1. Chapter 8 Study Text Chapter 8
Overheads and absorption costing

2. Overheads
• Overheads/indirect costs are those costs that cannot be traced directly
and in full to the products or services or department of the business.
• Overhead= indirect(material+labour+expenses)
• Overheads are categorised commonly ase
1. Production overhead
2. Administration overhead
3. Selling overhead
4. Distribution overhead
Slide 2

3. Absorption costing
• Absorption costing is a method of sharing overheads between
a number of different products or services on a fair basis.
• Absorption costing procedure
1. Allocation
2. Apportionment
3. absorption
Slide 3

4. Allocation
1) Allocation
• collection of costs by type
• allocation of as many costs as possible
directly to cost centers
Slide 4

5. Overheads
Total production costs
Direct costs Indirect costs
(overheads) Allocate &
apportion
COST CENTRES
Production 1 Production 2 Service
Allocate
COST UNITS
Slide 5

6. Apportionment
Two stages
1. Overheads that cannot be allocated to specific cost
centres are spread between cost centres on a fair
basis.
2. Re-apportionment of service cost center overheads
to production cost centers
Methods of re-apportionment
a) Direct method
b) Step-down method

7. Overheads Basis of apportionment
Overhead Basis
Rent and rates Floor space occupied
Depreciation Cost/NBV of equipment
Staff welfare Number of employees
Heat, light Volume of space occupied
Insurance of equipment Value of equipment
Insurance of building Floor space occupied
Stores costs Number of issues
Building repairs & Floor space occupied
maintenance
Slide 7

8. Re-apportionment
Direct method of re-apportionment:
• It involves apportioning the costs of each service Cost centre
to production cost centres only .Text example-page 143
Step-down method of re-apportionment:
• This method recognises the inter-service cost Centre work.
Each service cost centre’s costs are Not only apportioned to
production departments but to some ( but not all) of the
Other Service cost centres that makes use of the Service
provided

9. Reapportionment
To reapportion service cost centre overheads to production cost centres
there are 2 methods
Direct Step down
Method method
Inter-service Some inter-service
department department work
work is ignored is recognised
Slide 9

10. Overheads
Total production costs
Direct costs Indirect costs
(overheads) Allocate &
apportion
COST CENTRES
Production 1 Production 2 Service
Allocate
Production 1 Production 2 Reapportion
COST UNITS
Slide 10

11. Basis of re-apportionment
Service cost centre Possible basis of apportionment
Stores Number or cost value of material
requisition
Maintenance Hours of maintenance work done for each
cost centre
Production planning Direct labour hours worked in each
production cost centre

12. Absorption
Absorption involves;
• Identifing the absorption base
• Establishing an absorption rate for each
production cost center.
• Absorption of overheads in to cost units.

13. Absorption costing method
Total production costs
Direct costs Indirect costs
(overheads) 1.Allocate &
apportion
COST CENTRES
Production 1 Production 2 Service
Allocate
Production 1 Production 2 2.Reapportion
3. Absorb
COST UNIT
Slide 13

14. Possible bases of absorption
The most common absorption bases are as follows;
• A rate per machine hour
• A rate per direct labour hour
• A percentage of direct labour cost
• A percentage of direct material cost
• A percentage of total direct cost
• A rate per unit
• A percentage of factory overhead
• A percentage of sales value of factory cost

15. Choosing basis of absorption
Basis Use when
Unit Units are identical
Labour hour Labour intensive
Machine hour Machine intensive
% of direct labour Question asks for it

16. Absorption rate
Production overhead
_______________
OAR (overhead absorption rate) =
Activity level
Slide 16

17. Absorption into production
Overhead Pre-determined
Absorbed = Actual activity x OAR
Slide 17

18. Absorption costing -cost card
A cost card shows us the cost to make one unit
$/unit
Direct materials X
Direct labour X
Prime cost X
Overheads X
Full Product cost X
Slide 18

19. Predetermined overhead
absorption rates
• Calculated using budget figures
Steps in calculating and using POHAR
1. Estimate the overhead
2. Estimate the activity level for the period. This could
be total hours, units or direct cost or what ever
measure upon which the OHAR are to be based.
3. Divide the estimated overhead by the budgeted
activity level.This produces the POAR
4. Absorb or recover overheads in to cost units

20. Why use predetermined rates instead
of actual absorption rates
• It enable overheads to be absorbed through out the
accounting period.
• The actual overheads and actual activity level are not
known until the end of an accounting period, the
actual absorption rates can not be calculated until
then. In effect then the total cost of the product
cannot be determined until the end of the period as
well. This is too late for management planning and
control purpose like product pricing,production
scheduling,product cost estimation and routine
accounting functions like invoicing

21. Effect of using predetermined
absorption rates
At the end of the year actual overheads will be known
Overhead
absorbed ≠ Actual
overhead
Difference = under or over absorption
Slide 21

22. Non-production overheads
• For internal purposes and organisations which base
selling price of their product on estimates of total
costs or even actual costs. A total cost per unit of
output may be required. therefore it may be
appropriate to allocate non-production overheads to
units of output.
• Overhead absorption rate= estimated non-
production oH/ estimated production costs

23. Non-production overheads
Administration overheads include:
• Executive salaries and wages/salaries of all
staff in administration departments
• Office rent and rates
• Lighting and heating
• Cleaning
Selling costs are incurred in order to obtain sales
Distribution costs include warehouse cost and
delivery costs

24. Bases for absorption
Types of overhead Possible absorption base
Selling and marketing Sales value
Research and development Consumer cost (= production cost minus
cost of direct materials) or added value( =
sales value of product minus cost of
bought in materials and services)
Distribution Sales value
Administration Full production cost

25. Non-production costs in practice
In practice;
1.An absorption costing system may be
restricted to production costs only.
2.The non-production overheads are simply
treated as a period charge against profit.
3.The actual overhead costs are included in the
cost of sales.