Notes by Idrees Safi

MA1, Chapter 4

In this Chapter:
1. Overheads & Absorption
2. Cost Center Vs Cost Unit
3. Steps of Absorbing
4. Overheads Absorption Rate
5. Charging Overheads to a Single Unit
6. Pre determination of overheads
7. Overheads bookkeeping
8. Marginal costing
9. Deference between absorption & marginal costing

1
Overheads & Absorption
Overheads: are costs which cannot be directly traced in a single unit, in other words sum of all indirect costs are
called overheads.

Overheads By Function

Production Overheads: Non-Production

These are costs rekated Overheads: These
to the production are costs which are
process which cannot not related to
be directly traced. production.
Ex: Indirect labor, Ex: Administration,
Indirect material, Rent, Selling & Distribution,
Depreciation, Utilities... R&D, Finace..

Fixed NPO: Rent,

Fixed PO: Rent, Depreciation,
Insurence, Incurance,...
Depreciation,...
Variable NPO:
Variable PO: Selling agent
Indirect comission, Intrest,
material, Delivery, Sationary,
Advertaisment,
Utilities,... Telephone,...

Absorption
Is the method of charging overheads to a single cost unit.

In this method we will estimate the entire overhead expense that will incur in upcoming period determined as per
cost center.

What is a cost center?

A cost center is a department or function where we accumulate our cost.

Cost center vs Cost unit!

Cost center is based on function while cost unit is based on activity.

2
Absorbing Steps:
1. Allocating: to assign a specific cost to a specific cost center.

Assembly department supervisor salary → Assembly Department

Store keeper salary → Store Department

Canteen chief salary → Canteen

2. Apportionment: to share common costs on fair bases between deferent cost centers.

1. Rent on Floor Area

2. Heat & Light on KW/Floor Area

3. Maintenance on Number of Hours

4. Store on Number of MRNs

5. Canteen on Number of Employees

6. Cleaning on Floor Area

7. Depreciation on Carrying value of machine (Net book value)

8. Supervisor on Number of Hours

3. Reapportionment: to share the service costs on fair bases between production cost centers.

Can be done in two methods:

1. Direct Method: In which the cost of service department is directly charged to production departments only.

2. Step Down Method: In which the service departments having highest cost will first be allocated to all service and
production departments but no back allocation will be made.

Absorption
To charge the overheads to individual cost unit, we need an overheads absorption rate.

𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅𝒔
OAR = 𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚

Budgeted overheads → (from 3 steps)

Budgeted activity → (Based on department activity, could be machine hours or labor hours)

Charging OH to a sing unit:

OAR × Actual activity level (actual time spent on each unit in that cost center)

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Pre-determination Overheads Absorption:
Actual overheads might be deferent from absorption, known as over or under absorption.

Absorbed OH (OAR × Actual activity) – Actual overheads expenditure = Over/Under

Absorbed > Actual OH = Over

Absorbed <Actual OH = Under

Over absorption will reduce the profit

To adjust it:

1. Increase the profit (Gross profit) by over absorbed amount.

2. Reduce the cost by absorbed amount (Cost of sales).

Under absorption will increase the profit

To adjust it:

1. Increase the cost by absorbed amount (Cost of sales).

2. Reduce the profit (Gross profit) by over absorbed amount.

4
Overheads Bookkeeping
To absorb overheads:
DR Work in progress
CR Production overheads control account

Adjusting Entries
Over Under
DR Production overheads DR Income Statement
CR Income Statement CR Production overheads

Statement of Profit & Loss

31 Dec 2023
Sales XX
Less: Cost of sale (Opening + Production – Closing) (XX)
Gross Profit (Sales - COGS) XXX
Less: Administration Cost (XX)
Less: Sales & Distribution (XX)
Net Profit (GP – Total admin & Selling Expenses) XXX

Production= (Prime Cost + Production Overheads (fixed + variable))

Marginal Costing
Marginal costing, also known as variable costing or direct costing, is a costing method that only includes variable
costs (direct materials, direct labor, and variable overhead) in the cost of a product. Fixed overheads are treated as
period costs and are charged in full to the income statement in the period incurred.

Marginal costing is based on the principle of contribution:

Contribution = Sales – All variable costs

Statement of Profit & Loss

31 Dec 2023
Sales XX
Less: Cost of sale (Opening + Production – Closing) (XX)
Less: VNPOH (XX)
Contribution (Sales – All variable costs) XXX
Less: FPOH (XX)
Less: FNPOH (XX)
Net Profit (Contribution – All fixed costs) XXX

* Cost of Sales = Opening + Production – Closing

Production= (Prime Cost + VPOH)

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Difference between Absorption & Marginal Costings:
Category Overhead Absorption Costing Marginal Costing
Definition Include both fixed & variable overheads in include only variable costs in product costing,
the cost of each unit. fixed costs are treated as period costs.
Overhead absorption rate (based on Contribution margin (sales revenue minus
production units, labor hours, or machine variable costs) - Focuses on covering fixed
hours) - Total cost per unit includes fixed and costs after variable costs are accounted for
variable overheads
Uses - Used for external profit reporting - Used for - Used by eternal managers - Used for short
inventory valuation - Used for price term pricing and decision making -
determination
Advantages - Provides a complete picture of total - Simpler and easier to understand for
production costs - Better for long-term decision-making - Highlights the impact of
pricing and strategic decisions - Ensures that production volume on costs - Useful for
fixed costs are recovered through product evaluating the profitability of individual
pricing products
Disadvantages Can lead to over or under absorption if actual Ignores fixed costs when pricing, which may
production differs from estimates - lead to undervaluing the total cost - Not
Complexity in determining the accurate suitable for long-term decision-making, as
absorption rate fixed costs are crucial in those contexts - Can
misrepresent overall profitability by focusing
only on variable costs
Preferred for Long-term financial planning and strategic Short-term decision-making like accepting
pricing - Situations where accurate inventory special orders
valuation is necessary for financial reporting

Profit Reconciliation Statements:

Situation Impact on inventory Production vs Sales Which profit Why?
is higher
Closing > Opening Increase Production > Sales Absorption Absorption costing adds
some fixed costs to the
value of the unsold
products, making profit
look bigger.
Closing < Opening Decrease Production < Sales Marginal Absorption costing has
to release the fixed
costs from previous
inventory, making profit
lower.
Difference in Calculate as: (Change in inventory) ×
profit (Fixed cost per unit)
Change in Calculate as: (Production) – (Sales)
Inventory

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Question:
Safi is a car manufacturing company has the following data.

Production Departments
Department Names Number of Employees Floor Area (sqm) Net Book Value
Engine Assembly 50 2,000 sqm $100,000
Body Assembly 40 1,500 sqm $80,000
Painting 30 1,000 sqm $60,000
Quality Control 20 500 sqm $40,000

Service Departments
Department Names Number of Employees Floor Area (sqm)
Maintenance 10 300 sqm
Store 5 200 sqm
Canteen 5 500 sqm
Cleaning 10 300 sqm

Other Costs
Direct Costs Cost
Engine Assembly $30,000
Supervisor Salary
Body Assembly $28,000
Supervisor Salary
Painting Supervisor $25,000
Salary
Quality Control $27,000
Supervisor Salary
Indirect Costs Cost
Rent $60,000
Heat & Light $25,000
Maintenance $15,000
Canteen $20,000
Cleaning $10,000
Depreciation $30,000