Overhead Absorption

6 Key excerpts on "Overhead Absorption"

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  eBook - ePub

  Managing Finance

  • D. Crowther(Author)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  This over-recovery of overheads does, however, illustrate one problem with the treatment of overheads in this manner. This is that the calculation of the Overhead Absorption rate is based upon estimates of both cost and activity level. These estimates are made based largely upon past and current performance, adjusted for known factors, and so a firm is using past data to predict future performance. Using such estimates of costs can obviously affect the performance of the firm and affect its decision-making regarding such things as price setting, investment and the product mix. There is a danger using this method that these decisions are made upon inaccurate data as the true cost of production is known only after the event – at the end of the period. Office Furniture Company makes this calculation at the end of its year but most manufacturing companies, particularly those in which this information is crucial to decision-making, will operate Overhead Absorption rates on a month by month basis, recalculating as necessary in the light of actual data.

  We can see therefore that the calculation of the Overhead Absorption rate is crucial to a firm and it needs to get this rate as close to the actual as possible. This rate is of significance to business managers in all areas of the firm who will be making decisions, such as product mix, pricing or sales forecasting, based upon the cost of manufacture of the product. It is important therefore that these managers understand the basis of product costing as used in their firm and the possible consequences of using this method of treating overheads.

  Absorption Costing

  This procedure by which overheads are absorbed into the costs of production of a product is known as absorption costing. The procedure operates through the calculation of an Overhead Absorption rate, which we considered in the last chapter. You will remember that it can be explained as shown in Figure 8.1 .

  Figure 8.1 Steps in the absorption costing process

  The total overheads absorbed in this manner include:

  • Fixed costs: i.e. those costs which are not dependent upon the level of activity of the firm, such as rent or supervisory salaries.
  • Variable costs

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  Advanced Management Accounting

  • Ahmed Riahi-Belkaoui(Author)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  In general, firms can elect to distribute the pooled overhead over single basis. Overhead Absorption (Application) Assuming, first, that overhead has been distributed to the various departments and, second, that the service department overhead costs have been allocated to the various operating departments, the next step is to apply the overhead to the various work-in-process inventories. Overhead is applied to the products on the basis of a predetermined overhead rate computed as follows: Estimated overhead for the cost period Predetermined overhead rate = —: — — —— :—- Estimated level of activity for the cost period The cost period for the determination of the predetermined overhead rate is generally one year, although it may be different. The application of overhead is to the job-order cost sheets or the process summary reports in the subsidiary ledgers and to the Work-in-Process in the general ledger. This chapter focuses on the distribution base (capacity index) and the activity level (capacity level) to be used. Capacity Index Given that the cost object in overhead allocation is the product, the capacity index, or base that offers the best physical association with the product, it could be the units of production, direct-labor hours, direct-labor dollars, machine hours, or direct-material dollars. No specific rule exists for the choice of the optimal allocation base, but the actual situation can be used as a determinant. The following rules can be pro- posed: Cost Allocation Techniques 5 1. Where only one product is manufactured, the units-of-production method of allocation is adequate. If the firm manufactures several products that are alike except for one characteristic such as weight or volume, an allocation method based on the weights of the units is more satisfactory than the units-of-production method. 2. Where the departmental tasks are heavily automated, machine labor hours or machine labor dollars can be chosen.

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  Engineering and Commercial Functions in Business

  • William Bolton(Author)
  • 2014(Publication Date)
  • Newnes

    (Publisher)

  Cost allocation with absorption costing An alternative is to divide the costs of the service departments between the production cost centres and include it as an addition to their overhead costs. Thus, for example, the costs of the stores can be divided between the production cost centres according to the fraction of the cost of direct materials each cost centre uses. Thus for the data quoted in table 5.2, the stores overhead cost of £11 400 might be divided so that production cost centre A is allocated £4000 of it, cost centre B £5000 of it and cost centre C £2400. Maintenance costs might be divided between the producing cost centres according to the number of labour hours each centre has. Thus for the data quoted in table 5.2, the maintenance overhead cost of £8400 might be divided so that production cost centre A is allocated £2000, cost centre B £2000 and cost centre C £4400. The end result of this allocation is that there is an overhead cost for each production cost centre and that the total of all these overhead costs is the total overhead cost of the business. All the Cost elements 89 costs are thus absorbed by the production cost centres. Figure 5.3 illustrates how the various cost elements combine in this way to give the product cost. Production 1 costs 1 Direct labour costs Total costs Direct materials costs Production overheads + service | centre costs Goods finished | Cost | Service centre costs Figure 5.3 Cost allocation with absorption costing Example A manufacturing company has three production departments of machining, pressing and assembly and two service departments of engineering and administration. The overheads apportioned to each department are as given in table 5.3, all costs being in £. The engineer-ing service and administration costs are to be apportioned between the production departments on the basis indicated in table 5.3.

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  Cost and management accounting

  • Van Rensburg M(Author)
  • 2017(Publication Date)
  • Van Schaik Publishers

    (Publisher)

  Chapter 7 explained that information prepared for the financial statements of a company is not suitable for decision making, mainly because of cost behaviour. Financial statements, including the statement of comprehensive income and the statement of financial position, that are prepared according to accounting and reporting standards, are known as absorption (or full) costing. The absorption statement of comprehensive income should be adjusted so that the information is relevant to internal decision making, i.e. classified according to the behaviour of cost (or revenue) items instead of the function (e.g. manufacturing or non-manufacturing) of the cost items. When the classification is done according to the behaviour of cost or revenue items, it is known as direct (or variable) costing and is mainly used for internal decision making. This book will use the term “statement of comprehensive income” for the absorption costing method and “income statement” for the direct costing method. The difference between the two methods lies in the treatment of the fixed manufacturing overheads component, which can either be included as part of the cost of the product or be treated as a period cost.

  14.2 Absorption costing

  Absorption costing is the process whereby manufacturing overheads are assigned to products (or services in the service industry) so that the cost of inventory reflects all the manufacturing costs, i.e. direct materials, direct labour plus fixed and variable manufacturing overheads. In terms of absorption costing principles, fixed manufacturing overheads costs are apportioned to production and included as a product cost. This means that the cost of goods sold will include the fixed manufacturing overheads relating to the goods sold, while units of production not sold at the end of the reporting period will be valued at cost inclusive of the fixed manufacturing overheads capitalised as part of the product cost. Manufacturing overheads will be assigned to products using one of the bases (methods) discussed in Chapter 5 . This process of determining the value of inventory is in line with the guidelines of IAS 2 of IFRS. IAS 2 further stipulates that the overheads allocation must be done in a consistent manner and should be based on normal output (production) levels. IAS 2 also requires that the first-in-first-out (FIFO) or the weighted average principle should apply. You may refer to your Financial Accounting studies with respect to IAS 2 and inventory valuation. See Figure 14.1

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  Accounting for Managers

  Interpreting Accounting Information for Decision Making

  • Paul M. Collier, Sandy M. Kizan, Eckhard Schumann(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  If the company continued assigning overhead costs to each product based on labour hours, they could be under-pricing Product B or choosing a less-than-optimal mix of Products A and B. Although this is an extreme example, significant differences can result from the adoption of an activity-based approach to overhead allocation. Overheads allocated using direct labour hours un- der traditional costing do not reflect the actual causes for overhead costs being incurred. Cross- subsidization, as in this case, can be hidden in situations where a business sells a mixture of high- volume and low-volume products or services. The ABC method is preferred because the allocation of costs is based on cause-and-effect rela- tionships, while the traditional approach is based on an arbitrary allocation of overhead costs. How- ever, ABC can be costly to implement because of the need to analyze business processes in detail, to collect costs in cost pools, and to identify cost drivers and measure the extent to which individual products/services consume resources. For this reason, ABC is not for all companies. A company needs to assess the costs versus benefits prior to implementing an ABC system. ABSORPTION AND VARIABLE COSTING Variable costing is a method of reporting in which only variable costs are treated as inventoriable— that is, costs that are assigned, in some way, to each product made by the company. Direct materials, direct labour, and variable overhead costs are assigned to each product made during the period. However, fixed overhead costs are treated as period expenses—that is, they are expensed in the pe- riod in which they occur. They are not assigned to each product that is made and sold. Absorption costing, on the other hand, is a system where all production overhead costs (fixed and variable) are inventoriable. Variable costs (such as direct materials, direct labour, and variable overhead) are assigned directly to each unit made, similar to variable costing.

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  Management Accounting in a Dynamic Environment

  • Cheryl S. McWatters, Jerold L. Zimmerman(Authors)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  The choice of the methods also depends on how the allocated over- and under-absorbed costs are being used. If the purpose of the allocation is to communicate costs for planning purposes, the method that most closely approximates the cost of using indirect resources should be used. If the purpose of the allocation is to control managers, then the over- and under-absorbed overhead allocation should reflect controllability by the managers. The superiority of any of the following methods depends on the circumstances surrounding the allocation.

  Adjustment to Cost of Goods Sold

  The simplest method of accounting for over- or under-absorbed overhead is to adjust Cost of Goods Sold. If overhead is over-absorbed, the Cost of Goods Sold account is reduced by the amount of over-absorption. If overhead is under-absorbed, the Cost of Goods Sold account is increased. No adjustments are made to the Work-in-Process or Finished Goods inventory at the end of the period. This method, however, cannot be used for external reporting if the over- and under-absorbed overhead has a material impact (usually more than 3 to 5 percent) of Cost of Goods Sold.

  Proration

  Through proration

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