information about profitability.
Methods of charging overhead costs to products, as we shall see, are not
‘scientific’, and rely on fairly arbitrary assumptions.
There are better methods of measuring profitability, such as marginal costing.
There are also better ways of providing cost information to help managers make
decisions (relevant costs). Marginal costing and relevant costs are explained in
later chapters.
When absorption costing was first used in manufacturing, well over 100 years ago,
total overhead costs were fairly small compared with direct costs. Manufacturing
was labour-intensive, and direct labour costs were a significant proportion of total
costs. Adding a share of overheads to product costs, usually in proportion to the
cost of direct labour or direct labour time, was therefore a reasonable method of
dealing with overhead costs.
In a modern manufacturing environment, however, direct labour is a fairly small
proportion of total costs. Most work in production now consists of the ‘support’
activities of indirect labour employees, and the cost of this labour is an overhead
cost. Overhead costs are high compared to direct labour costs. As a consequence, it
is often argued that a costing system should use a different approach to overhead
costing, and try to present overhead costs in a way that is more useful to
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management for information purposes. One such technique, activity based costing,
is outside the scope of the syllabus.
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Stages in absorption costing
Cost centres and general expenses
Allocation, apportionment and absorption (recovery)
Overhead cost allocation
2 Stages in absorption costing
2.1 Cost centres and general expenses
In a system of absorption costing, each item of overhead cost is charged either:
to a cost centre, or
as a general expense.
The cost centres might be:
a cost centre in the production function (production overhead)
a cost centre in administration (= administration overhead)
a cost centre in sales and distribution (= sales and distribution overhead).
The cost centres in the production function might be:
a department engaged directly in production work (a production department), or
a department or service section engaged in support activities, such as inventory
management, production planning and control, quality control, repairs and
maintenance, and so on (= ‘service departments’).
In a system of absorption costing, overheads are charged to products or services on
the basis of this structure of cost centres and general expenses.
2.2 Allocation, apportionment and absorption (recovery)
There are three main stages in absorption costing for charging overhead costs to the
cost of production and cost units:
Allocation. Overheads are allocated to cost centres. If a cost centre is responsible
for the entire cost of an item of expenditure, the entire cost is charged directly to
the cost centre.
Apportionment. Many overhead costs are costs that cannot be allocated directly
to one cost centre, because they are shared by two or more cost centres. These
costs are apportioned between the cost centres. ‘Apportionment’ means sharing
on a fair basis.
Absorption (also called overhead ‘recovery’). When overheads have been
allocated and apportioned to production cost centres, they are charged to the
cost of products manufactured in the cost centre. The method of charging
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overheads to cost units is to establish a charging rate (an absorption rate or
recovery rate) and to apply this rate to all items of production.
Allocation
Overhead costs are recorded. Initially
they are allocated to a cost centre or
recorded as a general expense
Apportionment
Overhead costs are shared between the
departments or activities that benefit
from them
Absorption
(Overhead recovery)
Overheads are added to the cost of cost
units, using a fair basis for charging
(absorption costing only)
2.3 Overhead cost allocation
Many items of indirect cost cannot be charged directly to a cost unit (a unit of
product or service), but they can be charged directly to a cost centre (for example, a
department or work group). Items of expense that can be identified with a specific
cost centre should be charged in full as a cost to the cost centre. The process of
charging costs directly to cost centres is called cost allocation.
In absorption costing for a manufacturing company, overhead costs may be
allocated to:
production departments or production centres: these are cost centres that are
directly engaged in manufacturing the products
service departments or service centres: these are cost centres that provide
support to the production departments, but are not directly engaged in
production, such as engineering, repairs and maintenance, the production stores
and materials handling department (raw materials inventory), production
planning and control, and so on
administration departments
selling departments and distribution departments.
Production overheads are the overhead costs of both the production departments
and the service departments.
Overhead costs that cannot be directly allocated to a cost centre must be shared
(apportioned) between two or more cost centres.
For example:
The salary of the manager of the production planning department can be
allocated directly as a cost of the production planning cost centre, which is a
service department cost centre within production.
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Similarly the rental cost of equipment used by engineers in the maintenance
department can be allocated directly as a cost of the maintenance department,
which is also a service department cost centre within production.
If the machining department has its own electricity power supply, electricity
charges for the machining department can be allocated directly to the
department, which is a production department cost centre.
The salary of a supervisor in the finishing department can be allocated directly
to the finishing department, which is also a production department cost centre.
The cost of security guards for the manufacturing site cannot be allocated to any
specific department or cost centre; therefore security guard services are likely to
be recorded as a general production overhead expense, and the cost is allocated
to ‘security services’.
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Overhead apportionment
The apportionment of shared costs between cost centres
The basis of apportionment
3 Overhead apportionment
3.1 The apportionment of shared costs between cost centres
Some costs cannot be allocated in full to a cost centre, because they are shared by
two or more cost centres. These are divided between the cost centres on a fair basis.
The process of dividing the shared costs is called apportionment.
Shared costs may be divided between administration cost centres and selling and
distribution cost centres, as well as production centres and service centres.
However, examination questions on absorption costing will usually concentrate on
production overhead costs.
The apportionment of production overhead costs might be in two stages:
sharing (or dividing) general costs between production centres and service
centres
then sharing the costs of the service centres between the production centres.
Production overhead costs allocated
and apportioned to direct
production departments
Production overhead costs
allocated and apportioned to
service departments
Service department overheads
apportioned to direct production
departments
All production overheads now
allocated or apportioned to direct
production departments
After this has been done, all the production overhead costs have been allocated or
apportioned to the production centres. The total overhead costs of each production
centre should be:
(1) costs allocated directly to the production centre, plus
(2) shared costs apportioned to the production centre, plus
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(3) a share of the costs of each service department, apportioned to the production
centre.
3.2 The basis of apportionment
Shared overhead costs should be apportioned on a fair basis between cost centres.
For each item of shared expense, a ‘fair’ basis for apportionment must be selected.
Choosing the basis of apportionment for each cost is a matter of judgement, but
there is often an ‘obvious’ basis to choose. For example, the rental cost of a building
and the insurance costs for the building will be apportioned between the cost
centres that use the building. The basis of apportionment will probably be to share
the costs in relation to the floor space used by each cost centre.
In some cases, however, it might not be clear what the most suitable basis of
apportionment should be, and the choice is then simply a matter of judgement and
preference.
At the end of the apportionment process, all overhead costs should be allocated or
apportioned to a cost centre.
Example: apportionment of shared costs
A manufacturing company has two production departments, Machining and
Assembly, and two service departments, Repairs and Quality Control. The following
information is available about production overhead costs.
Total
Machining
Assembly
Repairs
Quality
control
$ $ $ $ $
Indirect labour cost 15,500
5,000
5,000
3,500 2,000
Indirect materials 5,300
1,500
2,400
1,000 400
Factory rental 14,400
Power costs 4,800
Depreciation (note 1) 14,000
Building insurance 1,800
Equipment insurance 4,200
60,000
Note: Depreciation is a charge for the use of items of plant and equipment, such as
machinery.
Indirect labour and indirect material costs have been allocated directly to these four
cost centres. The other overhead costs are shared between the cost centres and so
cannot be allocated directly.
Other information
Total
Machining
Assembly
Repairs
Quality
control
Cost of plant/equipment ($) 70,000 40,000 15,000 5,000 10,000
Floor area (square metres) 1,800
500
900
100 300
Kilowatt hours (000s) 800
600
100
50 50