Overheads and absorption - Overhead absorption rates and abs...

Learning Outcomes

By the end of this article, you will be able to explain how overheads are assigned to products using absorption costing, determine when to allocate, apportion, or absorb overheads, calculate overhead absorption rates (OAR) using different bases, and identify and account for under- and over-absorbed overheads. You will be able to select appropriate rates, understand their limitations, and apply them to scenarios as required by the ACCA exam.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how indirect production costs are assigned to products and services for cost accounting and inventory valuation. In this article, you should focus your revision on:

• The distinction between direct and indirect (overhead) costs
• The allocation, apportionment, and absorption of overheads into cost centres and products
• The calculation and application of overhead absorption rates (OAR) using units, labour hours, or machine hours
• The identification and treatment of under- and over-absorption of overheads
• The selection of appropriate absorption bases for different types of production environments
• The limitations and implications of absorption costing for decision making and financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the difference between allocation, apportionment, and absorption of overheads?
2. Calculate the overhead absorption rate (OAR) per unit if total budgeted overheads are $24,000 and budgeted output is 6,000 units.
3. State two possible causes of under-absorption of overheads.
4. Under what circumstances might a department use a machine hour rate for absorbing overheads instead of a labour hour rate?

Introduction

Overheads, also known as indirect costs, cannot be traced directly to a single product or service and must be spread across cost units using systematic methods. Absorption costing ensures that every unit produced bears an appropriate share of overhead costs by means of predetermined absorption rates. Correct calculation and application of these rates is critical for product costing, inventory valuation, and profit measurement under ACCA requirements.

Key Term: Overhead
An indirect cost that cannot be directly attributed to a single cost unit but supports overall production, including items like rent, depreciation, and supervisor salaries.

Key Term: Absorption costing
A costing method that allocates all direct costs and apportions overheads to products, ensuring each unit includes a share of both direct and indirect costs.

Key Term: Overhead absorption rate (OAR)
A predetermined rate used to charge overheads to products or services using an appropriate base such as units, labour hours, or machine hours.

Types of Overheads and Their Assignment

Overheads may be incurred throughout various areas of a business, such as production, service, or administration. To include them in product cost, overheads must first be gathered and then assigned to cost units.

• Allocation applies a whole cost directly to a single cost centre when possible.
• Apportionment involves distributing costs across multiple centres on a reasonable basis, such as floor space for rent.
• Reapportionment (if service cost centres exist) then redistributes service department overheads to production centres.

Overhead Absorption (Recovery)

After costs are assigned to production cost centres, they must be absorbed into product costs as production occurs. This is achieved through an overhead absorption rate (OAR), calculated in advance using budgeted data.

Calculation of Overhead Absorption Rate (OAR)

The OAR allocates overhead from cost centres to cost units. It is usually calculated as:

$\text{OAR} = \frac{\text{Budgeted overheads}}{\text{Budgeted level of activity}}$

The activity level could be budgeted units, direct labour hours, or machine hours. The selected base should reflect what drives the overhead costs.

• Use units when production is similar and overheads depend simply on output volume.
• Use labour hours when processes are labour intensive.
• Use machine hours when departments are machine driven.

Worked Example 1.1

A manufacturer allocates $54,000 in overhead to a machining department for the next year. The department expects to use 9,000 machine hours. Calculate the machine hour rate.

Answer:
OAR = $54,000 ÷ 9,000 = $6 per machine hour.

Application of OARs: Blanket vs. Departmental Rates

A blanket (factory-wide) OAR uses a single rate for all cost centres. Departmental rates calculate a separate OAR for each cost centre, allowing for greater accuracy, especially in diverse operations.

Worked Example 1.2

Department A budgets $20,000 overhead with 2,500 direct labour hours; Department B budgets $30,000 with 6,000 machine hours. Compute the OAR for each department.

Answer:
Department A (labour hour rate): $20,000 ÷ 2,500 = $8 per labour hour.
Department B (machine hour rate): $30,000 ÷ 6,000 = $5 per machine hour.

Advantages and Disadvantages of Different Bases

• Unit basis: Suitable where production is homogenous; simple but less accurate in mixed environments.
• Labour/machine hour basis: Reflects overhead incidence better in automated or manual operations.
• % of prime cost or direct wages: Generally less precise, avoided in practice.

Exam Warning

Overhead absorption rates must match the cost driver of the department. Using a labour hour rate in a machine-dominated department can under- or overstate product costs, risking misleading inventory or profit figures.

Absorbed, Under- and Over-Absorbed Overheads

When actual production or overheads differ from budgeted levels, the absorbed overheads may not match those actually incurred.

• Over-absorption: More overhead absorbed than incurred.
• Under-absorption: Less overhead absorbed than incurred.

Worked Example 1.3

A department sets an OAR of $4 per labour hour for $80,000 budgeted overhead and 20,000 budgeted hours. If 22,000 actual hours are worked and $90,000 is incurred, what is the under- or over-absorbed overhead?

Answer:
Overhead absorbed: 22,000 × $4 = $88,000
Actual overhead incurred: $90,000
Under-absorbed overhead: $2,000 ($88,000 − $90,000 = −$2,000)

Treatment

Under- and over-absorbed overheads may be adjusted in the profit and loss account at period end or carried forward if immaterial, depending on company policy and materiality.

Main Causes of Under/Over-Absorption

• Inaccurate budgeted activity levels
• Unforeseen events (machine breakdowns, absenteeism)
• Estimation errors in overhead budgets
• Actual costs or production differing from planned levels

Worked Example 1.4

The budgeted overhead for Factory X is $24,000 based on 8,000 machine hours. If actual machine hours are 7,500 and actual overhead incurred is $22,000, is there under- or over-absorption and by how much?

Answer:
OAR = $24,000 ÷ 8,000 = $3 per machine hour
Overhead absorbed = 7,500 × $3 = $22,500
Actual cost incurred = $22,000
Over-absorbed by $500

Choosing an Appropriate Absorption Base

Select the absorption base which most closely relates to the behaviour of the overheads in the cost centre:

• Labours hours: where indirect costs are proportional to labour effort
• Machine hours: where costs are caused by machine use
• Units: only if all outputs are highly similar

Limitations and Practical Considerations

Absorption costing matches costs to production but can distort product costs if the absorption base is poorly matched or overheads are not truly driven by the selected base.

• Blanket rates can distort costs when departments differ significantly.
• Changes in method or mix of production across periods can affect comparability.
• Incorrectly absorbed overheads affect stock valuation, gross profit, and may require reconciliation adjustments.

Summary

Overhead absorption assigns indirect costs to products or services based on predetermined rates using expected activity levels. The chosen absorption base should most accurately reflect cost causation in each cost centre. Differences between absorbed and actual overheads result in under- or over-absorption, which must be corrected for accurate profit reporting and inventory valuation. Understanding and calculating OARs, and recognising their limitations, are essential skills for ACCA exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between allocation, apportionment, and absorption of overheads
• Calculate overhead absorption rates (OAR) using different bases
• Apply blanket and departmental OARs and explain their suitability
• Identify causes and treatment of under- and over-absorbed overheads
• Select suitable absorption bases for different production environments
• Recognise limitations of absorption costing in product costing

Key Terms and Concepts

• Overhead
• Absorption costing
• Overhead absorption rate (OAR)