Welcome to the World of Absorption Costing!
In your BA2 journey, understanding how much a product or service actually costs to provide is one of your most important jobs as a management accountant. Think about it: if you don’t know the full cost of making a smartphone, repairing an engine, or serving a client, how can you decide what price to charge to ensure a sustainable profit?
In this chapter, we explore Absorption Costing and how to calculate Full Cost. Absorption costing is a method where we ensure all production costs—both direct costs and an absorbed share of indirect production overheads—are attached to the units we produce. Let’s break it down into a clear, step-by-step journey!
1. What is Absorption Costing and Full Cost?
In management accounting, a cost object is anything for which a separate measurement of costs is desired—such as a product, a service, an activity, or a customer.
To establish the full cost of a cost object under absorption costing, we classify costs into two main categories:
• Direct Costs: Costs that can be traced entirely and directly to a cost object (such as direct raw materials, direct labour, and direct expenses). Together, these form the prime cost.
• Indirect Costs (Overheads): Costs that cannot be economically traced directly to a single cost object (such as factory rent, supervisor salaries, machinery depreciation, and power).
The Core Principle: Every cost object should carry its prime cost plus a "fair share" of indirect overheads. Under absorption costing, fixed production overheads are treated as product costs rather than period costs.
2. The Three-Step Overhead Process
Before overheads can be absorbed into individual cost objects, production overheads must be collected and assigned to production departments through three structured stages:
Step A: Allocation
Allocation is the process of charging an entire item of overhead directly to a specific department (a cost centre) because it was incurred exclusively by that department.
Example: The wages of a supervisor who works solely in the Assembly Department are allocated directly to Assembly.
Step B: Apportionment
When an overhead cost is shared between two or more cost centres, it cannot be allocated in full. Instead, it must be divided between them on a fair and logical basis.
Common Apportionment Bases:
• Rent, rates, building insurance, heating: Split by Floor area (sq. metres).
• Canteen, staff welfare, HR costs: Split by Number of employees or headcount.
• Machinery depreciation and insurance: Split by Book value of machinery.
• Machine power / electricity: Split by Kilowatt hours (kWh) or machine hours.
Step C: Re-apportionment of Service Centre Costs
A factory has two types of cost centres: Production Centres (where goods are made, such as Machining and Assembly) and Service Centres (which support production, such as Maintenance and Stores). Because products do not pass directly through service departments, service department overheads must be re-apportioned into the production departments.
When service departments provide services to each other (reciprocal servicing), CIMA BA2 specifies two methods to deal with this reciprocal interaction:
1. Repeated-distribution method: Service department costs are re-apportioned repeatedly between departments in turn until the remaining service centre balances become negligible.
2. Simultaneous-equations method: Algebraic equations are set up to represent the total cost of each service centre, solving for the true total cost before distributing it to production centres.
3. Calculating the Overhead Absorption Rate (OAR)
Once all production overheads reside in production cost centres, they are absorbed into individual cost objects using an Overhead Absorption Rate (OAR). To allow standard unit costs and selling prices to be set before the period begins, the OAR is calculated using budgeted figures:
\[ \text{Predetermined OAR} = \frac{\text{Budgeted Production Overheads}}{\text{Budgeted Activity Level}} \]
The chosen activity base reflects how the department operates:
• Direct Labour Hours: Used in labour-intensive departments.
• Machine Hours: Used in machine-intensive / automated departments.
• Units of Output: Used when identical, homogeneous units are produced.
Example: If the Machining Department has budgeted overheads of \$120,000 and budgeted activity of 30,000 machine hours:
\[ \text{OAR} = \frac{\$120,000}{30,000 \text{ machine hours}} = \$4.00 \text{ per machine hour} \]
4. Calculating the Full Cost of a Cost Object
Once the OAR is established, management accountants calculate the full cost of a product, service, or job by combining direct costs with absorbed overheads.
Cost Card Structure:
• Direct Materials
• Direct Labour
• Direct Expenses
= Prime Cost
• Add: Absorbed Production Overhead (\(\text{OAR} \times \text{Actual activity per unit}\))
= Full Production Cost (Factory Cost)
• Add: Non-production Overheads (Administration, Selling, and Distribution costs)
= Total Full Cost
Worked Example: Full Cost of a Product
Delta Ltd manufactures custom bicycle frames (Product X). For each frame:
• Direct materials: \$45
• Direct labour: 3 hours at \$15 per hour = \$45
• Machine time: 2 hours in the Machining department (OAR = \$4 per machine hour)
• Assembly time: 3 labour hours in the Assembly department (OAR = \$6 per direct labour hour)
• Non-production overheads (administration and selling): \$15 per unit
Step 1: Calculate Prime Cost:
\[ \text{Prime Cost} = \$45 \text{ (Materials)} + \$45 \text{ (Labour)} = \$90 \]
Step 2: Calculate Absorbed Production Overhead:
\[ \text{Machining Overhead} = 2 \text{ hours} \times \$4 = \$8 \]
\[ \text{Assembly Overhead} = 3 \text{ hours} \times \$6 = \$18 \]
\[ \text{Total Absorbed Production Overhead} = \$8 + \$18 = \$26 \]
Step 3: Calculate Full Production Cost and Total Full Cost:
\[ \text{Full Production Cost} = \$90 \text{ (Prime Cost)} + \$26 \text{ (Overhead)} = \$116 \]
\[ \text{Total Full Cost} = \$116 + \$15 \text{ (Non-production)} = \$131 \]
Knowing the total full cost of \$131 allows Delta Ltd to set a selling price that ensures profitability using mark-up or margin pricing targets.
5. Under- and Over-Absorption of Overheads
Because the OAR is calculated before the accounting period begins using budgeted figures, the overhead absorbed into production will rarely match the actual overhead cost incurred.
Step 1: Calculate the overhead absorbed during the period:
\[ \text{Overhead Absorbed} = \text{Predetermined OAR} \times \text{Actual Activity Achieved} \]
Step 2: Compare absorbed overhead with actual overhead incurred:
• Under-absorption: \(\text{Actual Overhead} > \text{Absorbed Overhead}\). Not enough overhead was absorbed into production. The under-absorbed balance is an unexpected expense that is charged against profit in the statement of profit and loss.
• Over-absorption: \(\text{Absorbed Overhead} > \text{Actual Overhead}\). More overhead was absorbed into production than was actually spent. The over-absorbed balance is credited to the statement of profit and loss, improving reported profit.
Example: If actual overhead incurred is \$105,000, and 24,000 machine hours were worked at an OAR of \$4 per hour:
\[ \text{Absorbed Overhead} = 24,000 \times \$4 = \$96,000 \]
\[ \text{Under-absorption} = \$105,000 - \$96,000 = \$9,000 \text{ (Under-absorbed)} \]
6. Why Use Absorption Costing?
Advantages:
• Comprehensive pricing: Ensures selling prices cover all production overheads, protecting long-term profitability.
• Financial reporting compliance: Required under international financial reporting standards (e.g. IAS 2) for valuing inventory and cost of goods sold.
• Fair cost sharing: Acknowledges that products consume fixed production capacity and resources, not just variable materials and labour.
Disadvantages:
• Arbitrary apportionment: Choosing apportionment bases (such as floor space or headcount) can be subjective.
• Volume distortion: Unit full cost varies if volume changes, and producing for inventory can temporarily inflate reported profit by carrying fixed overhead into closing inventory.
Summary Checklist
Key Takeaways:
• Prime Cost: Direct Materials + Direct Labour + Direct Expenses.
• Full Production Cost: Prime Cost + Absorbed Production Overheads.
• Total Full Cost: Full Production Cost + Non-production Overheads.
• OAR Formula: \( \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity}} \).
• Overhead Absorbed: \( \text{OAR} \times \text{Actual Activity} \).
• Under-absorption: \( \text{Actual Overhead} > \text{Absorbed Overhead} \).
• Over-absorption: \( \text{Absorbed Overhead} > \text{Actual Overhead} \).
• Reciprocal Servicing: Handled using either the repeated-distribution method or the simultaneous-equations method.
Quick Tip for the Exam:
When calculating absorbed overheads, always multiply the predetermined OAR by the actual activity (actual labour or machine hours), never by the budgeted activity!