Absorption Costing | Sahithyan's Notes

Overhead absorption is a systematic process of distributing overhead among the units produced. That overhead has already been allocated, apportioned, and reapportioned to production departments.

Overhead Absorption Rate

The rate at which overheads are charged to the cost units. Computed as either an actual rate or a predetermined rate.

Absorbing production overheads ensures the full production cost of a product is known. Actual overheads and activity levels are only known at the end of the period. Predetermined or budgeted figures are used instead.

Basis is the units, cost, or hours used as the denominator.

Predetermined OAR

\text{Predetermined OAR} = \frac{\text{Budgeted Overhead Expenses for the Period}}{\text{Budgeted Basis}}

Used for planning, control, and pricing purposes.

Actual OAR

\text{Actual OAR} = \frac{\text{Actual Overhead Expenses for the Period}}{\text{Actual Basis}}

Methods of Overhead Absorption

Production Unit Method

\text{OAR} = \frac{\text{Production Overhead for the Period}}{\text{Number of Units of Output}}

Percentage Methods

\text{OAR} = \frac{\text{Production Overhead for the Period}}{\text{Base}} \times 100

Where the base is one of:

Direct labour cost.
Direct material cost.
Prime cost.

Hourly Rate Methods

\text{OAR} = \frac{\text{Production Overhead for the Period}}{\text{Hours}}

Where hours is one of:

Direct labour hours.
Machine hours.

Blanket Overhead Absorption

Total production overheads of the organization are absorbed on a single absorption basis, giving only one rate for the entire unit, plant, or department. Simple to apply.

Inaccurate when departments differ in the overhead they incur. A single rate does not reflect how each department’s output actually consumes overhead.

A separate rate per department gives more accurate product costs in that case. Each rate is based on whichever resource that department’s process consumes most. For example, machine hours for a machine-intensive department, labour hours for a labour-intensive department.

Absorbed Overhead

The overhead charged to production using the absorption rate, computed as the absorption rate multiplied by the actual activity level.

Comparing it against the actual overhead incurred gives under-absorption (absorbed overhead less than actual) or over-absorption (absorbed overhead more than actual). Arises for 1 of the following reasons:

Actual overhead costs differ from budgeted overheads.
The activity level differs from the budgeted activity level.
Both actual overhead and activity level differ from budget.

Worked Example

Budgeted production overhead for the period is $50000$ , budgeted output is $10000$ units, budgeted direct labour hours are $5000$ , budgeted direct labour cost is $20000$ , and budgeted direct material cost is $30000$ .

\begin{array}{llll} \text{OAR (Units)} & = & \dfrac{50000}{10000} & = 5 \text{ per unit} \\[0.8em] \text{OAR (Labour Hours)} & = & \dfrac{50000}{5000} & = 10 \text{ per hour} \\[0.8em] \text{OAR (\% Labour Cost)} & = & \dfrac{50000}{20000} \times 100 & = 250\% \end{array}

Production cost per unit, using the OAR from the Production Unit Method:

\begin{array}{llll} \text{Direct Material Cost per Unit} & = & \dfrac{30000}{10000} & = 3 \\[0.8em] \text{Direct Labour Cost per Unit} & = & \dfrac{20000}{10000} & = 2 \\[0.8em] \text{Production Cost per Unit} & = & 3 + 2 + 5 & = 10 \end{array}

By the end of the period, actual output is $10500$ units and actual overhead incurred is $54000$ . Using the predetermined OAR from the Production Unit Method:

\text{Absorbed Overhead} = 5 \times 10500 = 52500

Since absorbed overhead ( $52500$ ) is less than the actual overhead incurred ( $54000$ ), there is under-absorption of $1500$ .

Selling price per unit is $15$ and units sold for the period are $10200$ .

\begin{array}{llll} \text{Sales} & = & 10200 \times 15 & = 153000 \\ \text{Cost of Sales} & = & 10200 \times 10 & = 102000 \\ \text{Gross Profit} & = & 153000 - 102000 & = 51000 \end{array}

Under-absorption is charged as an additional expense, since actual overhead incurred exceeds what was absorbed into production cost.

\text{Profit} = 51000 - 1500 = 49500