AQA A-Level Accounting (7127)

## Learning Outcomes

- Understand how **absorption costing** deals with production overheads
- Identify the difference between **allocation**, **apportionment**, and **absorption**
- Calculate an **overhead absorption rate (OAR)** using labour hours or machine hours
- Apply an OAR to actual activity to find overhead absorbed
- Work out whether overheads are **under-absorbed** or **over-absorbed**
- Recognise common student errors in overhead calculations
- Structure exam answers that explain both calculations and their effect on profit

## AQA A-Level Accounting (7127) Syllabus

For the AQA A-Level Accounting (7127), you are expected to understand absorption costing in relation to overhead treatment, with a focus on the following syllabus points:

- Know that **absorption costing** includes all **production costs**, including production overheads, in product cost
- Identify the difference between **allocation**, **apportionment**, and **absorption**
- Understand that overheads are first collected in **cost centres**
- Explain why **service cost centre** overheads are reapportioned to **production cost centres**
- Calculate an **overhead absorption rate** using budgeted overheads and budgeted activity
- Apply labour hour and machine hour rates to actual activity
- Calculate and interpret **under-absorption** and **over-absorption** of overheads
- Understand that under-absorption tends to reduce profit, while over-absorption tends to increase profit in simplified exam treatments

## Test Your Knowledge

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

1. What is the difference between allocation and apportionment of overheads?
2. Why must service department costs be reapportioned before calculating final overhead absorption rates?
3. How is an overhead absorption rate calculated?
4. What is the difference between under-absorption and over-absorption?
5. Why are departmental overhead absorption rates often more accurate than one overall factory rate?

## Introduction

In absorption costing, a business includes not only direct materials and direct labour in the cost of a product, but also a share of **production overheads**. This matters because a business must recover all production costs through the selling price of its output.

For AQA, this topic is very calculation-heavy. You need to know the sequence clearly: collect overheads in cost centres, allocate and apportion them, reapportion service cost centre totals, calculate overhead absorption rates, apply those rates to actual activity, and then compare absorbed overhead with actual overhead.

> **Key Term: absorption costing**
> A costing method in which all production costs, including production overheads, are included in the cost of output.

### Cost centres and the flow of overheads

Before overheads can be charged to products, they must be collected in the right part of the business.

> **Key Term: cost centre**
> A section of a business to which costs can be charged.

There are two important types:

- **Production cost centres**: departments directly involved in making the product
- **Service cost centres**: departments that support production, such as maintenance, stores, or administration

The logic is simple. Service departments do not produce goods for sale, so their costs cannot stay there. They must be transferred to the production departments that do make the output.

> **Key Term: production cost centre**
> A cost centre directly involved in making goods or services.
>
> **Key Term: service cost centre**
> A cost centre that supports production departments but does not itself produce saleable output.

A good exam sequence is:

1. **Allocate** overheads that belong fully to one cost centre
2. **Apportion** shared overheads between cost centres
3. **Reapportion** service cost centre totals to production cost centres
4. Calculate **OARs**
5. Absorb overheads into jobs, units, or batches
   > **Test Tip:** If an AQA question includes a table with several departments, do not jump straight to the OAR. First check whether service department costs still need reapportioning.

### Allocation, apportionment and reapportionment

These three terms are often confused, but they happen at different stages.

> **Key Term: allocation**
> Charging an overhead cost directly and in full to one cost centre when it clearly belongs there.

Examples of allocation:

- indirect materials used only in one department
- a supervisor’s wages for one department only
  > **Key Term: apportionment**
  > Sharing an overhead between cost centres on a fair basis when more than one cost centre benefits.

Examples of common apportionment bases:

- **floor area** for rent, rates, heating, lighting
- **number of employees** for canteen or welfare costs
- **value of machinery** for machinery insurance or depreciation

After that comes reapportionment.

> **Key Term: reapportionment**
> Transferring service cost centre overheads to production cost centres on a suitable basis.

For example:

- maintenance may be reapportioned using value of machinery
- stores may be reapportioned using number of requisitions

AQA questions usually use direct reapportionment or straightforward step-down style layouts. Keep the method clear and tabular.

#### Worked example: allocation and apportionment

A business has two production departments, **A** and **B**, and one service department, **S**.

Overheads:

- Rent: **£12,000**
- Machinery insurance: **£6,000**
- Supervisor salary for A only: **£9,000**

Data:

- Floor area: A 400 sq m, B 300 sq m, S 100 sq m
- Value of machinery: A £50,000, B £25,000, S £25,000

Step 1: Allocate supervisor salary

- A = **£9,000**
- B = **£0**
- S = **£0**

Step 2: Apportion rent by floor area  
Total floor area = 400 + 300 + 100 = **800**

- A = 400/800 × £12,000 = **£6,000**
- B = 300/800 × £12,000 = **£4,500**
- S = 100/800 × £12,000 = **£1,500**

Step 3: Apportion machinery insurance by machinery value  
Total value = 50,000 + 25,000 + 25,000 = **£100,000**

- A = 50,000/100,000 × £6,000 = **£3,000**
- B = 25,000/100,000 × £6,000 = **£1,500**
- S = 25,000/100,000 × £6,000 = **£1,500**

Step 4: Total overheads before reapportionment

- A = 9,000 + 6,000 + 3,000 = **£18,000**
- B = 0 + 4,500 + 1,500 = **£6,000**
- S = 0 + 1,500 + 1,500 = **£3,000**

If service department S is then reapportioned 2:1 to A and B:

- A receives **£2,000**
- B receives **£1,000**

Final totals:

- A = **£20,000**
- B = **£7,000**

Common student errors here:

- using the wrong base for apportionment
- forgetting to total departments before reapportionment
- leaving service department costs unreapportioned

### Overhead absorption rates and absorbed overhead

Once the final production department overhead totals are known, the next step is to calculate the OAR.

> **Key Term: overhead absorption rate (OAR)**
> A rate used to charge production overheads to output, based on budgeted overheads and budgeted activity.

Formula:

$$
\text{OAR} = \frac{\text{budgeted overheads}}{\text{budgeted activity}}
$$

The activity base is usually:

- **direct labour hours**, or
- **machine hours**

#### Side-by-side comparison of common OAR bases

| Basis             | Formula                                           | Best used when                  |
| ----------------- | ------------------------------------------------- | ------------------------------- |
| Labour hour rate  | Budgeted overheads ÷ budgeted direct labour hours | Production is labour intensive  |
| Machine hour rate | Budgeted overheads ÷ budgeted machine hours       | Production is machine intensive |

A labour-intensive department should usually use labour hours. A machine-based department should usually use machine hours.

> **Test Tip:** Use the activity base stated in the question. Do not switch to a different base just because you think it looks better.

#### Worked example: labour hour OAR

Department A has final budgeted overheads of **£40,000** and budgeted direct labour hours of **5,000**.

Step 1: Calculate OAR

$$
\frac{£40,000}{5,000 \text{ hours}} = £8 \text{ per labour hour}
$$

Step 2: Apply to actual activity  
If actual labour hours for a job are **420**:

$$
420 \times £8 = £3,360
$$

So overhead absorbed = **£3,360**

#### Worked example: machine hour OAR

Department B has final budgeted overheads of **£54,000** and budgeted machine hours of **18,000**.

$$
\frac{£54,000}{18,000} = £3 \text{ per machine hour}
$$

If actual machine hours for a batch are **600**:

$$
600 \times £3 = £1,800
$$

So overhead absorbed = **£1,800**

Common student errors:

- dividing by **actual** hours instead of **budgeted** hours when calculating the OAR
- forgetting that absorbed overhead uses **actual activity × OAR**
- mixing labour hours and machine hours in the same department

### Under-absorption and over-absorption

Because the OAR is based on budgeted figures, the amount absorbed will often differ from the actual overhead incurred.

> **Key Term: under-absorption**
> When absorbed overhead is less than actual overhead incurred.
>
> **Key Term: over-absorption**
> When absorbed overhead is more than actual overhead incurred.

Formula logic:

- compare **absorbed overhead** with **actual overhead**
- if absorbed < actual → under-absorbed
- if absorbed > actual → over-absorbed

#### Worked example: under-absorption

Budgeted overheads = **£40,000**  
Budgeted labour hours = **5,000**

OAR:

$$
£40,000 \div 5,000 = £8 \text{ per labour hour}
$$

Actual labour hours = **4,600**  
Absorbed overhead:

$$
4,600 \times £8 = £36,800
$$

Actual overhead incurred = **£38,000**

Difference:

$$
£38,000 - £36,800 = £1,200
$$

This is **under-absorption of £1,200**.

#### Worked example: over-absorption

Using the same OAR of **£8 per labour hour**:

Actual labour hours = **5,200**  
Absorbed overhead:

$$
5,200 \times £8 = £41,600
$$

Actual overhead incurred = **£40,500**

Difference:

$$
£41,600 - £40,500 = £1,100
$$

This is **over-absorption of £1,100**.

#### Profit effect

For simplified AQA-style treatment:

- **under-absorption** is usually added to cost of sales, so **profit falls**
- **over-absorption** is usually deducted from cost of sales, so **profit rises**

Be careful: do not say absorption costing always increases profit here. The issue is specifically the adjustment for overhead absorbed versus actual overhead.

Common student errors:

- reversing the labels under and over
- comparing actual overhead with budgeted overhead instead of absorbed overhead
- stating the profit effect the wrong way round

### How to structure an evaluative answer

For a longer written response on absorption costing, build your answer in this order:

1. **State the method clearly**  
   Explain that production overheads are allocated, apportioned, reapportioned, then absorbed through an OAR.

2. **Use financial evidence**  
   Quote figures such as overhead totals, labour hours, machine hours, OARs, and the under- or over-absorption amount.

3. **Discuss suitability of basis**  
   Say whether labour hour or machine hour absorption is more suitable for that department and why.

4. **Comment on accuracy and limitations**  
   Departmental OARs are usually more accurate than one blanket rate where departments use resources differently. But any OAR is still based on budgeted figures, so under- or over-absorption can arise.

5. **Make a judgement**  
   Conclude whether the costing information is reliable enough for pricing, inventory valuation, or internal control.

A strong answer mixes calculation and judgement. Do not just say “more accurate” without explaining what makes it more accurate.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Absorption costing includes all production costs, including production overheads, in product cost
- Cost centres are sections of a business to which costs are charged
- Production cost centres make the output; service cost centres support production
- Allocation means charging an overhead directly to one cost centre
- Apportionment means sharing an overhead between cost centres on a fair basis
- Service cost centre costs must be reapportioned to production cost centres
- Overhead absorption rates are calculated using budgeted overheads and budgeted activity
- Labour hour and machine hour rates are the most common OAR bases
- Absorbed overhead equals actual activity multiplied by the OAR
- Under-absorption occurs when absorbed overhead is less than actual overhead
- Over-absorption occurs when absorbed overhead is greater than actual overhead
- Under-absorption tends to reduce profit, while over-absorption tends to increase profit in simplified exam treatments

## Key Terms and Concepts

- absorption costing
- cost centre
- production cost centre
- service cost centre
- allocation
- apportionment
- reapportionment
- overhead absorption rate (OAR)
- under-absorption
- over-absorption


Absorption and activity based costing - Absorption costing (allocation, apportionment, absorption, under/over-absorption)