Absorption costing

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  • Explain the concept of inter-service dept work and then chat through the approaches Direct method is most suitable if have only one service dept or +1 but no inter-service work Step method is not used in FIM Reciprocal method most suitable when +1 service depts and there is inter-service work between them – there are two techniques which we will see later Question will either tell you or the scenario will fit in with those referred to above – would expect a reciprocal approach
  • Now we need to take any costs in the service centres and re-apportion them to the production departments – so that all costs are sitting in production cost centres only –as it is through these centres that the physical units flow
  • Chat through each stage Direct cost are variable so allocate directly – don’t forget to do this - can often be so obsessed with overheads that forget this bit Then indirect costs – this is all of them at the minute (FC and VC) although later on and in questions will probably only be FC We’ll go through each stage in a bit more detail now
  • Note – we work out an OAR for each production dept.
  • Our aim is to be able to compile a cost card so chat through how we do it Prime costs easy to identify as variable Overheads more difficult as not easily attached to each cost unit – at this stage we consider them as a whole I.e fixed and variable We’re going to look at the methodology of identifying the overhead cost per unit but first we must understand the concept of cost centres AC is Required by ssap 9
  • Discuss why there are differences – actual volume and expenditure may differ from budget
  • Absorption costing

    1. 1. Chapter 8 Study Text Chapter 8Overheads and absorption costing
    2. 2. Overheads• Overheads/indirect costs are those costs that cannot be traced directly and in full to the products or services or department of the business.• Overhead= indirect(material+labour+expenses)• Overheads are categorised commonly ase1. Production overhead2. Administration overhead3. Selling overhead4. Distribution overheadSlide 2
    3. 3. Absorption costing• Absorption costing is a method of sharing overheads between a number of different products or services on a fair basis.• Absorption costing procedure1. Allocation2. Apportionment3. absorptionSlide 3
    4. 4. Allocation1) Allocation• collection of costs by type• allocation of as many costs as possible directly to cost centersSlide 4
    5. 5. Overheads Total production costsDirect costs Indirect costs (overheads) Allocate & apportion COST CENTRES Production 1 Production 2 Service Allocate COST UNITS Slide 5
    6. 6. ApportionmentTwo stages1. Overheads that cannot be allocated to specific cost centres are spread between cost centres on a fair basis.2. Re-apportionment of service cost center overheads to production cost centersMethods of re-apportionmenta) Direct methodb) Step-down method
    7. 7. Overheads Basis of apportionmentOverhead BasisRent and rates Floor space occupiedDepreciation Cost/NBV of equipmentStaff welfare Number of employeesHeat, light Volume of space occupiedInsurance of equipment Value of equipmentInsurance of building Floor space occupiedStores costs Number of issuesBuilding repairs & Floor space occupiedmaintenanceSlide 7
    8. 8. Re-apportionmentDirect method of re-apportionment:• It involves apportioning the costs of each service Cost centre to production cost centres only .Text example-page 143Step-down method of re-apportionment:• This method recognises the inter-service cost Centre work. Each service cost centre’s costs are Not only apportioned to production departments but to some ( but not all) of the Other Service cost centres that makes use of the Service provided
    9. 9. Reapportionment To reapportion service cost centre overheads to production cost centres there are 2 methods Direct Step down Method method Inter-service Some inter-service department department work work is ignored is recognisedSlide 9
    10. 10. Overheads Total production costsDirect costs Indirect costs (overheads) Allocate & apportion COST CENTRES Production 1 Production 2 Service Allocate Production 1 Production 2 Reapportion COST UNITS Slide 10
    11. 11. Basis of re-apportionmentService cost centre Possible basis of apportionmentStores Number or cost value of material requisitionMaintenance Hours of maintenance work done for each cost centreProduction planning Direct labour hours worked in each production cost centre
    12. 12. Absorption Absorption involves;• Identifing the absorption base• Establishing an absorption rate for each production cost center.• Absorption of overheads in to cost units.
    13. 13. Absorption costing method Total production costsDirect costs Indirect costs (overheads) 1.Allocate & apportion COST CENTRES Production 1 Production 2 Service Allocate Production 1 Production 2 2.Reapportion 3. Absorb COST UNIT Slide 13
    14. 14. Possible bases of absorptionThe most common absorption bases are as follows;• A rate per machine hour• A rate per direct labour hour• A percentage of direct labour cost• A percentage of direct material cost• A percentage of total direct cost• A rate per unit• A percentage of factory overhead• A percentage of sales value of factory cost
    15. 15. Choosing basis of absorptionBasis Use whenUnit Units are identicalLabour hour Labour intensiveMachine hour Machine intensive% of direct labour Question asks for it
    16. 16. Absorption rate Production overhead _______________OAR (overhead absorption rate) = Activity levelSlide 16
    17. 17. Absorption into production Overhead Pre-determined Absorbed = Actual activity x OARSlide 17
    18. 18. Absorption costing -cost card A cost card shows us the cost to make one unit $/unit Direct materials X Direct labour X Prime cost X Overheads X Full Product cost XSlide 18
    19. 19. Predetermined overhead absorption rates• Calculated using budget figuresSteps in calculating and using POHAR1. Estimate the overhead2. Estimate the activity level for the period. This could be total hours, units or direct cost or what ever measure upon which the OHAR are to be based.3. Divide the estimated overhead by the budgeted activity level.This produces the POAR4. Absorb or recover overheads in to cost units
    20. 20. Why use predetermined rates instead of actual absorption rates• It enable overheads to be absorbed through out the accounting period.• The actual overheads and actual activity level are not known until the end of an accounting period, the actual absorption rates can not be calculated until then. In effect then the total cost of the product cannot be determined until the end of the period as well. This is too late for management planning and control purpose like product pricing,production scheduling,product cost estimation and routine accounting functions like invoicing
    21. 21. Effect of using predetermined absorption rates At the end of the year actual overheads will be known Overhead absorbed ≠ Actual overhead Difference = under or over absorptionSlide 21
    22. 22. Non-production overheads• For internal purposes and organisations which base selling price of their product on estimates of total costs or even actual costs. A total cost per unit of output may be required. therefore it may be appropriate to allocate non-production overheads to units of output.• Overhead absorption rate= estimated non- production oH/ estimated production costs
    23. 23. Non-production overheadsAdministration overheads include:• Executive salaries and wages/salaries of all staff in administration departments• Office rent and rates• Lighting and heating• CleaningSelling costs are incurred in order to obtain salesDistribution costs include warehouse cost anddelivery costs
    24. 24. Bases for absorptionTypes of overhead Possible absorption baseSelling and marketing Sales valueResearch and development Consumer cost (= production cost minus cost of direct materials) or added value( = sales value of product minus cost of bought in materials and services)Distribution Sales valueAdministration Full production cost
    25. 25. Non-production costs in practiceIn practice;1.An absorption costing system may be restricted to production costs only.2.The non-production overheads are simply treated as a period charge against profit.3.The actual overhead costs are included in the cost of sales.

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