Absorption Costing

CPA SPM Prior Learning Accounting for Overheads - Absorption Costing Overheads are the costs incurred in the course of ...

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CPA SPM Prior Learning

Accounting for Overheads - Absorption Costing Overheads are the costs incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. The three types of accounting for overheads we need to study are: • Absorption Costing • Marginal Costing • Activity Based Costing The objective of absorption costing is to include in the total cost of a product “an appropriate share of the organisation’s total overhead”. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completing a job. Absorption costing is therefore a method for sharing overheads between products / services on a fair basis. The main reasons for using absorption costing are; inventory valuations, pricing decisions and establishing the profitability of different products. It is also worth noting that financial accounting standards and in particular “IAS 2 Inventories” recommend using absorption costing to value inventory. In theory management accountants can use any method to value inventory so therefore have a choice to use absorption, marginal or activity based costing. However, if the company’s cost accounting and financial accounting records are integrated into a single set of accounting records, this removes the choice and the management accountant will have to use absorption costing to comply with IAS 2. The three stages of absorption costing are: • Allocation • Apportionment • Absorption • Allocation is the process by which whole cost items are charged direct to a cost centre. A cost centre is generally a department. So if we have a supervisor for department A, and a supervisor for department B, the wages of these supervisors will simply be “allocated” to the relevant department. A problem arises when one supervisor may be responsible for two departments or cost centres and here we have to apportion the wages. Apportionment is used where the overhead cost is shared over several cost centres when allocation is not feasible or possible. E.g. the salary of a supervisor who is responsible for a number of cost centres. (See Aug 2009 Q1 part a). The first stage of overhead apportionment is to identify all overheads such as light and heat, rent, canteen etc. It is considered important that overhead costs should be shared out on a fair basis. The basis for apportionment in most cases would be:

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CPA SPM Prior Learning Rent, rates, light and heat, repairs and depreciation of buildings  floor area occupied by each cost centre Depreciation, insurance of equipment  Cost or book value of equipment HR, canteen, welfare, first aid etc.  Number of employees or number of labour hours worked in each cost centre Example: Swan Ltd has two production departments (A and B) and two service departments (maintenance and stores). Details of next year’s budgeted overheads are as follows: Light and Heat 19,200 Repair Costs 9,600 Machinery Depreciation 54,000 Rent and Rates 38,400 Canteen 9,000 Machinery Insurance 25,000 Total 155,200 Details of each department are as follows: A

B

Maintenance Stores

Total

6,000

4,000

3,000

2,000

15,000

48,000

20,000

8,000

4,000

80,000

50

40

20

10

120

15,000

20,000

12,000

5,000

52,000

Floor Area Machine Value Number of Employees Allocated Overheads

If we want to apportion light and heat for example, the fairest method of apportionment would be to use floor area. The total floor area is 15,000 sq. meters and Dept. A uses 6,000 sq. meters of this. So to apportion a fair amount to department A we take the total light and heat overhead of 19,200 and we multiply that by 6000/15,000 = 7,680. For Dept. B it will be 19,200 x 4,000/15,000 = 5,120. For maintenance it will be 19,200 x 3,000/15,000 = 3,840 For stores it will be 19,200 x 2,000/15,000 = 2,560 If we total up our apportioned overheads of 7,680 + 5,120 + 3,840 + 2,560 = 19,200, you can see we have our total light and heat overhead of 19,200 but it is now fairly apportioned between cost centres. Can you apportion the remaining overheads? Give it a try and see if you can fairly apportion each overhead to each cost centre. Your total apportioned overheads should = 155,200!!!

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CPA SPM Prior Learning Solution: Item of Overhead:

Basis of A Apportionment

B

Maintenance Stores

Total

Heat and Light Repair Costs Machine Dep. Rent and Rates Canteen

Floor Area Floor Area Machine Value Floor Area No of employees Machine Value

7680 3840 32400 15360 3750

5120 2560 13500 10240 3000

3840 1920 5400 7680 1500

2560 1280 2700 5120 750

19200 9600 54000 38400 9000

15000

6250

2500

1250

25000

78030

40670

22840

13660

155200

15,000

20,000

12,000

5000

52000

93030

60670

34840

18660

207200

Machinery Insurance Total Apportioned Overheads Allocated Overheads Total Overheads

Service Department costs: In the above example we have apportioned the costs of the general overheads, but what about the costs associated with the service departments i.e. maintenance and stores? Service costs also need to be apportioned. We apportion service costs to both production departments and service departments that use their services. Again it is considered important that service department overhead costs should be shared out on a fair basis. The basis for apportionment in most cases would be: • • •

Stores  No or cost of materials requisitions Maintenance  Hours of maintenance work done for each cost centre Production Planning  Direct labour hours worked on each production cost centre

Taking the above example of Swan Ltd Total Overheads were as follows: A

B

Maintenance Stores

Total

93030

60670

34840

207200

18660

(Remember both allocated and apportioned overheads need to be re-apportioned.)

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CPA SPM Prior Learning If we are told that usage of Swan Ltd.’s service departments were as follows: A B Stores Total Maintenance Maintenance Hours Used 5,000 4,000 1,000 10,000 No of Stores Requisitions 3,000 1,000 1,000 5,000 We must now re-apportion out the Maintenance and Stores Overheads. Total Maintenance Overheads are 34,840 and these must now be apportioned out between the other three departments. We will do this based on Maintenance Hours used of which there is a total of 10,000. For Dep. A we have 34,840 x 5,000/10,000 = 17,420 For Dep. B we have 34,840 x 4,000 / 10,000 = 13,936 For stores we have 34,840 x 1,000 / 10,000 = 3,484 We must now add these figures onto the total overheads figure for each (and reduce maintenance to 0 as it has been re-apportioned out).

Total Overheads Apportion Maintenance New Total Overheads

A

B

Maintenance

Stores

Total

93,030 17,420

60,670 13,936

34,840 -34,840

18,660 3,484

207,200 0

110,450

74,606

0

22,144

207,200

Next we must re-apportion the stores overheads. These will be done based on no of stores requisitions of which there are 5,000. However as we have apportioned out Maintenance already we will not include the 1,000 requisitions relating to maintenance so we will have 4,000 instead. For Dep. A we have 22,144 x 3,000/4,000 = 16,608 For Dep. B we have 22,144 x 1,000/4,000 = 5,536 Again we now add these figures onto the total overheads figure for each (and reduce stores to 0 as it has been re-apportioned out). A

B

Maintenance

Stores

Total

Total Overheads Apportion Maintenance New Total Overheads

93,030 17,420

60,670 13,936

34,840 -34,840

18,660 3,484

207,200 0

110,450

74,606

0

22,144

207,200

Apportion Stores

16,608

5,536

0

-22,144

0

Final Total Overheads

127,058

80,142

0

0

207,200

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CPA SPM Prior Learning As we can see the total overheads for Swan Ltd have at no stage changed from 207,200. It is just a matter of allocating and apportioning out the overheads fairly. Absorption is the process whereby overhead costs allocated and apportioned to cost centres are added to unit, job or batch costs. Overheads are usually added to cost units using a predetermined overhead absorption rate, which is calculated from the budget using a 4-step process: 1. Estimate the overhead likely to be incurred during the coming period. 2. Estimate the activity level for the period. This could be total hours, units or direct costs or whatever we wish to base the overhead absorption rates upon. 3. Divide the estimated overhead by the budgeted activity level. This produces the overhead absorption rate. 4. Absorb the overhead into the cost unit by applying the calculated absorption rate. Example: Ace Co Ace Co makes two products, the King and the Queen. Kings take 2 labour hours each to make and Queens take 5 labour hours. Ace Co estimates that 100,000 labour hours will be worked and overheads are expected to be €50,000 in the coming year. What is the overhead cost per unit for Kings and Queens if overheads are absorbed on the basis of labour hours? Solution: Step 1  Overheads are estimated at €50,000 Step 2  Labour hours are estimated at 100,000 Step 3  €50,000 100,000 hrs. = €0.50 per labour hour Step 4  King Queen Labour Hours per unit 2 5 Absorption Rate per labour hour €0.50 €0.50 Overhead absorbed per unit €1 €2.50 As we can see there is a great lack of precision about the way an absorption base is chosen. This arbitrariness is one of the main criticisms of absorption costing, and if absorption costing is to be used then it is important that the methods used are kept under regular review. The most common bases of absorption are direct labour hour rate or machine hour rate. • A direct labour hour basis is most appropriate in a labour intensive environment. • A machine hour rate is used in departments where production is controlled by machines. • A rate per unit would only be effective if all units were identical. Example Overhead Absorption: The budgeted production overheads and other budget data of BC Co are as follows: Budget

Dept. A

Dept. B

Overhead Cost Direct Materials cost Direct Labour Cost Machine Hours Direct Labour Hours Units of Production

€ 36,000 32000 40000 10000 18000

€ 5,000

1000

Calculate the Overhead Absorption Rate of each department. © Cenit Online 2016

CPA SPM Prior Learning Solution: Without further information we could either use the rate per machine hour or rate per labour hour for Dept. A. The Dept. B absorption rate will be based on units of output. Dept. A: Rate per machine hour = €36,000/10,000 hrs = €3.60 per machine hour Rate per direct labour hour = €36,000/ 18,000 hrs = €2 per direct labour hour Dept. B: Units of Output

=

€5,000/ 1,000 units

=

€5 per unit produced

Blanket Absorption Rates: A blanket absorption rate is an absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they were produced. Blanket overhead absorption rates are not appropriate where: • There is more than one department • Jobs do not spend an equal amount of time in each department If a single factory overhead absorption rate is used, some products will receive a higher overhead charge than they ought to bear if fairness was to apply, whereas other products will be undercharged. If a separate absorption rate is used for each department, charging of overheads will be fair and the full cost of production of items will represent the amount of the effort and resourced put into them. Question: The following data relate to one year in department A: Budgeted machine hours 25,000 Actual machine hours 21,875 Budgeted Overheads €350,000 Actual Overheads €350,000 Based on the data above, what is the machine hour absorption rate? A €12 B €14 C €16 D €18 Solution: The correct answer in this case is B. Budgeted Overheads Budgeted Machine Hours

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€350,000 25,000

=

€14 per machine hour

CPA SPM Prior Learning Over and under absorption of overheads: Over and under absorption occurs because the predetermined overhead absorption rates are based on estimates. It is quite likely that either one or both estimates will not agree with what actually occurs. Over absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred. Under absorption means that insufficient overheads have been included in the cost of sales. Example: The budgeted overhead in a production department is €80,000 and the budgeted activity is 40,000 direct labour hours. The overhead absorption rate using a direct labour hour basis would be €2 per direct labour hour. Actual overheads in the period are €84,000 and 45,000 direct labour hours are worked. Calculate the under or over absorption of overheads. Solution: Overhead incurred (actual) Overhead absorbed (45,000 x €2) Over absorption of overhead

Question:

Solution:

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€84,000 €90,000 €6,000

CPA SPM Prior Learning Sample Q from F2 Man Acc

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CPA SPM Prior Learning

Solution:

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CPA SPM Prior Learning

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