The Institute of Chartered Accountants of Bangladesh

Certificate Level – Management Information

Chapter – 03
Calculating unit costs (Part -02)

Accounting for
overheads

Apportion Allocation Absorption

Overhead absorption Under/Over

Secondary apportion rate (OAR) absorption

Absorption costing
In absorption costing the full cost of a cost unit is equal to its prime cost plus an
absorbed share of overhead cost.
The main aim of absorption costing is to recover overheads in a way that fairly reflects the
amount of time and effort that has gone into making a product or service.
Absorption costing involves the following stages:
 allocation and apportionment of overheads
 reapportionment of service (nonproduction) cost centre overheads
 absorption of overheads.
Calculating the absorption cost of a cost unit
The full or absorption Cost per unit
Particulars Amount Amount
Direct material............................. X
Direct labour or direct wages........ X
Direct expenses............................ X
Prime cost................................... X
Share of indirect cost/ overheads.... X
Absorption or full cost................ X

Distinction between Allocation and Apportionment:

Allocation Apportionment
Allocation deals with items Apportionment deals with only a particular portion of an
which are identifiable item of cost
Direct process of charging Needs the ascertainment of reasonable share of an
overhead expense to be borne by the various departments
benefited.

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 Wider term comparatively narrow than allocation
first stage second stage

Allocation of Overhead

Allocation of overheads

Assigning overheads
on an appropriate basis is important

Production or service cost centre

Overhead apportionment
The next step in absorption costing is overhead apportionment. This involves apportioning
general overheads to cost centres (the first stage) and then reapportioning the costs of
service cost centres to production departments (the second stage).

First stage: apportioning general overheads

Overhead apportionment follows on from overhead allocation. The first stage of overhead
apportionment is to identify all overhead costs as production department, production service
department, administration or selling and distribution overhead. This means that the costs
for heat and light, rent and rates, the canteen and so on (that is, costs which have been
allocated to general overhead cost centres) must be shared out between the other cost
centres.

The bases of apportionment for the most usual cases are given below:
Overhead to which the basis applies Basis
Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of buildings
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and Number of employees, or labour hours
cost offices, first aid worked in each cost centre
Heating, lighting. Volume of space occupied by each cost
centre
Second stage: Service Cost Centre Cost Apportionment:
The second stage of overhead apportionment concerns the treatment of service cost
centres. The next stage in absorption costing is, therefore, to apportion the costs of service
cost centres to the production cost centres. the following are the different ways:
A. Direct re-distribution method: Service department costs under this method
are apportioned over the production departments only, ignoring the services
rendered by one service department to the other
B. Step method or Non-reciprocal: This methods cognizance to the services
rendered by service department another service department. The sequence here
begins with the department that renders maximum number of services or cost to the
other departments distributed first and after this, the cost of the service department
serving the next largest number of department is apportioned.

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 C. Reciprocal basis: The reciprocal method for allocating costs of support
departments is the only method that recognizes all services provided to other
departments
i. Repeated Redistribution
ii. Trial and error method
iii. Simultaneous equation method
Reapportion service cost centre costs to production cost centres

Stage 1 P Stage 2

Individual
Total allocated / apportioned Product
Overheads S

Example
Sandy Plc has three production departments and two service departments. The following information is
available from the departmental distribution summary for the month of May2007
Particulars Amount Amount
Production departments
A 7,200
B 6,300
C 4,500 18,000
Service department
X 2,100
Y 2,700 4,800
22,800
The expenses of service departments are charged on a percentage basis as follows:
Service departments Production departments Service departments
A B C X Y
X 20% 40% 30% - 10%
Y 40% 20% 20% 20% -
Show the distribution of the service department cost under the repeated distribution method.

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Solution:
Sandy Plc – secondary distribution summary for May 2007
Ratio of Production departments Service department
Particulars
Apportionment
A B C X Y
Amount
According to primary distribution 7,200 6,300 4,500 2,100 2,700

Service Dept. X 20:40:30:10 420 840 630 (2,100) 210

Service Dept. Y 40:20:20:20 1,164 582 582 582 (2,910)
Service Dept. X 20:40:30:10 116 233 175 (582) 58
Service Dept. Y 40:20:20:20 23 12 12 11 (58)
Service Dept. X 20:40:30:10 2 5 4 (11) 0
Total 8,925 7,972 5,902 0 0
Example:
Sandy ltd. has two service departments X and Y and three production departments A, B and
C. from the following information prepare a secondary distribution summary on repeated
distribution method.
Particulars X Y A B C
Total as per primary distribution 3,000 3,600 12,000 6,000 4,500
Service rendered by:
X - 15% 25% 10% 50%
Y 10% - 20% 40% 30%

Working under Simultaneous equation method:

Since X gets service from Y to the extent of 10%, the total cost of X represents its own cost
plus 10% of Y's cost. Similarly, the total cost of Y represents its own cost plus 15% of X's
cost: because Y gets service form X to the extent 15%. Let x be the total cost of X
department and y be the total cost of Y department.
Putting the above in equation we get
x = 3,000+ 10% of y Again,
Or, x = 3,000 + 10y/100 y = 3,600 +15% of x
Or, 100x = 300000+10y Or, y = 3,600 + 15x/100
Or, 100x – 10y = 300,000 ------------ (i) Or, 100y = 360,000+15x
Or, 15x – 100y = - 360,000 ------------------ (ii)
Multiplying (i) by 10 we get-
1,000x – 100y = 3,000,000 ----------------- (iii)
By (iii) minus (ii) we get
985x = 3,360,000
Or, x = 3,411.17 or 3,411 (approx)
Putting this value in equation (i) we get
100 * 3411.17 – 10y = 300,000
Or, 10y = 41,117.17
Or, y = 4,111.70 or 4,112 (approx)

Overhead absorption

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Predetermined absorption rates
In absorption costing, it is usual to add overheads into product costs by applying a predetermined
overhead absorption rate. The predetermined rate is usually set annually in advance, as part of the
budgetary planning process.
Budgeted overheads
Overhead Absorption Rate (OAR) =
Budgeted machine hours
Bases of absorption
Overheads can also be absorbed into cost units using the following absorption bases:
 Machine hour rate (when production is machine intensive)
 Labour hour rate (when production is labour intensive)
 Rate per unit (is only effective if all units are identical in terms of the resources utilized in
their manufacture in each cost centre.)
 Percentage of direct materials cost
 Percentage of prime cost
 Percentage of direct wages.

Overhead absorption = OAR x Actual Hours worked

Under and over absorption of overheads

Overheads absorbed < Actual Overheads incurred Under-absorption of overheads
Overheads absorbed > Actual Overheads incurred Over- absorption of overheads
Example:
Neil Plc has budgeted overheads of Tk. 200,000 for the activity period. The organisation has decided to
absorb the overheads on the basis of the budgeted machine hours. The budgeted machine hours
worked for the period are 100,000. The actual overheads incurred for the period are Tk. 250,000 and
the machine hours worked are 135,000. Calculate the under- / over-absorption of overheads and give
reasons.
Answer
Budgeted overheads
Overhead absorption rate =
Budgeted machine hours

Tk. 200,000
=
100,000 hours

= Tk. 2 per machine hour

Actual overheads incurred Tk. 250000
Overheads absorbed (Tk. 2 x 135,000 hours worked) Tk. 270,000
Overheads over-absorbed Tk. 20,000

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Activity Based Costing (ABC)
ABC is an approach to costing that identifies individual activities as fundamental cost objects. It uses
the costs of these activities as the basis for assigning costs to ultimate cost objects such as products
or services.
An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity in
the ABC system.
Calculating product costs using ABC
Step 1 - Identify an organization's major activities
Step 2 -Identify the factors (cost drivers) which cause the costs of the activities
Step 3 - Collect the costs associated with each activity into cost pools.
Step 4 - Charge the costs of activities to products on the basis of their usage of the activities. A
product's usage of an activity is measured by the quantity of the activity's cost driver it generates.
Process of cost allocation:
The first-stage allocation in an ABC system is the process by which overhead costs are assigned to
activity cost pools.
The second-stage allocation in an ABC system is to relate overhead costs to ultimate cost objects
(products, customer orders, and customers). In this stage activity rates are used to apply costs to
products and customers.
Activity Based Costing Vs Traditional Cost Accounting (TCA)
 Traditional cost accounting is obsolete whereas Activity Based Accounting is used more by
various target-oriented companies.
 ABC methods help the company to identify the needs of keeping or eliminating certain
activities to add value to the products.
 TCA methods focus on the structure rather than on processes whereas ABC methods focus on
the activities or processes rather than on the structure.
 ABC provides accurate costs whereas TCA accumulates values arbitrarily.
 TCA is almost obsolete where as ABC methods are largely in use since 1981.
Example:
Ferris Corporation makes a single product—a fire-resistant commercial filing cabinet—that it sells to
office furniture distributors. The company has a simple ABC system that it uses for internal decision
making. The company has two overhead departments whose costs are listed on the following page:
Manufacturing overhead.................................. Tk. 500,000
Selling and administrative overhead................ Tk. 300,000
Total overhead costs ........................................Tk. 800,000
The company’s ABC system has the following activity cost pools and activity measures:
Activity Cost Pool Activity Measure
Assembling units.................... Number of units
Processing orders................... Number of orders
Supporting customers............ Number of customers
Other..................................... Not applicable
Costs assigned to the “Other” activity cost pool have no activity measure; they consist of the costs of
unused capacity and organization-sustaining costs—neither of which are assigned to orders,
customers, or the product.
Ferris Corporation distributes the costs of manufacturing overhead and of selling and administrative
overhead to the activity cost pools based on employee interviews, the results of which are reported
below:
Distribution of Resource Consumption across Activity Cost Pools
Assembling Processing Supporting
Units Orders Customers Other Total
Manufacturing overhead................. 50% 35% 5% 10%
100%
Selling and administrative overhead... 10% 45% 25% 20%
100%
Total activity .................................... 1,000 250 100
Units orders customers

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Required:
1. Perform the first-stage allocation of overhead costs to the activity cost pools.
2. Compute activity rates for the activity cost pools.
3. Office Mart is one of Ferris Corporation’s customers. Last year, Office Mart ordered filing
cabinets four different times. Office Mart ordered a total of 80 filing cabinets during the year.
Construct a table showing the overhead costs attributable to Office Mart.
4. The selling price of a filing cabinet is Tk. 595. The cost of direct materials is Tk180 per filing
cabinet, and direct labor is Tk. 50 per filing cabinet. What is the customer margin of Office
Mart?
Answer:
1. The first-stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools
Assembling Processing Supporting
Units Orders Customers Other
Total
Manufacturing overhead........ 250,000 175,000 25,000
50,000 500,000
Selling and admin overhead... 30,000 135,000 75,000 60,000
300,000
Total cost ............................ 280,000 310,000 100,000
110,000 800,000
2. The activity rates for the activity cost pools are:
a b a/b
Activity Cost Pools Total Cost Total Activity
Activity Rate
Assembling units ................... $280,000 1,000 units $280 per unit
Processing orders .................. $310,000 250 orders $1,240 per
order
Supporting customers........... $100,000 100 customers $1,000
per customer

3. The overhead cost attributable to Office Mart would be computed as follows:

(a) (b) (a) X (b)

Activity Cost Pools Activity Rate Activity ABC
Cost
Assembling units ........................ $280 per unit 80 units $22,400
Processing orders....................... $1,240 per order 4 orders $4,960
Supporting customers................. $1,000 per customer 1 customer $1,000

4. The customer margin can be computed as follows:

Sales ($595 per unit _ 80 units) ........................... 47,600

Costs:
Direct materials ($180 per unit _ 80 units) ....... 14,400
Direct labor ($50 per unit _ 80 units) ................ 4,000
Unit-related overhead (above).......................... 22,400
Order-related overhead (above) ........................ 4,960
Customer-related overhead (above)................. 1,000 46,760
Customer margin.................................................. 840

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Job costing- Is a form of specific order in which costs are attributed to individual jobs
Describe the situations where the use of job costing would be appropriate

Process Costing:
Process costing is the costing method applicable where goods or services result from a sequence of
continuous or repetitive operations or processes

Aircraft
Job manufacturing
Each job costing
Production Each jobShip-building
Any
Production is of a number of identical
two
consumes process maintains
units Tailor-made
jobs
Process
different is Mass
non- production
separate clothing
on a continuous arebasis
costing Difficult to establish identity of individual
materials
applies where repetitive & compared
jobsProduction
as identity to entire independent
production
involves number of
labour not processes throughout and output of one process of each
resources & continuous production
forms input of the next process other
Life cycle costing:
indirect
Life-cycle costing refers to the system that tracks process
and accumulates every individual cost which is
facilities
incurred during the whole life
service and abandonment stage.
cycle of a product starting from its initial planning stage to the post sales

Stages of product Life cycle

Planning & designing Manufacturing & sales Service & abandonment

stage stage stage

Research & Production

development After sales service

Marketing
Design Disposal of production
Distribution facility

Target costing
Target costing is an activity which is aimed at reducing the life-cycle costs of new products, while
ensuring quality, reliability and other consumer requirements
Thus the selling price determines the cost rather than the other way round.

Determine cost Determine target

unit cost

Add desired profit margin

Deduct desired profit margin

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 Determine the selling Determine the selling
price price
Traditional pricing Target Costing
Just-In-Time (JIT):
Just-in-time (JIT) is an approach to operations planning and control based on the idea that goods and
services should be produced only when they are needed.

Batch Questions Analysis

Nov-Dec 2015
2. (a) Define pre-determined overhead absorption rate. How is it calculated? 4
(b) A company produces two products, Bubble and Squeak, in two production cost centres. The initial allocation and
apportionment of Budgeted production overheads has been completed. Extracts from the budget are as follows:

Machining Cost Centre Finishing Cost Centre

Production overheads Tk. 38,000 Tk. 10,350
Machine hours per unit:
Product Bubble 6 2
Product Squeak 4 1
Production overheads are absorbed on a machine hour basis. Budgeted production is 800 units of Bubble and 700 units of
Squeak.
Determine the budgeted production overhead cost per unit of Bubble and Squeak.

For Bubble
A. Tk. 39.00
B. Tk. 24.50
C. Tk. 35.00
D. Tk. 40.50

For Squeak
A. Tk. 39.00
B. Tk. 24.50
C. Tk. 35.00
D. Tk. 40.50

Solution:
Particulars Machining Finishing
Production overheads (Tk.) Tk. 38,000 Tk. 10,350
Budgeted machine hours required:
For Bubble = (6 x 800) ; (2 x 800) 4,800 1,600
For Squeak = (4 x 700) ; (1 x 700) 2,800 700
7,600 2,300
Overhead absorption rate per machine hour =Tk. 38,000/7,600 = Tk. 10,350/2,300
= Tk. 5.00 = Tk. 4.50
Calculation of total production overhead cost per unit:
For, Bubble = Machining cost + Finishing cost
= (Tk. 5.00 x 6 + Tk. 4.50 x 2) = Tk. Tk. 39.00
For, Squeak = (Tk. 5.00 x 4 + Tk. 4.50 x 1) = Tk. 24.50
Nov- Dec 2014
1. (b) A company has two production departments and two service departments with production overheads as shown in the following
table:
Production Department Service Department
W X Y Z
Production overheads (Tk. ‘000) 500 600 600 800
Service department Y divides its time between the other departments in the ratio of 3:2:1 (for W, X and Z respectively)

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Department Z spends 40% of its time for servicing department W and 60% of its time for servicing department X. If all service
department overheads are apportioned to production departments, then calculate the total fixed overhead cost of department W.

1. What is method used for apportioning the overhead cost to production department
A. Direct method
B. Step method
C. Reciprocal method
D. Simultaneous equation method

2. Calculate the total fixed overhead cost of department W

A. Tk. 1,340
B. Tk. 1,300
C. Tk. 1,160
D. Tk. 1,100

Solution:
Production dept. Service dept.
Particulars
W X Y Z
Overhead as per primary allocation 500 600 600 800
Apportion of Y (3:2:1) 300 200 (600) 100
800 800 0 900
Apportion of Z (40:60) 360 540 0 (900)
Total 1,160 1,340 0 0

2. (a.) A management consultancy absorbs overheads on chargeable consulting hours. Budgeted overheads were Tk. 615,000
and actual consulting hours were 32,150. Overheads were under-absorbed by Tk. 35,000. If actual overheads were Tk. 694,075,
what was the budgeted overhead absorption rate per hour?

Answer:
Actual overheads Tk. 694,075
Under absorbed OH Tk. 35,000
Overhead Absorbed Tk. 659,075
So we know, OH absorbed = Actual hours x OAR
Or, Tk. 659,075 = 32,150 * OAR
Or, OAR = Tk. 659,075/32,150
So, OAR = Tk. 20.50

May-June 2014
3. (a) What is overhead? Classify different overhead costs with examples. 3
(b) ABC Ltd. has been using an overhead absorption rate of Tk.4.50 per labour hour. During the year the overhead expenditure
amounted to Tk. 215 and actual 44,000 labour hours were used. Calculate over absorbed/under absorbed amount?

Answer:
OH absorbed ( Tk. 4.5 x 44,000) = Tk. 198,000
Actual expenses incurred = Tk. 215, 000
OH under absorbed = Tk. 17,000

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