Absorption costing is a system in which all (fixed and variable) production overhead costs are charged to product/services using an allocation base (a measure of activity or volume such as labor hours, machine hours, or the number of units produced etc.). The allocation base used in absorption costing is often regarded as arbitrary.
Under absorption costing, a budgeted overhead rate can be calculated as either:
[-]. a business-wide rate, or
[-]. a cost centre overhead rate.
A business-wide budgeted overhead rate is calculated by dividing the production overheads for the total business by some measure of activity. Overhead rates can also be calculated for each cost centre separately. A cost centre is a location within the organization to which costs are assigned (it may be a department or a group of activities within a department). A cost centre budgeted overhead rate is a result of determining the overheads that are charged to each cost centre and the activity of that cost centre. It is preferable to calculate a separate overhead rate for each cost centre, as the costs and activity of each may be quite different.
The overhead charged to each cost centre must then be recovered as a rate based on the principal unit of activity within a cost centre, typically direct labor hours, machine hours or the number of units produced. We therefore calculate a direct labor hour rate or a machine hour rate or a rate per unit produced for each production cost centre, or for the business as a whole.
Under both methods, the budgeted overhead rate is:
estimated overhead expenditure for the period [divided by] estimated activity for the period
For example: a business with budgeted overhead expenditure of $100,000 and an activity level of 4,000 direct labor hours would have a business-wide budgeted overhead rate of $25 per hour ($100,000/4,000).Most businesses are able to identify their overhead costs and activity to individual cost centre levels and determine cost centre overhead rates.
This can be achieved using a three-stage process:
[a]. Identify indirect costs with particular cost centre. In many cases, although costs cannot be traced to products/services, they can be traced to particular cost centre. Accounting systems will separately record costs incurred by each cost centre. For example, supervision costs may be traceable to each cost centre. Certain consumables may only be used in particular cost centre. Each cost centre may order goods and services and be charged for those goods and services separately.
[b]. Analyze each line item of expenditure that cannot be traced to particular cost centre and determine a suitable method of allocating each cost across the cost centre. There are no rules for the methods of allocation, which are contingent on the circumstances of the business and the choices made by accountants. However, common methods of allocating indirect costs include:
- Expense — Allocation basis
- Management salaries — Number of employees in each cost centre
- Premises cost — Floor area occupied by each cost centre
- Electricity — Machine hours used in each cost centre
- Depreciation on equipment — Asset value in each cost centre
[c]. Identify those cost centre that are part of the production process and those service cost centre that provide support to production cost centre. Allocate the total costs incurred by service cost centre to the production cost centre using a reasonable method of allocation. Common methods of allocating service cost centre include:
- Service cost centre — Allocation basis
- Maintenance — Timesheet allocation of hours spent in each production cost centre
- Canteen — Number of employees in each cost centre
- Scheduling — Number of production orders
An example of cost allocation between departments is shown below. Using the previous example and the same overhead costs of $200,000, suitable methods of allocation have been identified over five departments as follows:
- Expense item — Method of allocation
- Indirect wages — From payroll
- Factory rental — Floor area
- Depreciation on equipment — Asset value
- Electricity — Machine hours
Of the five departments, two are service departments. Their costs can be allocated as follows:
- Service cost centre — Method of allocation
- Canteen — Number of employees
- Scheduling — Number of production orders