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OVERHEAD ABSORPTION

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					OVERHEAD ABSORPTION

This is the process by which overheads are included in the total cost of a product.

"The charging of overheads to cost units by means of rates separately calculated for each cost
centre, in most cases the rates are pre-determined." (CIMA)

The idea is that you want to reflect the load that the product or job places upon the production
facilities in the allocation of overhead.

Overhead absorption rate for a cost centre =

       Total overheads of the cost centre
       Total number of units of absorption
        base applicable to the cost centre

Cost Centre :
"A location, function or items of equipment in respect of which costs may be ascertained and
related to cost units for control purposes." (CIMA)
e.g.    The plating shop, The sales office.

Bases of absorption
Example : Data relating to the Machine Shop for October 19X7
Total Overhead                                  £6,000
Total Direct Labour hours                       800 hours
Total Direct Wages                              £1,600
Total Direct Material used                      £3,000
Total Machine hours                             1,200 hours
Total Units produced                            45 units

Overhead Absorption Bases
i. Direct Labour Hour overhead absorption rate (OAR)
       =        £ 6,000                =         £7.50 per direct labour hour
                800 hours
ii. Direct wages OAR
         =      £ 6,000                =         £ 3.75 per £ of wages or
                £ 1,600                          375% of wages
iii. Direct Material OAR
         =      £ 6,000                =         £ 2.00 per £ of materials or
                £ 3,000                          200% of materials
iv. Prime cost OAR
         =      £ 6,000                =         £ 1.30 per £ of prime cost or
                £ 4,600                          130% of prime cost
v. Machine hour OAR
         =      £ 6,000                =         £ 5.00 per machine hour
                1,200 hours




ACF 313 Management Accounting & QBM          1                                        14 February 2000
vi. Cost unit OAR
        =      £ 6,000                =         £ 133 per unit produced
                45 units

Using the calculated overhead absorption rate
Example
Unit X in the machine shop
Direct materials used                           £ 23.00
Direct wages                                    £ 27.50
Direct labour hours                             12 hours
Machine hours                                   17 hours

To calculate the full manufacturing cost of unit X using a direct labour hour overhead absorption
rate:
                                                                               £
Direct Labour                                                               27.50
Direct Materials                                                            23.00
       Prime cost                                                           50.50
Overheads
       12 hours @ £ 7.50 per hour                                           90.00
       Full manufacturing cost                                             140.50

       Comparison of alternative bases
                                                                                       Overhead
                                                                                       absorbed
Absorption base                     OAR         Cost data     Calculation               per unit

Direct labour hour                  £7.50       12 hours      12 x £7.50                    90.00

Direct wages                        375%        £27.50        3.75 x £27.50                103.13


Direct material                     200%        £23.00        2 x £23.00                    46.00

Prime cost                          130%        £50.50        1.3 x £50.50                  65.65

Machine hour                        £5.00       17 hours      17 x £5.00                    85.00

Cost unit                         £133.00       1 unit        1 x £133.00                  133.00




ACF 313 Management Accounting & QBM         2                                       14 February 2000
Choosing the appropriate absorption base
This requires judgement & common sense.
You want to reflect the characteristics of the cost centre in the absorption base.
Generally the time based methods
        (labour hours
        machine hours
        direct wages)
are more relevant.

Direct labour hour basis
Suitable in a labour intensive cost centre which has a good time recording system.

Machine hour basis
Suitable in a mechanised cost centre. A lot of the overheads will relate to the use of machinery
e.g. power, repairs, depreciation etc. so you want to reflect this in the overhead absorption base.

Direct wages
Similar to direct labour hour basis. Only suitable where there are uniform wage rates, in which
case it will give the same amount of overhead as direct labour hour basis.

Direct material
Only likely to be useful for absorbing material handling expenses.
For other manufacturing overheads the value of the material is unlikely to relate to the time spent
in the cost centre.

Prime cost
As this is a combination of direct wages and direct materials it is unlikely to be suitable.

Cost unit
This allocates the same amount of overhead to each unit. Therefore it is only likely to be suitable
where all the units produced are identical.
Predetermined overhead rates

                                     Budgeted total overheads
                                        for the cost centre
                                  Budgeted total number of units
                                     of the absorption base
e.g.
Budgeted overhead                                         12,600
Budgeted machine hours                                  840 hours

Machine hour overhead absorption rate             =                     12,600
                                                                           840
                                                  =             £15.00 per hour

It is better to predetermine the overhead absorption rate to avoid delays in the preparation of
management information.




ACF 313 Management Accounting & QBM           3                                      14 February 2000
Under/Over absorption

absorbed overhead > actual = over absorption
absorbed overhead < actual = under absorption
e.g.
                                                Budgeted                 Actual
Overheads                                       £6,000                   £6,312
Direct labour hours                                800                      792

Direct labour hour overhead absorption rate:
        6,000
                                     =          £ 7.50 per labour hour
        800

Actual hours                                       792
       Absorbed                                  5,940
Actual overhead                                  6,312
Under absorbed                                     372




ACF 313 Management Accounting & QBM        4                               14 February 2000
Determination of Overheads
Actual overheads are determined by using an Overhead analysis sheet to allocate and apportion
manufacturing overheads to the various cost centres.

Example Budgeted Overhead Costs
                                                                £'000                   £'000
Indirect Wages & Supervision
        Machine shop                                              100
        Assembly                                                  150
        Stores                                                     50
        Canteen                                                   100
                                                                                          400

Indirect Materials
        Machine shop                                              150
        Assembly                                                  350
        Stores                                                     50
        Canteen                                                    50
                                                                                          600

Light and Heat                                                    100
Rent                                                               60
Insurance of Machinery                                             60
Depreciation of Machinery                                         120
Insurance of Buildings                                             50
Management Salaries                                               120

Additional Information:
                            Total      Machine          Assembly         Stores         Canteen
Area occupied              100%             40%              40%           15%                5%
Book value
of Machinery              £600k           £200k            £250k          £50k             £100k
Number of
Employees                    480            180               220            20                 60
Value of
materials
issued from
stores                        45                10             10             --                25

The total overheads for each production cost centre can be calculated by a process of allocation
and apportionment, using an overhead analysis sheet.




ACF 313 Management Accounting & QBM         5                                      14 February 2000
Overhead Analysis Sheet

                            Basis of allocation/               Mach
Overhead                    apportionment             Total    RoomAssembly        Stores      Maint
Indirect wages              Allocation                 400      100      150            50          100
Indirect materials          Allocation                 600      150      350            50           50
Light & Heat                Area                       100       40       40            15             5
Rent                        Area                        60       24       24             9             3
Ins of machinery            Book value of mach          60       20       25             5           10
Deprec of machinery         Book value of mach         120       40       50            10           20
Ins of buildings            Area                        50       20       20           7.5           2.5
Management salaries         No of employees            120       45       55             5           15
                                                        ----     ----     ----         ----          ----
                                                      1510      439      714         151.5      205.5
Reapportionment of
Service Cost Centre
overheads
Stores                      Stores issues                        34       34        -151.5          83.5
                                                        ----     ----     ----         ----          ----
                                                                                                    289


Maintenance                 Book value of machinery             128      161                        -289
                                                        ----     ----     ----         ----          ----
                                                      1510      601      909


Budgeted machine hours                                          150
Budgeted labour hours                                                    600


Overhead absorption rates                                      £4.01    £1.52




ACF 313 Management Accounting & QBM           6                                  14 February 2000

				
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