Introduction “The process which charges fixed as well as variable overheads to cost units”

Definitions of Absorption Costing A method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or a number of overhead absorption rates (CIMA) A method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or a number of overhead absorption rates (CIMA) Absorption costing calculates the unit cost of an item taking into account all costs, fixed and variable, direct and indirect. Indirect/fixed costs are allocated to or absorbed by the products made Absorption costing calculates the unit cost of an item taking into account all costs, fixed and variable, direct and indirect. Indirect/fixed costs are allocated to or absorbed by the products made

Absorption costing- the essence All overheads are included when calculating the cost of producing particular items All overheads are included when calculating the cost of producing particular items Fixed costs are brought into the calculations on the assumption that they must be recovered Fixed costs are brought into the calculations on the assumption that they must be recovered All overheads are absorbed into cost units but each aspect of overheads is absorbed separately by cost centres on an appropriate basis – i.e. not a blanket approach All overheads are absorbed into cost units but each aspect of overheads is absorbed separately by cost centres on an appropriate basis – i.e. not a blanket approach Absorption costing is used to calculate profit and to calculate stock valuation for financial statements Absorption costing is used to calculate profit and to calculate stock valuation for financial statements

Classification of costs Production costs made up of Production costs made up of –Direct costs for materials, direct labour & other directly attributable expenses –Indirect costs (factory overheads) made up of indirect materials, indirect labour, indirect expenses Administrative expenses (indirect costs or overheads Administrative expenses (indirect costs or overheads Selling and distribution costs (indirect costs or overheads) Selling and distribution costs (indirect costs or overheads)

Total cost statement Direct materials + Direct labour + Direct expenses = Prime Cost + Factory overheads = Production costs + Selling and distribution costs + Administrative costs + Finance costs = Total costs

Steps in absorption costing Record all costs Record all costs Classify all the costs Classify all the costs Direct cost are directly linked to the output Direct cost are directly linked to the output Allocate the indirect costs to the service departments of a business Allocate the indirect costs to the service departments of a business Reallocate costs from service support departments to production departments Reallocate costs from service support departments to production departments Calculate an overhead recovery rate Calculate an overhead recovery rate Absorb both the direct and indirect costs (overheads) into individual products Absorb both the direct and indirect costs (overheads) into individual products

The three As Allocation: charging to a cost centre those overheads which result solely from the existence of that cost centre Allocation: charging to a cost centre those overheads which result solely from the existence of that cost centre Apportionment: the charging to a cost centre of a fair share of an overhead on the basis of the benefit received by the cost centre from the facilities provided by the overhead Apportionment: the charging to a cost centre of a fair share of an overhead on the basis of the benefit received by the cost centre from the facilities provided by the overhead Absorption: when all production overheads have been allocated and apportioned to a product cost centre, the total has to be charged to specific units of production Absorption: when all production overheads have been allocated and apportioned to a product cost centre, the total has to be charged to specific units of production

Key stages Allocation of costs directly incurred by particular cost centres Allocation of costs directly incurred by particular cost centres Apportion (divide up) all shared overhead costs between various cost centres Apportion (divide up) all shared overhead costs between various cost centres Apportion all service cost centre overheads to the production cost centres Apportion all service cost centre overheads to the production cost centres Absorb the allocated and apportioned overheads into the costs of production of cost centres Absorb the allocated and apportioned overheads into the costs of production of cost centres

In plain English We own a factory producing widgets and other goods. Widget production is one cost centre We own a factory producing widgets and other goods. Widget production is one cost centre First, all costs directly traceable to widget production are allocated to this cost centre. This includes overheads such as the cost of machinery dedicated to the production of widgets First, all costs directly traceable to widget production are allocated to this cost centre. This includes overheads such as the cost of machinery dedicated to the production of widgets Second, calculate the cost of service cost centres such as the HR Department. Apportion these costs to various production cost centres (including widget production) on some equitable basis Second, calculate the cost of service cost centres such as the HR Department. Apportion these costs to various production cost centres (including widget production) on some equitable basis Third, the apportioned costs are absorbed into each widget produced Third, the apportioned costs are absorbed into each widget produced This ensures all costs are recovered This ensures all costs are recovered

Allocate Allocate overhead costs that are directly incurred by particular cost centres. Allocate directly attributable costs Allocate overhead costs that are directly incurred by particular cost centres. Allocate directly attributable costs Allocation is the process of charging indirect costs that are wholly associated with a particular cost centre to that centre Allocation is the process of charging indirect costs that are wholly associated with a particular cost centre to that centre Examples: machines dedicated to the production of a particular product, building whose sole use is the production of a particular product Examples: machines dedicated to the production of a particular product, building whose sole use is the production of a particular product In both cases there is no need to divide up the costs between products since the facility is directly linked to the product In both cases there is no need to divide up the costs between products since the facility is directly linked to the product But if an overhead cannot be allocated it must be apportioned But if an overhead cannot be allocated it must be apportioned

Apportionment Apportionment is the process by which shared overheads are divided between cost centres on an equitable basis Apportionment is the process by which shared overheads are divided between cost centres on an equitable basis Divide all shared overheads between production and service cost centres Divide all shared overheads between production and service cost centres Re-apportion all service cost centre overheads to the production cost centres Re-apportion all service cost centre overheads to the production cost centres Example: service cost centres include HR department, maintenance, cleaning. Each production cost centre will be required to carry of these overheads Example: service cost centres include HR department, maintenance, cleaning. Each production cost centre will be required to carry of these overheads

Apportionment should… Be related in some way to the manner in which the cost is incurred by each centre Be related in some way to the manner in which the cost is incurred by each centre Reflect the use made of the resource by the cost centre Reflect the use made of the resource by the cost centre Be on a basis which is relatively easily attainable from the records of the organisation Be on a basis which is relatively easily attainable from the records of the organisation Be fair, reasonable and equitable Be fair, reasonable and equitable

Bases for apportionment Rent - floor place use by each cost centre Rent - floor place use by each cost centre Heating - cubic capacity of each cost centre Heating - cubic capacity of each cost centre Indirect labour - in proportion to direct labour Indirect labour - in proportion to direct labour Supervision/canteen/personnel department - in proportion to the number of employees in each cost centre Supervision/canteen/personnel department - in proportion to the number of employees in each cost centre Depreciation - in proportion to the capital value of the equipment Depreciation - in proportion to the capital value of the equipment Insurance - the book value of assets Insurance - the book value of assets Materials handling- weight or size Materials handling- weight or size

Absorb Overheads are broken down into components and then absorbed on a pro rata basis using a variety of yardsticks Overheads are broken down into components and then absorbed on a pro rata basis using a variety of yardsticks Absorb the allocated and apportioned overheads into the costs of production of each unit Absorb the allocated and apportioned overheads into the costs of production of each unit Calculate how much each unit should absorb Calculate how much each unit should absorb The transfer of the department or cost centre overheads to the product or unit costs by using cost absorption or recovery rates The transfer of the department or cost centre overheads to the product or unit costs by using cost absorption or recovery rates

Absorption rate Definition: A means of attributing overheads to a product or service base for example on direct labour hours, direct labour costs or machine hours. (CIMA) Definition: A means of attributing overheads to a product or service base for example on direct labour hours, direct labour costs or machine hours. (CIMA) Also known as the recovery rate - the rate at which overheads are charged to cost units Also known as the recovery rate - the rate at which overheads are charged to cost units Overhead absorption rates are expressed in relation to one of: units of output, direct labour hours, machine hours Overhead absorption rates are expressed in relation to one of: units of output, direct labour hours, machine hours

A simple example Direct costs per unit £5 Direct costs per unit £5 Directly attributable overheads £200k Directly attributable overheads £200k Service department overheads £360k apportionment on the basis of % of employees – widget production employs 33.3% of employees. Service department overheads £360k apportionment on the basis of % of employees – widget production employs 33.3% of employees. All other overheads £400k apportioned on the basis of % of area occupied- widget production takes up 25% of floor space All other overheads £400k apportioned on the basis of % of area occupied- widget production takes up 25% of floor space Output of widgets 100k Output of widgets 100k

A simple example Allocated overheads £200k Allocated overheads £200k Apportioned overheads £120k (33.3% of £360k) Apportioned overheads £120k (33.3% of £360k) Apportioned overheads £100k Apportioned overheads £100k (25% of £400k). (25% of £400k). Total overheads to be absorbed £420k. Total overheads to be absorbed £420k. This works out at £420k/100k or £4.2 per unit. This works out at £420k/100k or £4.2 per unit. Cost per unit= £5+£4.2= £9.2 Cost per unit= £5+£4.2= £9.2

Absorption rates Calculated by taking the overhead for a particular cost centre and dividing it by the number of units of the absorption base Calculated by taking the overhead for a particular cost centre and dividing it by the number of units of the absorption base Cost unit absorption rate = production cost centre overhead number of cost units number of cost units Direct labour hour absorption rate = production cost centre overheads number of labour hours number of labour hours

Absorption rates (1) Machine hour overhead absorption rate = production cost centre overheads number of machine hours number of machine hours Direct wage % overhead absorption rate = production cost centre overheads x 100 direct wages direct wages

Absorption rates (2) Materials cost % overhead absorption rate = production cost centre overhead x 100 direct materials direct materials Prime cost % overhead absorption rate = production cost centre overhead x 100 prime cost prime cost Selling overhead absorption rate = total selling overheads x100 total factory cost of sales total factory cost of sales

Over and under absorption Over and under absorption Absorption rates are based on budgeted or pre-determined figures Absorption rates are based on budgeted or pre-determined figures If output/sales are different from those budgeted then the result is: If output/sales are different from those budgeted then the result is: Over-absorption - absorbed overheads are greater than actual overheads Over-absorption - absorbed overheads are greater than actual overheads Under-absorption - absorbed overhead is less than actual overhead Under-absorption - absorbed overhead is less than actual overhead

Absorption costing statement Sales revenue Less Direct materials Direct labour Production overheads = Gross profit Less Selling overheads Distribution overheads Administrative expenses R and D costs = Net profit

Advantages of absorption costing Fixed costs are recovered - fixed costs are incurred in order to make output so it is only fair to charge all output with a share of these costs Fixed costs are recovered - fixed costs are incurred in order to make output so it is only fair to charge all output with a share of these costs Ensures that costs are fully recovered Ensures that costs are fully recovered Encourages cost consciousness Encourages cost consciousness It is fair in that it uses appropriate methods for each overhead It is fair in that it uses appropriate methods for each overhead Identifies total costs - this is useful where pricing is on a cost plus basis Identifies total costs - this is useful where pricing is on a cost plus basis Identifies the profitability of different products and services Identifies the profitability of different products and services Conforms with SSAP9 on the valuing of stocks Conforms with SSAP9 on the valuing of stocks

Problems of absorption costing All methods are arbitrary - no method of diving up fixed costs is satisfactory All methods are arbitrary - no method of diving up fixed costs is satisfactory Absorption cost is true only at the level of activity at which it was calculated Absorption cost is true only at the level of activity at which it was calculated Danger of under or over absorption of overheads Danger of under or over absorption of overheads Complex, time consuming and expensive Complex, time consuming and expensive Potentially misleading guide to profitability of products Potentially misleading guide to profitability of products The capacity levels chosen for overhead absorption rates are based on historical information and are open to debate The capacity levels chosen for overhead absorption rates are based on historical information and are open to debate

Full costing or absorption costing? The two terms are often but wrongly used interchangeably The two terms are often but wrongly used interchangeably It is true that in both cases the indirect costs are apportioned between various costs centres but… It is true that in both cases the indirect costs are apportioned between various costs centres but… –In full costing the overheads are apportioned as a whole and –Fixed and variable overheads are blanketed and expressed as some proportion of an easily calculated costs In absorption costing different allocation rules apply for different types of overhead In absorption costing different allocation rules apply for different types of overhead

Full costing: apportion overheads in same ratios as direct costs £ Product A Product B Product C Sales Direct costs 120 (60%) 120 (60%) 60 (30%) 60 (30%) 20 (10%) 20 (10%) Indirect costs 72 (60% of indirect costs) 72 (60% of indirect costs) 36 (30% of indirect costs) 36 (30% of indirect costs) 12 (10%of indirect costs) 12 (10%of indirect costs) Profit

Full costing Advantages Quick and cheap to calculate Quick and cheap to calculate Accessible to non specialists Accessible to non specialists Requires only basic information Requires only basic information All costs recovered by cost allocated to each centre All costs recovered by cost allocated to each centre A simplified version of absorption costing A simplified version of absorption costingDisadvantages Arbitrary and unfair Arbitrary and unfair Too general to be of great value for control purposes Too general to be of great value for control purposes The least accurate method of allocating overheads The least accurate method of allocating overheads Allocation of overheads gives a distorted view Allocation of overheads gives a distorted view

Key terms Absorb – process of charging overhead to cost units Absorb – process of charging overhead to cost units Absorption rate/recovery rate - the rate at which overheads are charged to cost units Absorption rate/recovery rate - the rate at which overheads are charged to cost units Allocation - the process of charging indirect costs that are wholly associated with a particular cost centre to that cost centre Allocation - the process of charging indirect costs that are wholly associated with a particular cost centre to that cost centre Apportion – the process by which shared overheads are divided between cost centres Apportion – the process by which shared overheads are divided between cost centres

Cost allocation - a summary Full costing - indirect costs are allocated using a single arbitrary method. A blanket approach which may not reflect the true cost of each product Full costing - indirect costs are allocated using a single arbitrary method. A blanket approach which may not reflect the true cost of each product Absorption costing - this method uses several criteria for allocation of indirect costs. An improvement on the blanket method but still largely subjective Absorption costing - this method uses several criteria for allocation of indirect costs. An improvement on the blanket method but still largely subjective Marginal costing - no attempt is made to allocate indirect costs. Marginal cost decision making is based on the value of the contribution that the product makes to indirect costs Marginal costing - no attempt is made to allocate indirect costs. Marginal cost decision making is based on the value of the contribution that the product makes to indirect costs