Manufacturing Overheads and the Stages of Absorption Costing

Direct materials and direct labour can be traced to the product. Everything else in the factory, from rent and electricity to supervisors and repairs, cannot. These overheads are real costs, and a manufacturer still needs to know what each product costs once they are included. Absorption costing is the system that shares them out.

This topic explains what manufacturing overheads are and how they are classified, what absorption costing is and what its critics say, and the three stages (allocation, apportionment and absorption) by which overhead reaches the cost of a unit. It also introduces cost centres. The next two topics deal with the arithmetic of apportionment and absorption.

Classifying overheads

The syllabus sets out how direct and indirect costs combine with behaviour to show which costs form part of inventory value.

Direct costs are charged straight to the cost of production because they can be identified with cost units, batches, processes, jobs or contracts. Overheads cannot be identified in that way, so they are recorded as overhead costs and split into production overheads (for example, in the factory), administration overheads and selling and distribution overheads.

Two ways to treat fixed production overhead

• Marginal costing. Fixed production overhead is a period cost, charged against profit in the period it is incurred. No share of it is added to unit cost.
• Absorption costing. Fixed production overhead is shared out among units or processes, so that the cost of units reflects a fair share of the cost of production. A cost that is charged to units in this way is said to be absorbed.

The two methods give different unit costs and different profits. A later topic compares them. Here we study absorption costing in detail.

Manufacturing, administration and selling overheads

Manufacturing overheads are product costs

Manufacturing costs are costs of making cost units. Under IAS 2, the cost of inventory includes the costs of purchase, the costs of conversion, and other costs of bringing it to its present location and condition. Conversion costs include costs tied directly to the units, such as direct labour, together with a systematic share of fixed and variable production overheads.

• Fixed production overhead: indirect costs of production that stay broadly constant whatever the volume, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management.
• Variable production overhead: indirect costs that vary directly, or nearly so, with output, such as indirect materials and indirect labour.

Selling and administration costs are period costs

Selling overheads are the costs of selling goods to customers rather than making them. They include distribution costs where these relate to delivering goods to customers. They are usually incurred after the goods are complete, although sales staff may win orders before production. Selling costs are period costs.

Administration costs relate to the running of the business as a whole, such as accounting, human resources and purchasing. Some administration, such as factory management, may be part of manufacturing cost, but the general term refers to the head office functions. Administration costs are period costs.

What absorption costing is

Absorption costing measures the cost of a product or service as its direct costs (direct materials, direct labour, sometimes direct expenses), plus variable production overhead, plus a share of fixed production overhead. The result is a full cost, which may be a full production cost or a full cost of sale.

Unit cost illustration (₦000 per unit). Direct materials 40, direct labour 25, variable overhead 10: marginal production cost 75. Fixed production overhead absorbed 30: total absorption cost 105. The marginal cost (75) is the cost that varies with each unit. The absorption cost (105) adds the share of fixed overhead.

The most important figure to get right is the 30. How a business arrives at it is the subject of the rest of this chapter.

Absorption costing in an income statement

Inventory valuation is central to absorption costing. The production cost of a period depends partly on how opening and closing stocks of work-in-progress and finished goods are valued, because a share of fixed overhead is carried inside each.

In favour of absorption costing, and against

Inventory values in the cost accounts and in the financial accounts may differ, even where both use absorption costing.

The stages of absorption costing

Absorption costing needs a fixed overhead absorption rate. The rate is usually calculated in advance, before the period starts, from what the firm expects to happen. Towards the end of one year, a company would work out the rate for the next year from its forecasts.

The basic idea

1. Identify the fixed production overhead expected in the period.
2. Share it to the departments (cost centres) in the factory.
3. Choose something that varies with production, such as units or hours, and divide each department’s overhead by the expected amount of that thing, to find an overhead cost per unit or per hour.

Basic example. A company expects fixed production overhead of ₦1,800,000 next year and plans to make 30,000 units. Each unit needs 3 labour hours, so 90,000 hours are expected. The rate can be ₦1,800,000 ÷ 30,000 = ₦60 per unit, or ₦1,800,000 ÷ 90,000 = ₦20 per labour hour. A unit using 3 hours absorbs 3 × ₦20 = ₦60 either way.

This treats a fixed cost as if it were variable: each unit made is given a slice of the fixed cost. That is why the amount absorbed can turn out to be more or less than the overhead actually incurred. Over-absorption and under-absorption are covered in a later topic.

The example is simple. A real factory makes several products and has several departments. Each product has different direct costs and uses each department to a different extent, so one rate for the whole factory would be unfair. A company must therefore identify the overheads, divide them among the departments, and set a rate for each department based on how its resources are used.

Cost centres

A cost centre is a location, function or group of machines or people for which costs are collected. For example, a group of machines might be a cost centre: the cost of running them is found, and from it a cost for each unit they make. Take a packing line with 3 machines, each run for 200 hours in a month. Its costs for the month are ₦54,000 and it packs 18,000 units. Cost per unit = ₦54,000 ÷ 18,000 = ₦3. Cost per machine hour = ₦54,000 ÷ (3 × 200) = ₦90.

In absorption costing, each item of overhead is charged either to a cost centre or to a general expense account. Cost centres may be in production, administration, or selling and distribution. Within production there are two kinds:

Allocation, apportionment and absorption

Two main stages carry overhead to the product.

Fixed production overhead may be allocated to production departments or to service departments. Production overhead is the overhead of both. Costs that cannot be allocated to a single centre are apportioned.

Examples of allocation and its limit

• The salary of the manager of the planning department goes entirely to the planning cost centre (a service department).
• Rent for equipment used only by engineers in the maintenance department is allocated to maintenance.
• Electricity from a meter that serves only the machining department is allocated to machining (a production department).
• A supervisor’s salary in the finishing department is allocated to finishing.
• The cost of security guards for the whole site cannot be allocated to one department, so it is recorded as a general production overhead (a “security services” cost centre) and later apportioned.

The ideas in more depth

Why three words?

Each word describes a different question. Allocation asks: whose cost is this? If the answer is one department, charge it all there. Apportionment asks: how should this shared cost be divided? That needs a judgement about what is fair. Absorption asks: how much of the department’s overhead should each unit carry? That needs a rate.

Keeping the three apart helps in exam answers, where marks are given for the correct term.

Why the rate is set in advance

Managers need a unit cost during the period, to quote prices and value stock, not after the year closes when actual overheads are known. So the rate is based on budgeted overhead and budgeted activity. The inevitable difference between the overhead absorbed and the overhead actually incurred is dealt with afterwards as over- or under-absorption.

The link to inventory

Because production overhead is absorbed into units, it is carried in closing inventory when units are unsold. Overhead that is not absorbed, such as administration and selling costs, is a period cost. This is the same split as the product and period costs from earlier topics.

Direct costs and behaviour

Note that direct costs are generally treated as variable. Overheads can be variable or fixed. Variable overheads, such as power to run machines, rise with output and are usually charged to units by a rate as well. The difficult part of absorption is the fixed element, because it does not change with output yet is spread as if it did.

Worked example: building up an absorption cost

1. Rate.
   ₦2,400,000 ÷ 60,000 hours = ₦40 per direct labour hour.
2. Fixed overhead per wardrobe.
   4 hours × ₦40 = ₦160.
3. Full production cost.
   Direct materials ₦28,000 + direct labour ₦16,000 + variable overhead ₦3,000 + fixed overhead absorbed ₦160 = ₦47,160.
   The marginal production cost is ₦47,000.
4. What is absorbed? Factory rent and depreciation of the spraying machine are production overheads, so they are part of the fixed production overhead that is absorbed. Advertising is a selling overhead and the chief accountant’s salary is an administration overhead. Both are period costs and are not absorbed into the cost of the wardrobe.

Common mistakes in the exam

• Confusing allocation (a cost wholly for one centre) with apportionment (a shared cost divided on a basis).
• Including administration and selling overheads in the cost of inventory.
• Describing absorption as the same thing as apportionment. Absorption charges units. Apportionment charges cost centres.
• Forgetting that the rate is calculated in advance from budgeted figures.
• Saying that absorption costing is always better or always worse. A balanced answer gives both views.
• Mixing up production departments and service departments.
• Not giving examples when the question asks for them.

Quick revision

• Production overheads are product costs (inventory). Selling and administration overheads are period costs.
• Absorption costing = direct costs + variable production overhead + share of fixed production overhead.
• Marginal costing treats fixed production overhead as a period cost.
• Rate set in advance: budgeted overhead ÷ budgeted activity.
• Allocation: whole cost to one centre. Apportionment: shared cost divided fairly. Absorption: charge to units using a rate.
• Cost centres: production departments make the product. Service departments support them.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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