Ibrahim Sameer (MBA - Specialized in Finance, B.Com – Specialized in Accounting & Marketing)

Absorption Costing

Overheads are made up of indirect materials,

indirect labour and indirect expenses.

Under absorption costing principles, the

production overheads of a business are absorbed into

the cost of each of the products.

Allocation & Apportionment of Overheads

The first stage of the process is the allocation of

specific overheads to specific cost centres – then joint

overheads are apportioned to each cost centre on an

appropriate basis.

The overheads of the service cost centres must then

be reapportioned to the production cost centres on an

appropriate basis.

Absorption of Overheads

Once all of the production overheads have been

apportioned to the production cost centres an

overhead absorption rate is determined normally

based upon direct labour hours or machine hours.

The overhead absorption rate is then used to cost each

product depending upon how many relevant hours

each product takes in each production cost centre.

Predetermined Absorption Rate (PAR)

In absorption costing, it is usual to add overheads into

product costs by applying a predetermined

overhead absorption rate. The predetermined rate is

set annually, in the budget.

Predetermined Absorption Rate (PAR)

The absorption rate is calculated by dividing the

budgeted overhead by the budgeted level of

activity.

For production overheads the level of activity is often

budgeted direct labour hours or budgeted machine.

Predetermined Absorption Rate (PAR)

Management should try to establish an absorption rate

that provides a reasonably ‘accurate’ estimate of

overhead costs for jobs, products or services.

Over & Under Absorption of Overheads

The rate of overhead absorption is based on estimates

(of both numerator and denominator) and it is quite

likely that either one or both of the estimates will not

agree with what actually occurs. Actual overheads

incurred will probably be either greater than or less

than overheads absorbed into the cost of production.

Over & Under Absorption of Overheads

Over absorption means that the overheads charged

to the cost of production are greater than the

overheads actually incurred.

Under absorption means that insufficient

overheads have been included in the cost of

production.

Accounting for Over & Under Absorption

Under absorption

Dr Income statement

Cr Production overhead control

Over absorption

Dr Production overhead control

Cr Income statement

Accounting for Over & Under Absorption

The process of charging an entire expenses to a single

cost centre is called allocation.

The process of sharing an expense amongst a number

of cost centre is called apportionment.

Q & A