Absorption Costing

Chapter 8
ABSORPTION COSTING
In previous chapters, we have seen how costs can be classified as direct material
costs, direct labour costs and overhead costs. This chapter explains how the costs of
products or services are established using a system of costing known as absorption
costing. In absorption costing, the main problem is how to charge a fair share of
overhead costs to products or services. This chapter covers syllabus areas C1 and
C2(c).
CONTENTS
1 Product costs and service costs
2 Treatment of overheads in absorption costing
3 Overhead allocation
4 Apportionment of overhead costs
5 Overhead analysis sheet
6 Service cost centre re-apportionment
7 The arbitrary nature of overhead apportionments
8 Overhead absorption
9 Under- and over-absorption of overheads
10 Accounting for production overheads
11 Investigating the causes of under-or over-absorbed overhead
12 Non-production overheads
13 Fixed, variable and semi-fixed overheads
KAPLAN PUBLISHING 125

PAPER MA2 : MANAGING COSTS AND FINANCES
LEARNING OUTCOMES
At the end of this chapter you should be able to:
• explain the rationale for absorption costing
• describe the nature of production and service cost centres and their significance for
production overhead allocation, apportionment and absorption
• describe the process of allocating, apportioning and absorbing production overheads

to establish product costs
• apportion overheads to cost centres using appropriate bases
• re-apportion service cost centre overheads to production cost centres using direct and
step down methods
• justify, calculate and apply production cost centre overhead absorption rates using
labour hour and machine hour methods
• explain the relative merits of actual and pre-determined absorption rates
• describe and illustrate the accounting for production overhead costs, including the
analysis and interpretation of over/under absorption
• describe and apply methods of attributing non-production overheads to cost units
• calculate product costs using the absorption costing method
• prepare profit statements using the absorption costing method.
1 PRODUCT COSTS AND SERVICE COSTS

Commercial organisations either sell products or provide services. They need to know
what their products or services cost. There are several reasons for wanting to know
about product costs and service costs.
• We need to know about costs in order to decide whether the products or

services are profitable.
• In some cases, products or services might be priced by adding a profit mark-up

on cost.
• In the case of products, closing inventory must be valued at its cost.
We have seen that the costs incurred by an organisation can be categorised as direct
or indirect. Unlike direct costs, indirect costs cannot be associated directly with
products or services.
Definition Overheads is a term for indirect costs.
A key issue with product costing and service costing is deciding what to do about
overhead costs.
126 KAPLAN PUBLISHING

ABSORPTION COSTING : CHAPTER 8
EXAMPLE
A company makes two products, X and Y. During a given period, the company makes
1,000 units of each product. The direct costs of Product X are $50,000 and the direct
costs of Product Y are $80,000. Overhead costs for the period are $150,000.
If we want to establish a cost for Product X and Product Y, the direct costs of each
product are easily established. But what about the overheads? Should each product
be given a share of the overhead costs? If the overhead costs are to be divided
between the two products, on what basis should the total cost be shared?
Definition Absorption costing is a method of costing in which the costs of an

item (product or service or activity) are built up as the sum of direct
costs and a fair share of overhead costs, to obtain a full cost or a fully-
absorbed cost.
1.1 PRODUCT COSTS AND ABSORPTION COSTING
When costs are incurred, they can be recorded as:
• direct materials
• direct labour
• (sometimes) direct expenses; or
• overheads.
Overhead costs are charged to a cost centre (or 'responsibility centre'), which might
represent:
• production overheads
• administration overheads
• selling and distribution overheads
• general overheads. However, general overheads are shared out between

production, administration and selling and distribution overheads.
Fully-absorbed product costs can therefore be built up as follows (with illustrative

figures included):
$
Direct materials 12
Direct labour 8
Direct expenses 2
–––
Total direct costs 22
Production overhead 16
–––
Full production cost 38
Administration overhead 6
Selling and distribution overhead 10
–––
Full cost of sale 54
–––

Notes:
1 In the statement of financial position, closing inventory is valued at its full

production cost.
This is consistent with the requirements for financial accounting. In any financial
statements that are produced for external users (such as shareholders or the
tax authorities), absorption costing must be used. In management accounts,
which are only used internally by the business managers, the business can
choose any method of stock valuation it wishes.
2 Absorption costing problems are concerned with building up the full production
cost and therefore concentrate on production overheads. Non-production
overheads may be charged as a period cost against profits or may be added to
full production cost using a given percentage.
1.2 SERVICE COSTS AND ABSORPTION COSTING
Fully-absorbed service costs can be built up in the same way. A service business
must first of all decide what a unit of service should be. For example:
• for a telecommunications business, a unit of service might be a cost per

telephone call per minute or the cost of a communications link
• for a private hospital, a cost might be a cost per patient day
• for an electricity supply business, a unit cost might be a cost per unit of
electricity supplied.
Service costs might be established as follows:

$
Direct materials 2
Direct labour 10
Direct expenses 4
–––
Total direct costs 16
Operating overhead 28
–––
Full operating cost 44
Administration overhead 10
Selling and distribution overhead 16
–––
–––

1.3 FIXED AND VARIABLE OVERHEADS
Overhead costs might be fixed costs or variable costs. In absorption costing,

production overheads, administration overheads and selling and distribution
overheads might therefore be separated into their fixed and variable cost components.
In absorption costing for products, the full production cost of a product might therefore
consist of direct materials, direct labour, direct expenses, variable production
overhead and fixed production overhead.
• Fixed overheads remain the same whatever the level of output or activity
during a period. It does not vary with changes in output levels or activity, but
remains constant.
• Variable overheads are amounts of indirect cost that vary with the level of
output or activity. As the level of output or activity rises then so does any
variable overhead cost.
1.4 REASONS FOR ABSORPTION COSTING
The main reasons for wanting to calculate full costs, as indicated earlier, are mainly to
value inventories of manufactured goods, and possibly also to calculate a selling price
based on full costs.
Inventory valuation
The costs of making a product include the costs of direct materials, direct labour and
direct expenses. In some organisations products are simply valued at this total figure
for costing purposes. However the overheads incurred by the production departments
are costs that are necessary to make those products. Production overheads, although
indirect costs of the cost units, are as much a cost of the product as the direct costs.
Therefore in order to value closing inventory at the full cost of producing each product
or cost unit, the cost unit incurred must include a share of the overheads in the
product cost. The full cost of producing the product or cost unit is the total direct costs
of the product plus its share of indirect production costs.
Pricing at a mark-up over full cost
One reason for costing products at their full cost could be for pricing purposes. If the
price of a product is to cover all of the costs of the product plus some margin to give a
profit then the full cost must be known in order to apply the profit margin. In the longer
term, if absorption costing is used, a business will have a more informed idea of the
long term profitability of a product as all production costs and revenues will have been
considered.
EXAMPLE
The cost of a unit of Product X is as follows:

$
Direct materials 1.60
Direct labour 2.20
Direct expenses 0.40
Indirect expenses 0.80
If the organisation's policy is to cover all costs of a product and then make a
profit equal to 20% of the total costs, at what price must Product X be sold?

SOLUTION
Total cost of Product X

$
Direct materials 1.60
Direct labour 2.20
Direct expenses 0.40
Indirect expenses 0.80
––––
5.00
Profit (20% × $5.00) 1.00
––––
Selling price 6.00
––––
2 TREATMENT OF OVERHEADS IN ABSORPTION

COSTING
In absorption costing, products, services or activities are charged with a fair share of
indirect costs. There is a three-stage process involved in charging overhead costs to
products or services:
• overhead allocation
• overhead apportionment
• overhead absorption, also called overhead recovery.
Each of these stages is explained below. However, in order to appreciate overhead

allocation and overhead apportionment, it is first of all necessary to know something
about the type of cost centres found in manufacturing organisations.
2.1 COST CENTRES AND ABSORPTION COSTING
A business can decide what its cost centres should be. Generally-speaking, cost
centres within a manufacturing organisation are likely to consist of:
• Production departments, in which items of product are manufactured. There

could be several production departments within any organisation, and
production might flow from one department to another and then another. For
example, production might flow from a machining department to an assembly
department and then a finishing department. Similarly, in textile production,
work might flow from a carding department to a spinning department to a
weaving department. Each production department might be a separate cost
centre. Alternatively, a cost centre might be a single machine or a group of
machines under the direction of one supervisor.
• Service departments within the production area. These are departments

operating within the production function that are not involved directly in the
manufacture of products. Instead, they provide service and support to
production departments. These can include a stores department, a
maintenance and repairs department, a canteen department, and so on.
• Administration departments or functions, for administration overheads.

• Selling and distribution departments or functions, for selling and distribution

costs.
• General cost items that cannot be attributed to a single department or work

area. Examples are rental costs for a factory building, lighting and heating
costs, building security and maintenance costs, and so on.
In the description of absorption costing that follows, administration overheads and

selling and distribution overheads are ignored, and the focus of attention is on full
production costs. Costs centres will therefore be categorised as production
departments, service departments and general costs.
3 OVERHEAD ALLOCATION
Overhead allocation is the first of the three stages in establishing a full cost for a
product or service.
Definition Overhead allocation is the process of charging a whole item of cost

to a cost centre.
ACTIVITY 1
A manufacturing business operates with two production departments, P and Q and a

service department S. It manufactures widgets. It incurs the following costs in a given
period.
$
Labour costs in Department S 6,500
Direct labour costs in Department P 4,700
Costs of supervision in Department Q 2,100
Material costs of widgets 10,300
Machine repair costs, Department Q 800
Materials consumed in Department S 1,100
Depreciation of machinery in Department S 700
Indirect materials consumed in Department P 500
Lighting and heating 900
Costs of works canteen 1,500
Allocate these costs as overhead costs to the following cost centres:
• production Department P
• production Department Q
• service Department S
• a cost centre for general costs.
Indicate with reasons why you have not allocated any of the cost items in the list.
For a suggested answer, see the ‘Answers’ section at the end of the book.

4 APPORTIONMENT OF OVERHEAD COSTS

Once overhead costs have been allocated to cost centres, general overheads must be
shared out, or apportioned. This may be to production or service cost centres.
Definition Overhead apportionment is the process of sharing out overhead

costs on a fair basis.
Apportionment should be on a fair basis, but there are no rules about what 'fair'
means.
An organisation should establish, for each item of general cost, what this basis ought
to be. For many costs, there are two or more different bases that could be used.
Some examples should help to illustrate the considerations involved.
4.1 EXAMPLES
EXAMPLE 1
A general cost in a manufacturing company is factory rental. Annual rental costs are
$80,000. How should this cost be apportioned between production cost centres and
service cost centres?
Rental costs are usually apportioned between cost centres on the basis of the floor
space taken up by each cost centre. For example, suppose that three cost centres
have floor space of 10,000 square metres, 15,000 square metres and 25,000 square
metres, and annual rental costs are $80,000. If we apportion rental costs between the
cost centres on the basis of their floor space, the apportionment would be as follows:
Annual rental $80,000
Total floor space (10,000 + 15,000 + 25,000) 50,000 square metres
Apportionment rate ($80,000/50,000) $1.60/square metre
$
Apportion to cost centre with 10,000 square metres 16,000
––––––
80,000
––––––
EXAMPLE 2
The costs of heating and lighting might also be apportioned on the basis of floor
space. Alternatively, since heating relates to volume rather than floor space, it could
be argued that the costs should be apportioned on the volume of space taken up by
each cost centre. Yet another view is that electricity costs relate more to the
consumption of electrical power by machines, therefore the apportionment of these
costs should be on the basis of the number and power of the machines in each cost
centre.
A reasonable argument could be made for any of these bases of apportionment.

EXAMPLE 3
Supervisors’ costs could be apportioned on either of the following bases:
• the number of employees in each cost centre
• the hours worked by employees in each department (on the grounds that the
costs relate more to the number of hours in attendance at work rather than the
numbers of employees).
ACTIVITY 2
What would be the most appropriate basis of apportionment of the following

overheads?
(a) Oil used for machine lubrication.
(b) Depreciation of machinery.
(c) Petrol for vehicles used by the organisation.
5 OVERHEAD ANALYSIS SHEET

A record of the overheads allocated and apportioned can be set out on an overhead
analysis sheet.
5.1 OVERHEAD ANALYSIS SHEET: OVERHEAD APPORTIONMENT
The purpose of the analysis sheet is to show how the overhead costs are built up for
each production and service cost centre.
5.2 WORKED EXAMPLE
The example below illustrates the apportionment of overheads using an overhead

analysis sheet.
This example stops at the point where general overheads have been apportioned to
production departments and service departments. It does not show how service
departments are re-apportioned to the production departments.
Note that this example is longer than any question that could be asked for in an exam.
But it should explain all the possible elements that you could be asked to calculate in
this area.

EXAMPLE
An organisation has two production departments, A and B, and two service

departments, stores and the canteen.
The overhead costs for the organisation in total are as follows:

$
Rent 32,000
Building maintenance costs 5,000
Machinery insurance 2,400
Machinery depreciation 11,000
Machinery running expenses 6,000
Power 7,000
There are also specific costs that have already been allocated to each cost centre as
follows:
$
Department A 5,000
Department B 4,000
Stores 1,000
Canteen 2,000
The following information about the various cost centres is also available:
Total Dept A Dept B Stores Canteen
Floor space (sq ft) 30,000 15,000 8,000 5,000 2,000
Power usage 100% 45% 40% 5% 10%
Value of
machinery ($000) 250 140 110 – –
Machinery hours (000) 80 50 30
Value of
equipment ($000) 20 – – 5 15
Number of
employees 40 20 15 3 2
Value of stores
requisitions ($000) 150 100 50 – –
Allocate and apportion the costs to the four departments.
Do not reapportion the service cost centre costs to the production cost centre.

5.3 SOLUTION
OVERHEAD ANALYSIS SHEET PERIOD ENDING..................

TOTAL PRODUCTION SERVICE
Dept A Dept B Stores Canteen
$ $ $ $ $
Overheads allocated
directly to cost centres 12,000 5,000 4,000 1,000 2,000
Overheads to be
apportioned
Rent
Basis: floor space 32,000
15/30 × $32,000 16,000
8/30 × $32,000 8,534
5/30 × $32,000 5,333
2/30 × $32,000 2,133
Building maintenance
Basis: floor space 5,000
15/30 × $5,000 2,500
8/30 × $5,000 1,333
5/30 × $5,000 834
2/30 × $5,000 333
Machinery insurance 2,400
Basis: machine value
140/250 × $2,400 1,344
110/250 × $2,400 1,056 – –
Machinery
depreciation 11,000
Basis: machine value
140/250 × $11,000 6,160
110/250 × $11,000 4,840 – –
Machinery running
expenses 6,000
Basis: machine hours
50/80 × $6,000 3,750
30/80 × $6,000 2,250 – –
Power 7,000
Basis: power usage
percentages
$7,000 × 45% 3,150
$7,000 × 40% 2,800
$7,000 × 5% 350
$7,000 × 10% 700
––––––––– ––––––––– ––––––––– ––––––––– –––––––––
Allocated and
apportioned costs 75,400 37,904 24,813 7,517 5,166
––––––––– ––––––––– ––––––––– ––––––––– –––––––––

6 SERVICE COST CENTRE RE-APPORTIONMENT

The aim of allocating and apportioning production overheads is to establish the total
overhead costs for each production cost centre. In order to achieve this, the overhead
costs that have been allocated and apportioned to service cost centres within
production have to be re-apportioned to the production cost centres.
There are two main methods of service cost centre re-apportionment:
• Direct method – this method is used where service cost centres do not provide
services for one another.
• Step-down method – this method is used where at least one of the service
cost centres provides a service to another service cost centre as well as to the
production cost centres.
When service cost centre overheads are re-apportioned, the end result is the same.
All overhead costs are charged to production departments. However, the amount of
overheads charged to each production department will be different. In other words, the
direct method and the step-down method will share out the overhead costs in a
different way.
6.1 DIRECT METHOD OF RE-APPORTIONMENT
With the direct method of re-apportionment, general overheads which have been
apportioned to service cost centres will be re-apportioned to production cost centres
only. The order of re-apportionment is irrelevant with this method.
EXAMPLE – Direct method of re-apportionment
Using the information produced in the previous worked example, the allocated and
apportioned overhead costs are:
OVERHEAD ANALYSIS SHEET PERIOD ENDING.................

$ $ $ $ $
Total overhead 75,400 37,904 24,813 7,517 5,166
–––––– –––––– –––––– –––––– ––––––
The apportionment of the stores department costs will be on the basis of the value of
requisitions by each production cost centre. The apportionment of the canteen costs
should be on the basis of the number of employees in production departments A and
B.
It is assumed that the stores cost centre does no work for the canteen and the
canteen does no work for the stores cost centre.
Consequently, none of the stores costs should be apportioned to the canteen and
none of the canteen costs should be apportioned to stores.

The following data is available:

Total Dept A Dept B Stores Canteen
Number of employees 40 20 15 3 2
Value of stores
requisitions ($000) 150 100 50 – –
Show how the service cost centre costs should be re-apportioned, and the
resulting total overhead costs of each production cost centre.
SOLUTION

$ $ $ $ $
Allocated/apportioned
overhead 75,400 37,904 24,813 7,517 5,166
Apportion stores 5,011 2,506 (7,517)
Basis: requisitions
100/150 × $7,517
50/150 × $7,517
Apportion canteen 2,952 2,214 (5,166)
Basis: number of
employees
20/35 × $5,166
15/35 × $5,166
–––––– ––––––
Total overhead 45,867 29,533
–––––– ––––––
Conclusion This is the simplest situation, where the service cost centres are
isolated from each other. The assumption is implicit that the stores
personnel do not use the canteen and that the canteen does not use
the stores function. This is a situation where service centres do not
service each other.
6.2 STEP-DOWN METHOD OF RE-APPORTIONMENT
With the step-down method, a service cost centre’s costs are first re-apportioned to
production cost centres and another service cost centre. The second service cost
centre’s total cost, which now includes a share of the first service cost centre’s cost, is
re-apportioned to production cost centres. Unlike the direct method, the order of re-
apportionment is relevant with the step-down method.

EXAMPLE – Step-down method of re-apportionment
Suppose that, in the previous example, stores cost centre employees use the
canteen.
The solution would now change as follows:
SOLUTION

$ $ $ $ $
Allocated/apportioned
overhead 75,400 37,904 24,813 7,517 5,166
Apportion canteen 2,719 2,039 408 (5,166)
Basis: number of
employees
20/38 × $5,166
15/38 × $5,166
3/38 × $5,166
Apportion stores 5,283 2,642 (7,925)
Basis: requisitions
100/150 × $7,925
50/150 × $7,925
–––––– ––––––
Total overhead 45,906 29,494
–––––– ––––––
Note: The key to this step-down method of re-apportionment is to start by re-

apportioning the overhead costs of the service cost centre that does work for the other
service cost centre.
ACTIVITY 3
A manufacturing business has two production cost centres and two service cost
centres. The allocated overhead costs and apportioned general overhead costs for
each cost centre are as follows.
$
Production cost centre P1 140,000
Production cost centre P2 200,000
Service cost centre S1 90,000
Service cost centre S2 120,000

Required:
(a) Show how the overheads would be charged to each production cost centre if it
is assumed that neither service cost centre does any work for the other. Cost
centre S1 does 60% of its work for P1 and 40% of its work for P2. Cost centre
S2 does one-third of its work for P1 and two-thirds of its work for P2.
(b) Show how the overheads would be charged to each production cost centre if it
is assumed that service cost centre S2 does work for cost centre S1 as well as
the two production cost centres, as indicated in the table below.
Apportionment ratio
Cost centre Cost centre Cost centre Cost centre
P1 P2 S1 S2
Cost centre S1 60% 40% – –
Cost centre S2 25% 50% 25% –
7 THE ARBITRARY NATURE OF OVERHEAD

APPORTIONMENTS
At the end of the process of allocation and apportionment of production overheads, all
overhead costs have been charged to production cost centres.
The process of apportionment attempts to be fair, but the selection of the bases for
apportionment is based on judgement and assumption.
• General cost items can often be apportioned on any of two or more different
bases, and depending on the basis chosen, the amount of cost charged to each
responsibility centre/cost centre will differ.
• Similarly, the basis for apportioning service department costs to production

departments can differ, depending on the assumptions made or point of view
taken.
• The decision about whether to allow for the work done by service departments
for other service departments is also significant. The assumption chosen will
affect the amount of overheads charged from the service departments to each
production department.
Methods of apportioning overheads should be kept under review, to make sure that
they remain valid and sensible.
If a basis of apportionment no longer appears valid, a change in the apportionment

basis should be proposed to management, giving the reasons for the proposed
change.
8 OVERHEAD ABSORPTION
Allocation and apportionment are the first two stages in the process of charging
overhead costs to products or services.
The third stage in the absorption costing process is overhead absorption, also called
overhead recovery.

Definition Overhead absorption is the process of adding overhead costs to the

cost of a product or service, in order to build up a fully-absorbed
product cost or service cost.
As a result of overhead absorption, in theory at least, the total amount

of overheads incurred should be absorbed into the costs of the
products manufactured (or services provided) by the business.
8.1 BASIS OF ABSORPTION
Production overhead costs are absorbed into product costs on a basis selected by the
organisation. The absorption basis should be appropriate for the particular products or
services. The most common bases of absorption are:
• an absorption rate per unit, but only if the organisation produces a single
product or several standard products
• an absorption rate per direct labour hour worked
• an absorption rate per machine hour worked
• an absorption rate based on a percentage of direct labour costs
• an absorption rate based on a percentage of prime cost (a percentage of direct

materials, direct labour and direct expense costs).
The only bases for absorption required for your syllabus are direct labour hours and
machine hours.
8.2 ABSORPTION RATES
An absorption rate is the rate at which overheads are added to costs.
• If the absorption basis is direct labour hours worked, the absorption rate will be
$Y per direct labour hour. For example, if the absorption rate for production
overhead is $5 per direct labour hour, a job taking 4 direct labour hours will be
charged with $20 of overhead.
• If the absorption basis is machine hours worked, the absorption rate will be $Z
per machine hour. For example, if the absorption rate for production overhead is
$15 per machine hour, a job taking 2 machine hours will be charged with $30 of
overhead.
The absorption rate is calculated as:
Overhead costs
Volume of activity (direct labour hours, machine hours)
Overhead costs for any production department are the allocated and apportioned
overheads, assembled by the methods described above.
An organisation might have just one absorption rate for its entire production
operations. However, an organisation with more than one production department is
likely to have a different absorption rate for each department, so that separately-
calculated production overheads are added to product costs for the work done in each
department.
The basis of absorption can differ between production departments and the absorption
rate can differ between departments.

8.3 ABSORPTION RATES BASED ON THE BUDGET
It might seem logical that overhead absorption rates should be based on the actual
overhead costs in a period and the actual volume of activity (direct labour hours or
machine hours worked, or units produced).
In practice, this is not the case. Overhead absorption rates are based on budgeted
overhead costs and the budgeted volume of activity.
Budgeted overhead costs

Absorption rate =
Budgeted volume of activity
There are several important reasons for using budgeted figures:
1 If we used actual costs we would have to wait until after the end of the period to
calculate product costs. This is because actual overhead costs cannot be
known until the period has ended and information about actual costs has been
gathered and analysed.
2 As full product cost is often used as a basis to set prices, it needs to be known
in advance.
3 Overheads, by their nature, are often incurred unevenly throughout the year.
For example, heating costs may be higher in the winter, holiday pay may be
higher in the summer. By using budgeted costs to calculate an absorption rate,
overheads can be spread fairly to all production units throughout the year.
4 The ‘average’ cost calculated should recover all overhead costs and provides a
stable basis to establish prices.
By using absorption rates based on budgeted overhead spending and budgeted

activity volume, we can establish absorption rates in advance, and charge overhead
costs to products as soon as they are made (and to services as soon as they are
performed).
8.4 OVERHEAD ABSORPTION
Once an overhead absorption rate has been calculated, the amount of overhead
absorbed can be calculated as follows:
Overhead absorbed = Actual activity level × Budgeted overhead absorption rate
For example, if the budgeted overhead absorption rate of Department M is $8 per

machine hour, and the actual machine hours worked in Period 1 were 1,700, the
overhead absorbed would be:
Overhead absorbed (Department M) = 1,700 machine hours × $8 = $13,600
The following example shows how the overheads absorbed by three different
departments are incorporated into the cost of a job.

EXAMPLE
Job 1234 goes through three production departments. The direct materials cost of the
job are $200 and the direct labour costs are:
Department 1 (3 direct labour hours) $18
Department 2 (1.5 direct labour hours) $12
Department 3 (6 direct labour hours) $48
The job takes 3 machine hours in department 2.
The production overhead absorption rates are:

Department 1 $5 per direct labour hour
Department 2 $10 per machine hour
Department 3 $12 per direct labour hour
Calculate the full production cost of Job 1234.
SOLUTION
$ $
Direct materials 200
Direct labour:
Department 1 18
Department 2 12
Department 3 48
––––
78
Production overhead:
Department 1 (3 direct labour hours at $5 per hour) 15
Department 2 (3 machine hours at $10 per hour) 30
Department 3 (6 direct labour hours at $12 per hour) 72
––––
117
––––
Full cost of the job 395
––––
ACTIVITY 4
Cuecraft Ltd manufactures pool and snooker cues. It has three production cost
centres:
• machining
• finishing
• packing.
The planned overhead for the next budget period has been allocated and apportioned
to the cost centres as:
Machining $65,525
Finishing $36,667
Packing $24,367

Budgeted cost centre activity volumes for the same period show:
Machining 7,300 machine hours
Finishing 6,250 direct labour hours
Packing 5,200 direct labour hours
Determine separate overhead absorption (recovery) rates for each cost centre
on the following bases:
• Machining – machine hours
• Finishing – direct labour hours
• Packing – direct labour hours.
ACTIVITY 5
Assume that Cuecraft produces a pool cue ‘pot 3’ and it takes 4 hours to complete.
The activity takes place in the following cost centres:
Machining 3 hrs
Finishing 0.9 hr
Packing 0.1 hr
Using the overhead absorption rates calculated in Activity 4, show the overhead
recovered in a unit of ‘pot 3’.
9 UNDER- AND OVER-ABSORPTION OF OVERHEADS

Overhead absorption rates are based on budgeted overhead costs and the budgeted
volume of activity; they are pre-determined.
In practice, for each accounting period, it is often the case that:
• actual overhead expenditure will differ from budgeted overhead expenditure,

and
• the actual volume of activity will differ from the budgeted volume of activity.
As a consequence, the amount of overheads charged to product costs will differ from
the actual overhead expenditure.
We might charge more overhead costs to production than the amount of overhead
expenditure actually incurred. If so, there is over-absorbed or over-recovered
overheads.
We might charge less in overhead costs to production than the amount of overhead
expenditure actually incurred. If so, there is under-absorbed or under-recovered
overheads.

Over-absorbed overhead during a period is treated as an addition to profit, because it

is an adjustment to allow for the fact that too much overhead cost has been charged to
the items produced in the period. Similarly, under-absorbed overhead during a period
is treated as a reduction in profit, because it is an adjustment to allow for the fact that
the overhead cost charged to the items produced in the period is less than the actual
overhead costs incurred.
EXAMPLE
A company has a single production department. Its budgeted production overheads

for 20X4 were $200,000 and its budgeted volume of production was 50,000 direct
labour hours. The company has decided to absorb production overheads into product
costs on a direct labour hour basis.
During 20X4, actual production overhead expenditure was $195,000 and 54,000 direct
labour hours were worked.
The absorption rate is $4 per direct labour hour ($200,000/50,000 hours, based on the
budget).
The overheads absorbed into product costs are $4 for each direct labour hour actually
worked.
$
Total production overheads absorbed (54,000 hours × $4) 216,000
Overheads actually incurred 195,000
–––––––
Over-absorbed overheads 21,000
–––––––
Here, overheads are over-absorbed because $216,000 in production overhead costs
has been charged to the cost of items produced, but actual overhead spending was
only $195,000. Production has been charged with too much overhead.
Over-absorbed overhead is taken to the income statement as an addition to profit in

the period, to compensate for the fact that the recorded costs of production are in
excess of actual expenditure.
EXAMPLE
For the year ended 31 December 20X4 the planned overhead for the Machining Cost
Centre at Cuecraft Ltd was:
Overhead $132,000
Volume of activity 15,000 machine hours
In January 20X4 the cost centre incurred $12,000 of overhead and 1,350 machine
hours were worked.
Calculate the pre-determined overhead rate per machine hour and the overhead
under or over-recovered in the month.

SOLUTION
Absorption rate, based on the budget:
Planned overhead $132,000

= = $8.80 per machine hour
Machine hours 15,000 machine hours
$
Overhead absorbed
1,350 machine hours at $8.80 11,880
Overhead incurred 12,000
––––––
Under-absorbed overhead 120
––––––
Here, the amount of overheads actually charged to production are $11,880, which is
less than actual expenditure. We therefore have under absorption of overhead.
Under recovery of overheads is shown as a separate item in the costing income

statement. Since production has been charged with less overheads than the amount
of overheads incurred, under absorption is shown as a cost in the income statement,
thereby reducing the profit.
ACTIVITY 6
A manufacturing business has two production departments, X and Y, for which the
following annual budgeted figures have been prepared.
Department X Department Y
Budgeted overhead expenditure $840,000 $720,000
Overhead absorption basis Machine hours Direct labour hours
Budgeted activity 40,000 60,000
machine hours direct labour hours
Actual overhead expenditure and actual activity levels for the year were:
Department X Department Y
Actual overhead expenditure $895,000 $735,000
Actual activity 41,500 62,400
machine hours direct labour hours
Required:
(a) Establish the overhead absorption rates for each department for the year.
(b) Calculate the under- or over-absorbed overhead in each department for the
year.

10 ACCOUNTING FOR PRODUCTION OVERHEADS

If a manufacturing business maintains cost accounts in a cost ledger, overheads are
accounted for within the double entry bookkeeping system of the cost ledger.
Three accounts are particularly relevant to accounting for production overheads:
• the production overhead account. This account is debited with the actual cost
of indirect materials, labour and expenses and credited with overhead absorbed
to production. The balance on this account represents over- or under-absorbed
overhead and is either written off directly to the income statement or is passed
to an under/over-absorbed overhead account
• the work-in-progress account. This account is debited with production

overhead absorbed. The full cost of production is therefore built up on the debit
side of this account
• the under- or over-absorbed overhead account. This account collects

under/over absorption balances from the production overhead account prior to
write off to the income statement.
The entries in these accounts are as follows:

Production overheads account
Debit side $ Credit side $
(overheads incurred) (overheads absorbed)
Stores account X Work-in-progress account X
(indirect materials) (overheads absorbed)
Wages control account X
(indirect labour)
Various accounts X
(indirect expenses)
[Over-absorbed overhead] X [Under-absorbed overhead] X
(balancing figure) (balancing figure)
––– –––
X X
––– –––
Work-in-progress account
(elements of production cost) (completed production)
Opening inventory,
work-in-progress
Stores account X Finished goods account X
(direct materials) (completed production)
Wages control account X
(direct labour)
Production overhead account X Closing inventory, X
(production overhead work-in-progress
absorbed)
––– –––
X X
––– –––

If under-absorbed
Under-/over-absorbed overhead account
Production overhead account X Income statement X
–– ––
X X
–– ––
If over-absorbed
Under-/over-absorbed overhead account
Income statement X Production overhead account X
–– ––
X X
–– ––
EXAMPLE
A manufacturing business has a single production department. It uses absorption

costing and absorbs production overhead into costs on a direct labour hour basis.
The production overhead budget for the year to 30 June 20X4 was $800,000, and
budgeted direct labour hours were 100,000.
During the year to 30 June 20X4, the following costs were incurred:
$
Direct materials 420,000
Indirect materials 40,000
Direct labour 750,000
Indirect labour 315,000
Indirect expenses 505,000
Opening work-in-progress was $90,000 and closing work-in-progress was $70,000.
The number of labour hours actually worked was 110,000 hours.
Prepare the following accounts in the cost ledger of the business.
• Production overhead account
• Work-in-progress account
• Under-/over-absorbed overhead account.

SOLUTION
Workings
The overhead absorption rate is $8 per direct labour hour ($800,000/100,000 hours).
Production overheads absorbed were $880,000 (110,000 hours × $8 per hour).

Production overheads account
$ $
Stores account 40,000 Work-in-progress 880,000
Wages control account 315,000
Indirect expenses 505,000
Over-absorbed overhead 20,000
––––––– –––––––
880,000 880,000
––––––– –––––––
Work-in-progress account
$ $
Opening inventory 90,000 Finished goods 2,070,000
Stores 420,000 (balancing figure)
Wages control 750,000
Production overhead 880,000 Closing inventory 70,000
–––––––– ––––––––
2,140,000 2,140,000
–––––––– ––––––––
Under/over-absorbed overhead account

$ $
Income Production overhead
statement 20,000 account 20,000
––––––– –––––––
20,000 20,000
––––––– –––––––
11 INVESTIGATING THE CAUSES OF UNDER- OR OVER-

ABSORBED OVERHEAD
The intention of absorbing production overhead is to share the costs of the overheads
among the various products manufactured or jobs worked on. Ideally, the amount of
over-head absorbed should equal the amount of overhead expenditure incurred. In
practice, this rarely happens, and there are some under- or over-absorbed overheads.
This is because the absorption rate is decided in advance, based on the budgeted
overhead expenditure and budgeted volume of activity.
Even so, the amount of under- or over-absorbed overhead should not usually be large,
provided the budgeting is realistic and provided that actual results meet budgeted
expectations.
If the amount of under- or over-absorbed overhead is large, something could have

gone wrong, which should be a matter of some concern to management. Certainly,
management should expect to be informed of the reasons why there has been a large
amount of under- or over-absorption.

The accountant will be expected to investigate the reasons for the under- or over-
absorption, and report his or her findings to management.
There are several reasons why a large amount of under or over absorption of
overhead might occur.
• Actual overhead expenditure was much higher than budgeted, possibly due to
poor control over overhead spending.
• Actual overhead expenditure was much less than budgeted, possibly due to
good control over overhead spending.
• Actual overhead expenditure was much higher or lower than budgeted, due to
poor budgeting of overhead expenditure.
• The actual volume of activity was higher or lower than budgeted, for operational
reasons that the production manager should be able to explain.
• The actual volume of activity was higher or lower than budgeted, due to poor
budgeting of the volume of activity.
12 NON-PRODUCTION OVERHEADS
In a system of absorption costing, it is quite usual for administration overheads and
sales and distribution overheads to be treated as period costs and written as a charge
to the income statement, instead of being added to the cost of cost units.
However, it is also possible to calculate a full cost of sale by absorbing non-production

overheads into costs.
• Administration overheads might be absorbed into unit costs as a percentage of

full production cost.
• Sales and distribution overheads might be absorbed into unit costs as either a
percentage of sales value, or as a percentage of full production cost.
EXAMPLE
Sleepy Limited has budgeted the following sales and costs for next year.
$
Full production costs 240,000
Administration overheads 60,000
Sales and distribution overheads 80,000
Sales revenue 450,000
Production overheads will be absorbed at the rate of $4 per direct labour hour.
Administration overheads will be absorbed as a percentage of full production cost.
Sales and distribution overhead will also be absorbed as a percentage of full
production cost.
Calculate the fully absorbed cost of sale for a product that has a direct material
cost of $240 and a direct labour cost of $160, with labour paid at the rate of $8
per hour.

SOLUTION
Administration overheads will be absorbed at the rate of 25% (60,000/240,000) of full

production cost.
Sales and distribution overheads will be absorbed at the rate of 33.33%

(80,000/240,000) of full production cost.
The full cost of sale for the product is:

$
Direct materials 240
Direct labour 160
Production overheads (20 hours × $4) 80
––––
Full production cost 480
Administration overheads (25% × $480) 120
Sales and distribution overheads (33.33% × 160
$480)
––––
––––
13 FIXED, VARIABLE AND SEMI-FIXED OVERHEADS

In the examples above, overheads have been treated as a total cost. An organisation
might, however, distinguish between its fixed overheads and variable overheads, and
apply a different overhead absorption rate for each.
To do this, it might be necessary in the budget to separate semi-fixed and semi-

variable overhead costs into their fixed and variable elements.
This can be done using the high-low method, which we met in Chapter 3.
EXAMPLE
It has been estimated that total production overhead costs are as follows:
$
At 16,000 direct labour hours of work 86,000
Required:
(a) Use these estimates to obtain a fixed overhead absorption rate and a variable
overhead absorption rate for the budget period, in which the budgeted level of
activity is 18,000 direct labour hours. Both the fixed overhead and variable
overhead absorption rate should be on a direct labour hour basis.
(b) Suppose that actual results during the period were as follows:
Total overheads incurred $90,600
Direct labour hours worked 17,400
Calculate the amount of under- or over-absorbed overhead.

SOLUTION
(a)
$
At 19,000 hours the cost is 89,750
At 16,000 hours the cost is 86,000
–––––––––– –––––––––
The difference is 3,000 hours and 3,750
–––––––––– –––––––––
The difference must represent variable cost as by definition fixed costs do not
change with activity.
Variable overhead cost per hour is therefore ($3,750/3,000) $1.25
This is the absorption rate for variable overheads.
$
As total overhead cost of 19,000 hours is 89,750
And total variable overhead cost of 19,000 hours (× $1.25) is 23,750
––––––
Therefore fixed costs must be 66,000
––––––
The absorption rate for fixed overhead, given a budget of 18,000 direct labour
hours, should therefore be $3.667 per direct labour hour.
(b)
$
Absorbed overheads:
Fixed (17,400 hours × $3.67) 63,858
Variable (17,400 × $1.25) 21,750
––––––
Total absorbed overheads 85,608
Overheads incurred 90,600
––––––
Under-absorbed overhead 4,992
––––––
ACTIVITY 7
A manufacturing business uses absorption costing, and establishes separate

absorption rates for fixed production overhead and variable production overhead. The
absorption rates for next year will be based on 40,000 direct labour hours. Expenditure
budgets for fixed and variable costs should be derived from the following estimates of
cost:
$
Actual results for the period were:
Direct labour hours worked 41,500 hours
Variable overhead costs incurred $67,500
Fixed overhead costs incurred $91,000

Required:
(a) Establish a fixed overhead absorption rate and a variable overhead absorption
rate for the year.
(b) Calculate the amount of under- or over-absorbed overhead for both fixed and
variable overhead.
(c) Prepare the following accounts for the cost ledger:
• production overhead account
• under-/over-absorbed overhead account.
ACTIVITY 8
For the year ended 31 December 20X4 the planned overhead for finishing and
packing cost centres at Cuecraft Ltd was $74,000 and $49,000 and cost centre activity
volumes were planned as 12,750 and 10,500 direct labour hours.
During January 20X4 the following information was available:

Finishing Packing
Overhead incurred $6,900 $4,000
Activity
Direct labour hours 1,100 900
Calculate the pre-determined overhead recovery rates and the overhead under
or over-recovered for each cost centre for the month, showing clearly the
entries in the overhead control account.
CONCLUSION
Absorption costing is a very important and complex topic. This chapter explained how to
build up a full product cost by including an absorbed amount of overhead. This involved
allocation, apportionment and absorption of overhead. You should also be prepared to
calculate under or over absorption of overheads and carry out bookkeeping entries in
relation to overheads.

KEY TERMS
Overheads – a term for indirect costs.
Absorption costing – a method of costing in which the costs of an item (product or service
or activity) are built up as the sum of direct costs and a fair share of overhead costs, to
obtain a full cost or a fully-absorbed cost.
Overhead allocation – the process of charging a whole item of cost to a cost centre.
Overhead apportionment – the process of sharing out overhead costs on a fair basis.
Overhead absorption – the process of adding overhead costs to the cost of a product or
service, in order to build up a fully-absorbed product cost or service cost.
Under-absorption – overhead absorbed into the product is less than overhead incurred.
Under absorption reduces calculated profit.
Over-absorption – overhead absorbed into the product is greater than overhead incurred.
Over absorption increases calculated profit.
High-low method – a technique used to separate fixed and variable costs.
SELF TEST QUESTIONS

Paragraph
1 What are the reasons for using absorption costing? 1.4
2 What are service cost centres? 2.1
3 What bases of apportionment are used for overheads? 4
4 What is the difference between the direct and step-down method of

overhead reapportionment? 6
5 What are the particular problems of dealing with service cost centres? 6
6 What are the common methods of absorbing overhead? 8.1
7 Why are absorption rates based on budgeted figures? 8.3
8 What is over and under recovery of overhead? 9
9 What is the accounting entry for production overhead absorbed? 11
10 What are the causes of under- or over-absorbed overhead? 12

EXAM-STYLE QUESTIONS
1 The process of cost apportionment is carried out so that:
A costs may be controlled
B cost units gather overheads as they pass through cost centres
C whole items of cost can be charged to cost centres
D common costs are shared among cost centres.
2 What is cost allocation?
A The charging of discrete identifiable items of cost to cost centres
B The collection of costs attributable to cost centres and cost units using the
costing methods, principles and techniques prescribed for a particular business
entity
C The process of establishing the costs of cost centres or cost units
D The division of costs amongst two or more cost centres in proportion to the
estimated benefit received, using a proxy e.g. square feet
3 A company absorbs overheads on the basis of machine hours which were budgeted at
11,250 with overheads of $258,750. Actual results were 10,980 hours with overheads
of $254,692.
Overheads were:
A under absorbed by $2,152
B over absorbed by $4,058
C under absorbed by $4,058
D over absorbed by $2,152.
4 The following budgeted and actual data relate to production activity and overhead
costs in Winnie Ltd.
Budget Actual
Production overhead
Fixed $94,000 $102,600
Variable $57,500 $62,000
Direct labour hours 25,000 26,500
The company uses an absorption costing system and production overheads are
absorbed on a direct labour hour basis.
Production overhead during the period was:
A under absorbed by $4,010
B over absorbed by $4,010
C under absorbed by $9,876
D over absorbed by $9,876.

5 An overhead absorption rate is used to:
A share out common costs over benefiting cost centres
B find the total overheads for a cost centre
C charge overheads to products
D control overheads.
6 Floaters plc has the following production and fixed overhead budgets for the coming
year:
Production department 1 2
Fixed overhead $2,400,000 $4,000,000
Total labour hours 240,000 200,000
Total materials cost $200,000 $400,000
Department 1 labour is paid $5 per hour and department 2 labour $4 per hour.
The variable production cost of an IC is as follows:

$
Labour
Department 1 3 hours 15
Department 2 2 hours 8
Materials
Department 1: 1kg @ $4 per kg 4
Department 2: 2 kgs @ $5 per kg 10
Variable overheads 7
––––
$44
––––
If fixed overheads are absorbed on the basis of labour hours, the fixed overhead cost
per unit of IC is:
A $70
B $72.72
C $102.67
D $148
7 A company has four production departments. The following information is available:

Department K L M N
Fixed costs $10,000 $5,000 $4,000 $6,000
Labour hours per unit 5 5 4 3
If the company recovers overheads on the basis of labour hours and plans to produce
2,000 units, then the fixed cost per unit is:
A $3.00
B $12.00
C $12.50
D $17.00

8 A firm absorbs overheads on the basis of labour hours. In one period 11,500 hours
were worked, actual overheads were $138,000 and there was $23,000 over
absorption. The overhead absorption rate per hour was:
A $10
B $12
C $13
D $14
9 What will result if the budgeted level of activity is below the actual volume of activity
and actual expenditure on fixed production overheads is the same as budget?
A There will be too much expenditure on fixed production overheads
B There will be too little expenditure on fixed production overheads
C Fixed production overheads will be over-absorbed
D Fixed production overheads will be under-absorbed

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Chapter 8

1 Product costs and service costs

2 Treatment of overheads in absorption costing

4 Apportionment of overhead costs

5 Overhead analysis sheet

6 Service cost centre re-apportionment

7 The arbitrary nature of overhead apportionments

9 Under- and over-absorption of overheads

10 Accounting for production overheads

11 Investigating the causes of under-or over-absorbed overhead

13 Fixed, variable and semi-fixed overheads

KAPLAN PUBLISHING 125

At the end of this chapter you should be able to:

• explain the rationale for absorption costing

• describe the process of allocating, apportioning and absorbing production overheads

• apportion overheads to cost centres using appropriate bases

• explain the relative merits of actual and pre-determined absorption rates

• describe and apply methods of attributing non-production overheads to cost units

• calculate product costs using the absorption costing method

• prepare profit statements using the absorption costing method.

1 PRODUCT COSTS AND SERVICE COSTS

• We need to know about costs in order to decide whether the products or

• In some cases, products or services might be priced by adding a profit mark-up

• In the case of products, closing inventory must be valued at its cost.

Definition Overheads is a term for indirect costs.

126 KAPLAN PUBLISHING

Definition Absorption costing is a method of costing in which the costs of an

1.1 PRODUCT COSTS AND ABSORPTION COSTING

When costs are incurred, they can be recorded as:

• (sometimes) direct expenses; or

• selling and distribution overheads

• general overheads. However, general overheads are shared out between

Fully-absorbed product costs can therefore be built up as follows (with illustrative

KAPLAN PUBLISHING 127

1 In the statement of financial position, closing inventory is valued at its full

1.2 SERVICE COSTS AND ABSORPTION COSTING

• for a telecommunications business, a unit of service might be a cost per

• for a private hospital, a cost might be a cost per patient day

Service costs might be established as follows:

128 KAPLAN PUBLISHING

1.3 FIXED AND VARIABLE OVERHEADS

Overhead costs might be fixed costs or variable costs. In absorption costing,

1.4 REASONS FOR ABSORPTION COSTING

Pricing at a mark-up over full cost

The cost of a unit of Product X is as follows:

KAPLAN PUBLISHING 129

Total cost of Product X

2 TREATMENT OF OVERHEADS IN ABSORPTION

• overhead absorption, also called overhead recovery.

Each of these stages is explained below. However, in order to appreciate overhead

2.1 COST CENTRES AND ABSORPTION COSTING

• Production departments, in which items of product are manufactured. There

• Service departments within the production area. These are departments

• Administration departments or functions, for administration overheads.

130 KAPLAN PUBLISHING

• Selling and distribution departments or functions, for selling and distribution

• General cost items that cannot be attributed to a single department or work

In the description of absorption costing that follows, administration overheads and