Welcome to the World of Absorption Costing!
In your BA2 journey, understanding how much a product actually costs to make 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 or a slice of pizza, how can you decide what price to sell it for to make a profit?
In this chapter, we are going to explore Absorption Costing. This is a method where we try to "soak up" (or absorb) all the costs of production into the units we make. Don't worry if this seems a bit heavy on numbers at first; we’ll break it down into a simple step-by-step journey!
1. What is Absorption Costing?
The goal of absorption costing is to determine the full factory cost of a product. This includes:
• Direct Costs: Things you can easily trace to the product (like the screen on a phone or the flour in bread).
• Indirect Costs (Overheads): Things you need but can't easily pin down to one specific unit (like the factory’s electricity, the rent, or the supervisor's salary).
The Core Idea: Every single unit produced should carry a "fair share" of the total factory overheads. If we don't include these, we might underprice our products and lose money.
2. The Three-Step Process: Allocation, Apportionment, and Absorption
Think of this process like dividing a big restaurant bill among friends. Some people ordered specific things (Allocation), some shared a large pizza (Apportionment), and finally, we need to figure out exactly how much each person pays (Absorption).
Step A: Allocation
Allocation is used when a cost can be linked 100% to a specific department (called a cost center).
Example: If the Maintenance Department has its own specific set of tools, the cost of those tools is allocated directly to Maintenance.
Step B: Apportionment
This is where it gets interesting! Apportionment is used for shared costs. If a cost belongs to several departments, we have to split it up using a fair "base."
Common Bases for Apportionment:
• Rent / Rates: Split based on Floor Area (sq. meters).
• Canteen Costs / HR: Split based on the Number of Employees.
• Depreciation of Machinery: Split based on the Value of Machinery.
• Electricity (Light & Heat): Split based on Volume of Space or Floor Area.
Quick Review: Allocation is for "whole" costs; Apportionment is for "shared" costs.
Step C: Re-apportionment (Service to Production)
In a factory, some departments make products (Production Centers), while others just help out (Service Centers, like Maintenance or the Canteen). Products don't actually pass through the Canteen, so we can't charge the customer directly for canteen costs. Instead, we move the Service Center costs into the Production Centers.
Once all costs are sitting in the Production departments, we can finally charge them to the product.
3. Calculating the OAR (Overhead Absorption Rate)
Now that we have all the overheads sitting in the production departments, how do we "stick" them onto the products? We use a formula to find the Overhead Absorption Rate (OAR).
We usually calculate this at the start of the year using budgeted (estimated) figures so we can set our prices early.
The Formula:
\( \text{OAR} = \frac{\text{Total Budgeted Overheads}}{\text{Total Budgeted Activity Level}} \)
The "Activity Level" can be different things, but usually, it is:
• Labor Hours: Use this if the work is mostly done by hand.
• Machine Hours: Use this if the work is mostly done by robots or machines.
Example: If your budgeted overheads are \$100,000 and you expect to work 20,000 machine hours:
\n\( \text{OAR} = \frac{\$100,000}{20,000 \text{ hours}} = \$5 \text{ per machine hour} \)
Memory Aid: Think of the OAR as the "tax" each product must pay for every hour it spends in the factory.
\n\n4. Under and Over Absorption
\nBecause we use budgeted (estimated) numbers to calculate the OAR, by the end of the year, the "actual" numbers are almost always different. This leads to a mistake in our accounts that we need to fix.
\n1. Absorbed Overheads: This is what we thought we spent based on actual work.
\n\( \text{Absorbed Overheads} = \text{OAR} \times \text{Actual Activity Level} \)
2. Compare to Actual Overheads: Compare what we "absorbed" to what we actually paid in cash.
\nUnder-absorption: We didn't charge enough. Actual cost was Higher than what we absorbed. (Bad news! Expenses will increase in the profit statement).
\nOver-absorption: We charged too much. Actual cost was Lower than what we absorbed. (Good news! Expenses will decrease in the profit statement).
Don't worry if this seems tricky! Just remember: if the actual bill was \$1,000 but you only "charged" the products \$900, you have under-absorbed by \$100.
5. Why Use Absorption Costing?
Advantages:
• It recognizes that overheads are a necessary part of production.
• It helps in setting prices that cover all costs, not just direct ones.
• It follows the "matching principle" in accounting (costs match the revenue they help create).
Disadvantages:
• It can be complex to calculate.
• The "bases" used for apportionment (like floor area) can sometimes be a bit arbitrary or unfair.
Summary Checklist
Key Takeaways:
• Allocation: Direct assignment of a whole cost to a department.
• Apportionment: Splitting shared costs using a fair base (like sq. meters).
• OAR: Calculated as \( \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity}} \).
• Absorbed Overheads: \( \text{OAR} \times \text{Actual Activity} \).
• Under-absorption: Actual costs > Absorbed costs.
• Over-absorption: Actual costs < Absorbed costs.
Quick Tip for the Exam:
Always check if the question asks for Labor Hours or Machine Hours when calculating the OAR. Using the wrong activity level is the most common mistake students make!