2.0ABSORPTION AND ACTIVITY BASED COSTING

Accounting For Overhead Expenditure:

Definition: These are costs that cannot be traced and assigned directly to the products or services provided. These are classified as:

(i.)Indirect materials

(ii.)Indirect labor

(iii.)Indirect expenses.

These are costs that cannot be directly assigned to cost objectives such as a product, process, sales territory or customer group i.e. supervision, lighting and heating and rent and rates expenses in product costing.

What are Product costs?

These are costs that are inventoriable and therefore can be capitalized as assets in the Balance Sheets of businesses. Product costs are required for two purposes:

i)for financial accounting requirements in order to allocate costs incurred during a period between:

  1. cost of goods sold, and
  1. inventory.

ii)for providing useful information for managerial decision-making.

Elements of manufacturing Product Costs:

In any manufacturing organizations, the calculation of product costs consists of three elements, viz. direct materials, direct labor and manufacturing overheads.

Product costs$

Direct Materialsxx

Direct Laborxx

Prime Costsxx

Manufacturing overheadsxx

Total Manuf. Costsxx

How are manufacturing costs determined?

Allocation of manufacturing overhead costs to products. Most companies allocate overheads to products using a two-stage procedure.

Stage 1: Overheads are assigned thro, allocation, apportionment and re-apportionment of service centres’ costs to production cost centres,

Stage 2: While the second stage allocates the costs accumulated in the production cost centres to products. This is cost absorption.

ProductionDepartmentalProducts

DepartmentsOverhead

absorption rates

AD

Overhead

CostBE

CF

Procedures in Manufacturing Overheads Costs Allocation:

STEP 1:Overhead costs are initially collected by cost centres and analyzed by nature (i.e. material, labor and overheads) of the expenditure.

STEP 2:A measure is selected for absorbing production centre expenses to products. The measure is usually called an allocation base and can either be direct laborhours and/or directmachine hours. These are the most frequently used allocation bases on an assumption that all these costs are volume/production units driven.

STEP 3: Computation of the overhead absorption rates

Usually an overhead absorption rate for each production cost centre is computed by dividing the total costs assigned to the centre by the total quantity of the allocation base consumed in that cost centre.

Overhead expenses are then allocated to products by multiplying the overhead rate of each centre by the quantity of the allocation base consumed by each product.

The Use of Blanket Rates

In some organisations the first stage of the two-stage overhead allocation procedure is omitted. They do not assign manufacturing overheads to cost centres. Instead, they establish a single overhead rate for the factory as a whole, and this rate is used to assign costs to products irrespect of the departments in which they were produced. This is called a blanket rate.

If a diverse product range is produced with products spending different proportions of time in each department separate cost centres overhead rates should be established.

An illustration of the overhead allocation procedure:

The annual overhead costs for a factory with three production departments (two machine shops and one assembly shop) and two service departments (stores and maintenance departments) are as follows:

$$

Indirect wages and supervision:

Machine shop: X100 000

Machine shop: Y 99 500

Assembly 92 500

Stores 10 000

Maintenance 60 000362 000

Indirect Materials:

Machine shop: X100 000

Machine shop:Y100 000

Assembly 40 000

Stores 4 000

Maintenance 9 000253 000

Lighting and heating 50 000

Rent100 000

Insurance of Machinery 15 000

Depreciation of machinery150 000

Insurance of buildings 25 000

Salaries of works Management 80 000420 000

1 035 000

The following information is also available:

BookAreaNo ofDirectMachine

Value ofOccupiedEmployeesLabourHours

Machinery(Sq. metres)Hours

Machine $$$$$

Shop : X800,000 10,00030200,000100,000

Shop: Y500,000 5,00020150,000 50,000

Assembly100,000 15,00030200,000 _

Stores 50,000 15,00010 _ _

Maintenance 50,000 5,00010 _ _

1500,00050,000 100

Maintenance department records indicate that the amount of the time spent on maintenance work in other departments was as follows:

Machine Shop X12 000 Hours

Machine Shop Y 8 000 Hours

Assembly 5 000 Hours

25 000 Hours

Details of total Materials issues from stores (i.e. direct and indirect materials) to the production departments are as follows:

$

Machine Shop X400,000

Machine Shop Y300,000

Assembly100,000

800,000

To allocate the items above to the production and service departments, we must prepare an overhead analysis sheet as shown below:

Overhead Analysis Sheet:

Production DepartmentsService Department

Items ofBasis of Total Shop X Shop YAssembly Stores Mainte-

Expenditure Apportionmentnance

Overhead Allocation:

$ $ $ $$$

1. Indirect Actual362,000 100,000 99,500 92,500 10,000 60,000

Wages and

Supervisors

2. Indirect Actual253,000 100,000 100,000 40,000 4,000 9,000

Material

Overhead Apportionment:

3. Lighting andArea 50,000 10,000 5,000 15,00015,000 5,000

Heating

4. RentArea100,000 20,00010,000 30,000 30,000 10,000

5. InsuranceBook value 15,000 8,000 5,000 1,000 500 500

Of machineryof Machinery

6. Depreciation Book value150,000 80,00050,000 10,000 5,000 50,000 of Machinery of Machinery

7. InsuranceArea 25,000 5,000 2,500 7,500 7,500 2,500

of Building

8. Salaries ofNo of 80,000 24,00016,000 24,000 8,000 8,000

works employees

management

STEP 1:(i) 1 035,000 347,000 288,000 220,000 80,000 100,000

Reapportionment of service Department Costs:

9. StoresValue of - 40,000 30,000 10,000 (80,000)

Materials Issued

10. MaintenanceTechnical Estimates -48,00032,000 20,000(100,000)

1 035,000 435,000 350,000 250,000 - -

STAg 2

Machine X Machine Y Assembly

Machine Hours100,000 50,000

Or Direct Labour hours 200,000

Machine Hour Overhead rate$4.35$7,00

Direct Labour Hour Rate $1.25

Notes:

  • Indirect wages and indirect materials cannot be allocated to specific products, but they can normally be assigned specifically to the appropriate departments.
  • The remaining items listed on the overhead analysis sheet cannot be directly assigned to any department on an actual basis. Thus an appropriate method for apportioning/sharing the overhead costs to the departments has to be established.

Charging Overhead To The Products:

  • The final step in cost allocation process is to absorb the overheads to products passing through the production departments. If we assume that product A spends 3 hours in the machine shop X, 2 hours in machine shop Y and 1 hour in the assembly department, then the following will be the overheads allocated to it:

$

Machine Shop X: 3 hrsx4.3513.05

Machine Shop Y: 2 hrsx7.0014.00

Assembly Depart: 1 hrs x 1.25 1.25

28.30

Production DepartmentsService Department

Items ofBasis of Total Shop X Shop YAssembly Stores Mainte-

Expenditure Apportionmentnance

Allocated Items: $ $ $ $$ $

1. Indirect Actual362,000 100,000 99,500 92,500 10,000 60,000

Wages and

Supervision

2. Indirect Actual253,000 100,000 100,000 40,000 4,000 9,000

Material

Apportioned Items:

3. Lighting andArea 50,000 10,000 5,000 15,00015,000 5,000

Heating

4. RentArea100,000 20,00010,000 30,000 30,000 10,000

5. InsuranceBook value 15,000 8,000 5,000 1,000 500 500

Of machineryof Machinery

6. Depreciation Book value150,000 80,00050,000 10,000 5,000 50,000 of Machinery of Machinery

7. InsuranceArea 25,000 5,000 2,500 7,500 7,500 2,500

of Building

8. Salaries ofNo of 80,000 24,00016,000 24,000 8,000 8,000

works employees

management

STEP 1:(i) 1 035,000 347,000 288,000 220,000 80,000 100,000

Reapportionment of service Department Costs:

9. StoresValue of - 40,000 30,000 10,000 (80,000)

Materials Issued

10. MaintenanceTechnical Estimates -48,00032,000 20,000-(100,000)

STEP 2 1 035,000 435,000 350,000 250,000 - -

Computation of the Departmental Absorption Rates:

Machine X Machine Y Assembly

Machine Hours100,000 50,000

Or Direct Labour hours: 200,000

Machine Hour Overhead rate$4.35$7.00

Or Direct Labour Hour Rate: $1.25

Notes: Treatment of Indirect Materials and Wages:

  • Indirect wages and materials cannot be allocated to any specific products, but they can normally be assigned specifically to the appropriate departments.
  • The remaining items listed on the overhead analysis sheet cannot be directly assigned to departments on an actual basis. Thus an appropriate method for apportioning the overheads to the departments has to be established.

Charging Overhead To The Products:

  • The final step is to allocate the departmental overhead costs to products passing through the production departments. If we assume that product A spends 3 hours in machine shop X, 2 hours in machine shop Y and 1 hour in the assembly department, then the following will be the overhead costs to be allocated:

$

Machine Shop X: 3 hrsx4.3513.05

Machine Shop Y: 2 hrsx7.0014.00

Assembly Depart: 1 hrs x 1.25 1.25

Assembly depart: 1 hrx1.2528.30

Predetermined Overhead Rates:

  • The problem in the Computation of Overhead absorption rates:

Calculation of overhead absorption/recovery rate as discussed above is not applicable in practice because this would mean calculations would have to be delayed until the end of the accounting period. By which time the information would have been rendered useless as this information is needed for financial reporting at the end of the year and making economic decisions in running the enterprise.

  • Therefore overhead rates are in practice based on estimates of annual estimated overhead expenditure and the anticipated activity level / output.
Under and Over-recovery of overheads:

The impact of pre-calculated overhead rates based on estimated annual overhead expenditure and activity level on costs is that it will be most unlikely that the overheads absorbed by the products actually manufactured during a period will be the same as the actual overhead incurred as per budgets. This discrepancy would mean that in those periods when the actual output equals the planned output, then the costs charged to the profit and loss account would also be equal to the budgeted overhead expenditure. Therefore no under- charging or over – charging of overheads in the profit and loss account would occur.

Illustration

Big Lizards Limited has a budgeted production overhead expenditure of $50,000 and a budgeted activity level of 25 000 direct labour hours (i.e. a overhead recovery rate of $2 per direct labour hour)

Required

The under/over absorbed overhead, and the reasons for the under/over absorption if;

a)Actual Overheads cost $47 000 and 25,000 direct labour hours are

worked.

b)Actual Overheads cost $50,000 and 21 500 direct labour hours are worked.

c)Actual Overheads Costs $47,000 and 21 500 direct labour hours are worked.

SOLN (S):Situations (a)(b)(c)

A: Budgeted Volume/capacity25 000hrs25 000 hrs25 000hrs

B: Budgeted Expenditure$50,00050,00050,000

C: Overhead Absorption Rate (BA)$2 per hr$2 per hr$2 per hr
D: Actual Volume worked25 000 hrs21,500hrs21,500hrs

E: Actual Expenditure$47 000$50 000$47 000

F: Absorbed Overhead (CxD)$50 000$43 000$43 000

G: (Under)/Over absorbed$3 000$(7 000)$ (4 000)

overhead (F-E)

The overhead absorption rate is pre-determined based on budgeted estimates of overhead costs and the volume of activity.

Under or over recovery of overhead costs will occur if either:

a)actual overhead costs; or

b)the actual activity level/volume; or

c)both are different from the budget.

Under – recovery or Over – recovery of overheads are credited or debited to overheads – adjustment account, the balance of this account is posted to profit and loss account for the period.

Treatment of Under or Over Recovery of Overhead costs Diagram:

AllocatedUNSOLDIncluded in the

to productsinventory valuation

(Product cost)UNITin the B/S and

recorded as an

Overheadexpense of the next

costsperiod

SOLD

UNITS EXPENSED

Under-recoveryProfit statement:

(Period cost)expense of current

Accounting period

NOTE:

The allocation of overheads to products is appropriate for stock valuation and profit measurements but such calculations are inappropriate for cost control. With respect to cost control, overheads should be assigned to responsibility centres and not products. Costs must be traceable to the individuals who have the authority to incur the costs.

Non-Manufacturing Overheads:

In respect of financial accounting, only manufacturing costs are allocated to products. Non-manufacturing overheads are regarded as period costs and are disposed of in exactly the same way as the under or over – recovery of manufacturing overheads. For external reporting it is therefore unnecessary to allocate non – manufacturing overheads to products.

However it is not uncommon for selling price to be based on estimates of total costs (manufacturing and non-manufacturing overheads for product pricing purposes). Accountants face difficulties in allocating non-manufacturing overheads because these cost allocations are very arbitrary. Consequently, it may be preferable not to allocate non-manufacturing overheads to products, but to add a percentage profit margin to each product so that it provides a profit contribution as well as a contribution to the non-manufacturing overheads.

ABSORPTION AND VARIABLE COSTING

The Concept of Absorption Costing:

Absorption costing and full costing are used to refer to a costing system in which all the fixed manufacturing overhead costs are allocated to products.

An alternative costing system to absorption costing is the direct costing system, the direct/variable/marginal costing assigns only variable manufacturing overhead costs to products. At times the terms Direct Costing and marginal costing are used for the same.

The argument for absorption costing and variable costing is to achieve acceptable methods of stock valuation and cost of goods sold for external reporting.

An Absorption Costing System:

Cost

ProductionNon manufacturing

Costscost

MaterialLaborOverheads

Work in ProgressFinishedProfit and

Stockgoods stockloss account

A Variable Costing System

Cost

ProductNon manufacturing

Costcosts

MaterialsLaborOverheads

VariableFixed

OverheadsOverheads

Work in progressFinishedProfit and

Stockgoods stockloss account

External and Internal Reporting:

  • No doubt absorption costing is required for external reporting a purpose that it has served well, however whether to adopt variable costing or absorption costing for internal reporting is still a heated debate.
  • Internal reporting needs:

Management normally requires profit statements at monthly or quarterly intervals, and will in no doubt wish to receive separate profit statements for each major product group or segment of the business.

-This information is particularly useful in evaluating the performance of the divisional managers.

-Therefore for internal reporting purposes variable costing has been used with some success.

Illustration:

The following information is available for periods 1 – 6 for a company that produced a single product:

$

Unit selling price10

Unit variable cost6

Fixed costs for each period300

Normal activity level is expected to be 150 units per period, and production and sales for each period are as follows:

P 1P 2P 3P 4P5P6

Unit sold:150120180150140160

Units Produced:150150150150170140

There were no opening stocks at the start of period 1, and the actual manufacturing fixed overhead costs incurred was $300 per period. We shall also assume that non-manufacturing overhead costs are $100 per period.

The variable and absorption cost statements for the periods 1 – 6 are shown below:

Variable Costing Statements

Periods

P1P2P3P4P5P6

$$$$$$

Opening stock--180--180

Production Cost9009009009001020840

Closing stock-(180)--(180)(60)

Cost of sales9007201080900840960

Fixed costs:300300300300300300

Total cost120010201380120011401260

Sales150012001800150014001600

Gross Profit300180420200260300

Less: Non-Manuf.

Overheads:100100100100100100

Net Profit20080320200160240

When a system of variable costing is used, the product cost is $6 per unit, and includes variable costs only since only variable production costs are allocated to the products under a variable costing system.

Absorption Costing Statements:

Periods

P1P2P3P4P5P6

$$$$$$

Opening stock--240--240

Production Cost120012001200120013601120

Closing stock-(240)--(240)(80)

Cost of sales12009601440120011201280

Adjustment for

under/(over)

recovery of overheads----(40)20

Total costs12009601440120010801300

Sales150012001800150014001600

Gross Profits300240360300320300

Less:

Non-Manufacturing

Costs100100100100100100

Net Profit200140260200220200

When using the absorption costing method, both the variable costs and fixed manufacturing overhead costs are allocated to individual products and are included in the production costs.

It can be seen from the above statements that an under-recovery of fixed overheads occurs whenever production volume is less than the normal level of activity of 150 units, since the calculation of the fixed overhead rate of $2 per unit was based on the assumption that actual production would be 150 units per period.

Variable and Absorption Costing:their impact on profits

The problem of fixed manufacturing overhead treatment:

The value of closing stock under absorption costing system includes the fixed manufacturing overhead. However in a direct costing system only the variable manufacturing overhead costs are carried in the closing stock inventory.

  • The profits calculated under the absorption costing and variable-costing systems would be equal provided production volume is equals sales volume, i.e., Periods 1 and 4.
  • When production is in excess of sales, absorption-costing system will show a higher profit than the variable costing system because cost of sales is understated. This is because fixed manufacturing overheads are over-absorbed P2 and P5, in units, which remained in the inventory with both fixed and variable manufacturing overheads.
  • When sales are in excess of production, the variable costing system will show a higher profit than the absorption costing system, periods 3 and 6, this arises because of under-absorption of fixed manufacturing overheads caused by the closing stock of the previous year that was carried less fixed manufacturing overhead costs.
  • These violent fluctuations in the profit figures arising in absorption costing is the result of under and over-recovery of fixed overhead treated as costs, and such adjustments can at times give a misleading picture of profit.

Conclusion:

The reasons for changes are that, with a system of variable costing, profit is a function of sales volume only; as long as the selling price and cost structure remain unchanged. However, with absorption, profit is a function of both sales volume and production volume.

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