CHAPTER 3: OVERHEADS – ABSORPTION COSTING

METHOD
1. Introduction

✓ Overheads are the expenditure which cannot be conveniently traced to or identified with any
particular cost unit.
✓ Such expenses are incurred for output generally and not for a particular work order.
✓ Overheads also represent expenses that have been incurred in providing certain ancillary
facilities or services which facilitate or make possible the carrying out of the production
process;
✓ Overheads are incurred not only in the factory of production but also on administration, selling
and distribution.

2. Steps Involved in Overhead Absorption Costing

✓ Collection & classification of Overheads.

✓ Distribution of Overheads to all departments (Primary Distribution)
✓ Re-distribution of service department Overheads to production departments (Secondary
Distribution)
✓ Absorption of Overheads to the products.

3. Primary Distribution of Overheads

✓ Overheads which are related to more than one department are required to be distributed
between/ among the departments. This distribution of overheads between/ among the
departments is called apportionment.
✓ The example of overheads may include e.g. rent of building, power, lighting, insurance,
depreciation etc.
✓ To apportioning these overheads over different departments benefiting thereby, it is
necessary at first to determine the proportion of benefit received by each department and
then distribute the total expenditure proportionately on that basis.
✓ But the same basis of apportionment cannot be followed for different items of overheads since
the benefit of service to a department in each case has to be measured differently.

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 A. Basis of Primary Distribution of Overheads
✓ The following is an indicative basis of Primary Distribution of Overheads:
Overhead Cost Bases of Apportionment

1. Rent and other building expenses Floor area, or volume of department

Lighting and heating (conditioning)
Fire precaution service
Air- conditioning
2. Perquisites Number of workers
Labour welfare expenses
Time keeping
Personnel office
Supervision
3. Compensation to workers Direct wages
Holiday pay
ESI and PF contribution
Perquisites
4. General overhead Direct Labour hour, or Direct wages, or
Machine hours.
5. Depreciation of plant and machinery Capital values
Repairs and maintenance of plant and
machinery
Insurance of stock
6. Power/steam consumption Technical estimates
Internal transport
Managerial salaries

7. Lighting expenses (Light) No. of light points, or Area or Metered units

8. Electric power (machine operation) Horse power of machines, or Number of

machine hour, or value of machines or units
consumed.
9. Material handling Weight of materials, or volume of materials,
Stores overhead or value of materials or unit of materials.

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 B. Format for Primary Distribution
Production Departments Service Departments

Primary Distribution Machining Assembling Finishing X Y Z

Direct Material - - - ✓ ✓ ✓

Direct Labour - - - ✓ ✓ ✓

Direct Expenses - - - ✓ ✓ ✓

Rent (Floor Area) ✓ ✓ ✓ ✓ ✓ ✓

Electricity (KWH) ✓ ✓ ✓ ✓ ✓ ✓

Lighting ✓ ✓ ✓ ✓ ✓ ✓

(Light points)
Indirect Wages ✓ ✓ ✓ ✓ ✓ ✓

(Direct Wages)
Depreciation ✓ ✓ ✓ ✓ ✓ ✓

(Value of Plant)
Overheads as per ✓ ✓ ✓ ✓ ✓ ✓

Primary
Distribution

C. Allocation vs Apportionment of Overheads:

Allocation Apportionment

• Allocation deals with the whole • Apportionment deals with the proportions of an
items of cost, which are identifiable item of cost
with any one department.
• Allocation is a direct process of • Apportionment is an indirect process because
charging expenses to different cost there is a need for the identification of the
centres appropriate portion of an expense to be borne by
the different departments benefited.

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 4. Secondary Distribution of Overheads

✓ At the end of primary distribution, the overheads are totalled for all the departments.
✓ The next step is to distribute the service department overheads back to the production
departments. This is referred to as secondary distribution or re-distribution of overheads,
which can be broadly done under these three methods:

Secondary Distribution of Overheads

Direct Re Step Ladder Reciprocal Service

Distribution Method Method / Non Method
Reciprocal
Method Simultaneous
Equation Method

Repeated
Distribution
Method

Trail & Error

Method

Format Secondary Distribution

Production Departments Service Departments

Secondary Distribution Machining Assembling Finishing X Y Z

X ✓ ✓ ✓ (✓)
Y ✓ ✓ ✓ (✓)
Z ✓ ✓ ✓ (✓)
Overheads as per
✓ ✓ ✓ - - -
Secondary Distribution

A. Direct Re Distribution Method

✓ This method assumes that the service department will provide services only to a production
department and will not provide services to other service departments.
✓ In reality when such services are in fact provided to other service departments. This method
ignores it. (NO TRAFFIC)

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 B. Step Ladder Method / Non reciprocal Method
✓ This method assumes that the service department can provide service to all other department
including other service department but cannot receive service from the service department to
which it has provided services (ONE - WAY TRAFFIC)

C. Reciprocal Service Method

✓ This method assumes that a service department can provide service to all the department
including other service department and can also receive service from the service department
to which it has provided services. (TWO - WAY TRAFFIC)

(a) Simultaneous Equation Method

✓ According to this method firstly, the costs of service departments are ascertained. These costs
are then re-distributed to production departments on the basis of given percentages.

(b) Repeated Distribution Method

✓ Under this method, service departments’ costs are distributed to other service and production
departments on agreed percentages and this process continues to be repeated, till the figures
of service departments are either exhausted or reduced to too small a figure.

(c) Trial and Error Method

✓ According to this method the cost of one service cost centre is apportioned to another service
cost centre. The cost of another service centre plus the share received from the first cost
centre is again apportioned to the first cost centre.
✓ This process is repeated till the amount to be apportioned becomes negligible, that means
repeated distribution method is followed to the extent of service departments only.
✓ All apportioned amounts for each service cost centre are added to get the total apportioned
cost.
✓ These total service cost centre costs are redistributed to the production departments.

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 5. Absorption of Overheads

✓ Absorption is the last step in Overheads accounting it is the process through which Overheads
in Production department is given to each of product produced.
✓ Absorption process has two steps:
Step 1: Calculation of Absorption rate
(Overheads ÷ Base Quantity)
Step 2: Charging of Overheads to the products
(Absorption Rate x Base Quantity consumed by the respective product)
✓ It should be noted that Base Quantity can be different for each of the production department
and has to be selected keeping in mind the factor which pre dominantly influences the incurrence
of Overheads in that particular department.
✓ It is the management discretion to choose an appropriate absorption rate and has to be
exercised with at most care since it influences the stock valuation and profit computation.

Doubt Busters:
It should be noted that Production Overheads absorbed and not Production Overheads incurred
is considered while preparing cost sheet.

6. Six Types of Absorption Rates

Absorption Rate: Formula: Expression:

Labour Hour Rate Overheads Per Labour Hour
Labour Hours
Machine Hour Rate Overheads Per Machine Hour
Machine Hours
Material Cost Rate Overheads % of Direct Material Cost
Material Cost
Labour Cost Rate Overheads % of Direct Labour Cost
Labour Cost
Prime Cost Overheads % of Prime Cost
Prime cost
Production Unit Rate Overheads Per Unit
Production Units

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 7. Pre-Determined Rate Vs Actual Rate

✓ Pre - Determined rate is determined in advance by estimating the amount of the overhead for
the period in which it is to be used.
Pre - Determined rate = Budgeted Overheads ÷ Budgeted Base Quantity
✓ Actual rate is determined at the year-end by calculating the actual amount of the overhead
used during the period.
Actual rate = Actual Overheads ÷ Actual Base Quantity

Overheads

Budgeted Overheads Absorbed Overheads Actual Overheads

Budgeted Overheads ÷ Per Determined Rate x Actual Overheads ÷ Actual

Budgeted Base Quantity Actual Base Quantity Base Quantity

8. Treatment of Under and Over Absorbed Overheads in Cost Accounting

Under or Over Absorption = Actual Overheads – Absorbed Overheads

✓ Under or Over Absorption happens due to the use of pre-determined rate for absorption.
✓ If Actual Overheads > Absorbed Overheads = Under Absorption
✓ If Absorbed Overheads > Actual Overheads = Over Absorption
✓ It should be noted that Production Overheads absorbed and not Production Overheads
incurred is considered while preparing cost sheet.
✓ Hence at the end of the year treatment should be given in cost sheet and cost ledger
accounts for the under or over Absorbed Overheads.
✓ There are two ways of treating under and over absorption.

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 Treatment of Under or Over Absorption

Due to Normal Price Level changes

Due to Inefficiency or Abnormal
Product Cost
reasons Period Cost

Apportion to entire
Production during the year
using Supplementary Transfer to Costing Profit
Overhead rate. and Loss A/c

Supplementary Absorption Rate

✓ When under or over absorption is treated as product cost a portion of it is charged to stocks
using supplementary rate.
✓ Procedure to Apportion the under or over absorption due to Normal Price Level Changes using
Supplementary overhead rate.
Step 1: Apportion to entire production during the period using a Supplementary overhead rate.
Step 2: Supplementary rate = Amount of under or over absorption ÷ Quantity Produced
Step 3: Quantity Produced = Quantity sold + Closing Finished Goods + (Closing W I P x Degree
of completion)
Step 4: The apportioned amount is transferred to
Quantity Sold - Cost of Sales A/c
Closing Finished Goods – Finished Goods Control A/c
Closing W I P – W I P Control A/c

✓ Journal Entry for under absorption apportionment using supplementary rate.

Cost of Sales A/c Dr
Finished Goods Control A/c Dr
WIP Control A/c Dr
Costing Profit and Loss A/c (Period Cost) Dr
To Production Overheads A/c.

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 9. Blanket Rate Vs Departmental Rate

✓ When a single Overhead Absorption rate calculated for the entire factory such an absorption
rate is called as Factory Wide rate or Plant wide rate or Blanket Absorption Rate.
✓ Blanket rate = Total Overhead ÷ Total Base Quantity
✓ Suitable for Multiple products requiring different resources and Costly but accurate.
✓ When the Overhead Absorption rate is calculated for each production department using the
appropriate absorption base it is called as Departmental rate.
✓ Departmental rate = Departmental Overhead ÷ Departmental Base Quantity
✓ Suitable for one product only or All products pass through all departments or processed for
same time in each department

10. Machine Hour Rate Method

A. Direct Machine Hour Rate

✓ According to this method, only the expenses directly or immediately connected with the
operation of the machine are taken into account. e.g., power, depreciation, repairs and
maintenance, insurance, etc.
✓ The rate is calculated by dividing the estimated total of these expenses for a period by the
estimated number of operational hours of the machines during the period.

B. Comprehensive Machine Hour Rate

✓ As per this method, in the expenses stated above there may still be other manufacturing
expenses such as supervision charges, shop cleaning and lighting, consumable stores and shop
supplies, shop general labour, rent and rates, etc. incurred for the department as a whole and,
hence, not charged to any particular machine or group of machines.
✓ In order to see that such expenses are not left out of production costs, one should include a
portion of such expenses to compute the machine hour rate.
✓ Steps involved in determining of Machine Hour Rate are as follows:
Step 1: Calculate total of overheads apportioned to a production department
Step 2: Apportion further these overheads to machines or group of machines in the
department.
Step 3: Allocate machine specific costs (directly identifiable with the machine)
Step 4: Estimate total productive hours for the machine
Step 5: Aggregate overheads as apportioned in step-2 and allocated in step-3 and divide it by
Estimated total productive hours

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 Step 6: The resultant figure is machine hour rate

11. Capacity Determination

✓ Capacity means the Ability to produce

✓ Types of Capacity
Maximum/ Theoretical/ Units per Hour x Hours per day x No. of days per year
Installed/Rated

Practical/Achievable Working Days = Total Days – Holidays – Weekly off Total Da

Practical Hours = (Practical Days x Hours Per day) – Normal
Idle Time
Practical Units = Practical Hours x Units per Hour
Normal/Average/ Expected Average of past actual capacity
Actual Capacity used during the period
Budgeted/Estimated Used to determine or Rate or for planning
Idle (Budgeted - Actual) Normal = Maximum – Budgeted
Abnormal = Budgeted - Actual
Licensed Approved by an authority

12. Core Theory Topics

Advantages of Classification of Overheads into Fixed and Variable

Advantages Explanation
Controlling Segregating expenses into fixed and variable helps control costs. Fixed
Expenses costs are policy-related and remain constant regardless of output.
Variable expenses change with activity volume and can be controlled by
adjusting output.
Preparation of Segregating costs into fixed and variable components helps in preparing
Budget a flexible budget. It allows for cost estimation at different activity
Estimates levels and comparison with actual expenses.
Decision Making Segregation helps in making key decisions like setting prices during
tough times, or deciding whether to make or buy products, or shut down
or continue operations. Fixed costs and variable costs must be separated
for these decisions.

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 Allocation of Overheads over Various Departments or Departmentalisation of Overheads
Advantages Explanation
Better Estimation of Expenses Departmentalization allows for more accurate estimation
of expenses. Some costs can be estimated more precisely
when related directly to a department.
Better Control Control is easier when expenses are tracked for each
department separately. Knowing how much should be
spent and how much is actually spent helps identify over-
spending in specific departments.
Ascertainment of Cost for Each To determine the cost of a job, it's necessary to know the
Department expenses incurred in each department that the job passes
through. This ensures the correct allocation of indirect
expenses.
Suitable Method of Costing Different costing methods can be used for each
department, such as batch costing for manufacturing
parts or output costing for assembling products.

Some other basis of apportioning overhead costs:

Basis of Explanation
Apportioning
Overhead Costs
Analysis or Survey Sometimes, an analysis of expenditure is required to determine how costs
of Existing should be apportioned. For example, lighting expenses can be divided based
Conditions on the number of light points in each department.
Ability to Pay This method distributes costs based on the income of the paying
department, similar to a taxation principle. For example, sales expenses can
be distributed based on the sales volume in different territories. However,
this method may be inequitable, as it may not reflect the actual effort
needed for selling.
Efficiency or Under this method, overheads are distributed based on pre-determined
Incentives levels of production or sales. If the actual production exceeds the planned
levels, the cost per unit decreases. Conversely, if the levels are not met,
the cost per unit increases.

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 Advantages and disadvantages of Machine hour rate:
Advantages Disadvantages
Machine-based overhead charges are ideal Additional data on machine operating time must
when machines are the main factor of be recorded and maintained.
production.
Under-absorption of machine overheads shows Computing a separate machine hour rate for
the extent to which machines have been idle. each machine/group adds extra work.
Particularly useful when one operator handles
several machines or multiple operators work on
a machine (e.g., automatic screw
manufacturing or belt press for conveyer
belts).

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