Chapter 6 Overheads & Absorption Costing. Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing)

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1 Chapter 6 Overheads & Absorption Costing Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing)

2 Overheads Overheads is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

3 Absorption Costing: An Introduction The objectives of absorption costing is to include in the total cost of a product an appropriate share of the organization s total OH. An appropriate share is generally taken to mean an amount which reflect the amount of time and effort that has gone into producing a unit or completing a job.

4 Practical Reasons for Using Absorption Costing The main reason for using absorption costing are for inventory valuations, pricing decisions and establishing the profitability of different product.

5 International Accounting Standard 2 (IAS 2) Absorption costing is recommended in financial accounting by IAS 2 inventories. IAS 2 deals with financial accounting system.

6 International Accounting Standard 2 (IAS 2) IAS 2 states that in the normal course of business in bringing the inventories to their present location and condition. Therefore in absorption costing inventory should be valued at full factory cost (prime cost + OH)

7 Absorption Costing Stages The three stages of absorption costing are: Absorption Apportionment Allocation

8 OH Allocation Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre. For eg: A production department, to which production OH are charged. An administrative department, to which administration OH are charged.

9 OH Apportionment Apportionment is a procedure whereby indirect costs are spread fairly between cost centres. Service cost centre costs may be apportioned to production cost centres by using the reciprocal method. OR A method of sharing OH cost involves spreading common costs over cost centres on the basis of benefit received.

10 OH Apportionment OH Apportionment is used to spread common costs over cost centres.

11 Stage 1 Apportionment of General OH (Bases of Apportionment)

12 Stage 2 Apportionment of Service Department Costs There are three method of apportioning the service department cost to production department. Direct method (not test in the exam) Step down method (not test in the exam) Repeated distribution or reciprocal method (always tested in the exam)

13 Stage 2 Apportionment of Service Department Costs (Basis of Apportionment)

14 The Reciprocal (Algebraic) Method of Apportionment The results of the reciprocal method of apportionment may also be obtained using algebra and simultaneous equation.

15 OH Absorption OH absorption is the process whereby OH costs allocated and apportioned to production cost centres are added to unit, job or batch costs. OH absorption sometimes called OH recovery.

16 Calculating of Overhead Absorption Rate (OAR) OH are usually added to cost unit using predetermined OAR, which calculate using budget figures from the budget. OAR are used to charge OH to product.

17 Calculating of Overhead Absorption Rate (OAR) The main disadvantage of OAR is under/over absorption is likely to occur when using predetermined OAR as actual costs & hours worked are unlikely to be the same as budgeted costs and hours worked.

18 Calculating of Overhead Absorption Rate (OAR) Step 1 Step 2 Estimate the OH likely to be incurred during the coming period Estimate the activity level for the period. This could be total hours, units or direct costs or whatever it is upon which the OAR are to be based. Step 3 Divide the estimated OH by the budgeted activity level. This produces the OAR Step 4 Absorb the OH into the cost unit by applying the calculated absorption rate.

19 Blanket Absorption Rates & Departmental Absorption Rates A blanket OAR is an absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they were produced.

20 Over & Under Absorption OH Over and under absorption of OH occurs because the predetermined OAR are based on estimates. Over absorption means that the OH charged to the cost of sales are greater then the OH actually incurred. If actual OH incurred Absorbed OH = Negative (Over absorbed)

21 Over & Under Absorption OH Under absorption means that insufficient OH have been included in the cost of sales. If actual OH incurred Absorbed OH = Positive (Under absorbed)

22 Reasons for Over & Under Absorbed OH The OAR is predetermined from budget estimates of OH cost and the expected volume of activity. Under or Over recovery of OH will occur in the following circumstances: Actual OH cost are different from budgeted OH The actual activity level is different from the budgeted activity level.

23 Questions & Answers

24 Thank You Ibrahim Sameer Seek knowledge from cradle to grave

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

Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing) Variances A variance is the difference between a planned, budgeted, or standard cost and the actual cost incurred.