Absorption Costing

1. Absorption Costing Miss Hunter

2. Introduction Every business has costs, those costs can be direct or indirect. Direct costs are those associated with producing something Indirect costs are all other costs like office costs and admin anything that cant be directly related to production. To properly calculate the cost of every unit produced you need to know what direct costs are involved and you also need to apportion the indirect costs associated with producing the good. It is easy to determine the direct costs saw as raw materials, machinery, etc but it is sometimes difficult to divide the indirect costs and apportion them to each product. This is the purpose of absorption costing

3. Costs Activity Imagine you were producing your gift baskets as a business. Try and think of all the direct and indirect costs involved in producing each basket. Put them into a table like the one below.

4. Costs

5. Absorption costing Absorption costing requires managers to gather information on the direct costs, such as materials, and also the indirect costs or overheads such as admin costs. This method enables us to calculate the cost of production as precisely as possible. If the cost of meeting an order is underestimated, then the business might set the price too low, and make a loss on the order. Or, vice versa, the cost could be too high, and then the business might lose the order to a competitor.

6. Cost centres and cost units • We must firstly collect and record the production costs and overheads of running a business. A cost centre is a particular area or point of a business for which costs are collected. • In the case of manufacturing businesses, there are two main types of cost centre: • Production cost centres (e.g. production departments such as machining or assembly). • Service cost centres (e.g. admin or canteen). • When we have collected and recorded costs into cost centres, the process of absorption costing involves calculating the cost of each unit of production or Cost Unit

7. What is absorption costing? It is also known as full or total costing. The key point is that all overheads (indirect costs) are ‘absorbed’ into cost units. Therefore, all costs are included when calculating the cost of producing particular items. The main difficulty of absorption is deciding how to divide the cost of overheads (indirect) between these cost centres.

8. The 5 stages in the absorption costing process 1. ALLOCATION – of those overheads that are ‘directly’ incurred by particular cost centres, for example, we might be able to pinpoint depreciation of a machine to the production department. 2. APPORTION – divide all shared overheads between the production and service cost centres. (For example, sharing the rent of a building between several cost centres contained within that building). 3. APPORTION or ‘REAPPORTION’ all service cost centre overheads to the production cost centres. This is also called secondary apportionment (an example might be splitting the cost of running a canteen (service cost centre) up amongst several production cost centres. The reason is that only the production cost centres that are directly associated with the manufacture of the cost units. 4. ABSORB the allocated and apportioned overheads into the costs of production of cost units. 5. INCLUDE DIRECT COSTS, which can easily be attributed to individual products (cost units). This stage may have been completed in stage one, so could be ignored depending on the question

9. Stage 1 - ALLOCATION We must include the direct and indirect costs of production. Most exam questions provide direct costs associated with particular products or cost units, so can easily be charged to the relevant cost centre. For example, wages paid to assembly line workers can be allocated directly to the production department. Note: Sometimes this part is left until the end of the calculation. Some indirect costs that are wholly associated with a particular cost centre can also be charged ‘directly’ to that cost centre. Examples might include the wages of an assembly line supervisor, or depreciation of an assembly line machine. They can be allocated directly to the production department. Not all indirect costs can be charged to production departments. For example, the rent of a sales office might be charged directly to the sales department (service cost centre). Example: Consider Dentons Ltd, a clothing manufacturer

10. Stage 2 -Apportionment of overheads to cost centres Sometimes overheads are shared between several cost centres. For example, the cost of heating and insurance on a building might be shared amongst several production and service departments. A number of methods can be used to apportion overheads, as shown in the table on the next slide. There are no set guidelines to follow, but the basis must be equitable, which means that a fair share of the overheads should be apportioned to the relevant cost centre.

11. Apportionment of overheads to cost centres

12. It is important to apportion the overheads fairly because businesses will want to determine as accurately as possible the true cost of operating each cost centre. If they are not apportioned fairly, the business might charge an inappropriate price to its customers. Also, managers (who are responsible for cost centres) might be demotivated, if their centres are charged an unrealistic share of overheads, as it would suggest they are running an expensive department, and seem perhaps inefficient.

13. Example Consider Dentons Ltd, a clothing manufacturer. They have three overheads, £10,000 for heating, £40,000 in wages for 2 supervisors and £20,000 for insuring equipment. The business is divided into 4 cost centres. Some further information about Dentons Ltd is provided in the table below.

14. Example We must now apportion the 3 overheads, to the cost centres. The earlier table gave examples of how this can be done. Heating: The heating costs of £10,000 can be apportioned according to the proportion of total floor space each that each cost centre occupies. Cost to be apportioned =floor space occupied by cost centre * total heating cost Total floor space So: Cutting = 25m2 * £10,000 = £625 400m2 Assembly= 200m2 * £10,000 = £5,000 400m2 Canteen= 100m2 * £10,000 = £2,500 400m2 Maintenance= 75m2 * £10,000 = £1,875 400m2

15. Supervision Supervision: The supervisory costs of £40,000 can be apportioned according to the proportion of total staff employed in each cost centre. Cost to be apportioned = number of staff employed by cost centre *total supervisor cost Total number of staff So: Cutting = 15 * £40,000 = £12,000 50 Assembly= 30 * £40,000 = £24,000 50 Canteen= 2 * £40,000 = £1,600 50 Maintenance= 3 * £40,000 = £2,400 50

16. Insurance Insurance: The insurance costs of £20,000 can be apportioned according to the total book value of equipment(fixed assets) used in each cost centre. Costs to be apportioned = book value of equipment in cost centre * total insurance cost Total book value So: Cutting = 50,000 * £20,000 = £5,000 200,000 Assembly= 135,000 * £20,000 = £13,500 200,000 Canteen= 10,000 * £20,000 = £1,000 200,000 Maintenance= 5,000 * £20,000 = £500 200,000

17. Apportionment The following table shows the share of overheads apportioned to each cost centre. Sometimes more than one basis for apportionment could be used. For example buildings insurance could be apportioned according to the size of the floor area of each cost centre, ORto the book value of the buildingsof each cost centre. It is therefore a subjective judgement. However, it should always be made clear which basis is chosen, and the decision should be consistent and appropriate.

18. Apportionment

19. Stage 3 – Reapportionment of service centre overheads We now must apportion the service cost centreoverheads to the production cost centres. This is called reapportionment or secondary apportionment. Therefore, the costs involved in running service cost centres, such as canteen andmaintenance (other examples might include stores and planning), must be shared between the production departments. The reason for this, is that it is only the production cost centres that are directly associated with the manufacture of the cost units.

20. Stage 3 We can now illustrate how overheads are apportioned to production cost centres. Firstly we will consider each cost centre as it stands now, and then reapportion the service cost centre overheads to the production cost centres.

21. Stage 3 The ‘directly’ allocated costs are those costs such as depreciation of a specific machine that can be associated straight away with a particular cost centre (stage 1). The apportioned costs are taken from the workings on the previous page (stage 2). They are those costs which needed apportioningto different cost centres. We now need to reapportion the service cost centre (canteen and maintenance) costs in the following ways: Canteen: according to the number of meals served to staff in each cost centre Maintenance: according to the number of hours that maintenance staff work in each cost centre.

22. The total number of meals served is 12,500. These are split up amongst the three departments. This example presumes that no canteen staff have meals. • The 6,000 maintenance hours are split equally between the cutting and assembly departments.

23. The £9,500 canteen overheads need to bereapportioned to the two production cost centres. Remember that the Cutting department used 30% of meals so = £2,850 (30% of £9,500) The Assembly department used 60% of the meals so = £5,700 (60% of £9,500) The Maintenance department used 10% of the meals so = £950 (10% of £9,500) We can nowreapportionthe Maintenance overheads to the two production cost centres. Remember the Maintenance overheads now include some reapportioned Canteen overheads. Remember that both the Cutting, and Assembly cost centres used 50% of the Maintenance hours. Therefore we can split the £12,325 Maintenance overheads equally, which = £6,162.50.

24. Stage 4 – ABSORPTION of the allocated and apportioned (and reapportioned!) overheads into the cost units This will ensure that all costs are taken into account when calculating the cost of producing the goods that are to be sold. The rate at which the overheads are charged to cost units is called the overhead absorption rate (OAR). There are several methods available, but we must know only 2 methods for the exam

25. Machine hour overhead absorption rate: This method is most suitable when production is capital intensive (large investment in fixed assets like machinery compared to labour). Therefore, most of the overheads are related to the cost of using the machinery. They include, for example depreciation, power, insurance, maintenance etc. Machine hour OAR = Total cost centre overheads = rate per machine hour Number of machine hours Imagine that in a machining department, the total annual overheads are estimated to be £250,000. The budgeted annual total of machine hours in this cost centre is 10,000 hours. Machine hour OAR = £250,000 =£25 per machine hour 10,000 If a particular cost unit takes 6 hours to produce in the machining department then £150 (6 * £25) overheads will be absorbed to the production of that single unit.

26. Direct labour hour overhead absorption rate: This method is most suitable when production is labour intensive, i.e. when direct labour costs are high relative to capital costs. Direct labour hour OAR =Total cost centre overheads= rate per direct labour hour Total direct labour hours For example, a packaging department has total annual overheads estimated to be £60,000. The budgeted annual total labour hours is 20,000 hours. Direct labour hour OAR = £60,000 = £3 per direct labour hour 20,000 If it takes ½ hour to pack a cost unit, then £1.50 (0.5 * £3) overheads will be absorbed to each unit.

27. Step 5: Calculating the total cost unit Firstly add together each production cost centre – from step 4. e.g. £25 + £3 = £28. The final step is to consider any direct costs (materials, labour etc) which would be provided in the exam question (if these have not been dealt with in stage 1). We do not have to do any working out with these direct costs, apart from perhaps working out the direct costs per unit (if only a total is given). We can then addthese direct costs to the first bullet point and we have the total cost per unit!!!