This document discusses overhead absorption and absorption costing. It begins by defining overhead absorption as the amount of indirect costs assigned to cost objects. It then outlines the steps in overhead absorption, which include classifying indirect costs, aggregating costs into cost pools, determining allocation bases, and assigning overhead. The document contrasts absorption costing with variable costing and explains how absorption costing complies with GAAP by including fixed overhead costs in inventory valuation. It provides an example of calculating overhead absorption rates for a company. Big companies like Tesla also use overhead absorption to allocate indirect production costs. Under- or over-absorption of overhead can occur if actual overhead costs differ from estimated costs or output levels.

1. UNEC Business School’s MBA Program
Student: Nigar Poladova
Subject: Management accounting
Project:Overhead absorptionin big companies
İnstructor: Sanan Quluyev
Academic year and semester: (2021/2022, I semester)
Course: I
Group:E1/2-20
Project group: II
Year: 2021
Plan:
1. AbsorptionCosting
2. Absorption Costing vs. Variable Costing
3. Calculation of overhead absorptionrates
4. Overhead absorptionin big companies (Tesla)
5.Reasons for under/over absorption
6.Summary

2. İntroduction.
Overhead absorption is the amount of indirect costs assigned to cost
objects. Indirect costs are costs that are not directly traceable to an activity or
product. Costobjects are items for which costs are compiled, suchas
products, productlines, customers, retail stores, and distribution channels.
Overhead absorption is a necessary part of the requirement by both the
GAAP and IFRS accounting frameworks to include overhead costs in the
recorded amount of inventory that is shown in a company's financial
statements. Overhead absorption is not needed for internal management
reporting, only for external financial reporting. Examples of indirect costs
are selling and marketing costs, administrative costs, and production costs,
which are usually charged to expense in the period incurred. However,
indirect productioncosts are classified as overhead and then charged to
products through overhead absorption. Overhead absorption involves the
following steps:
1. Classify indirect costs. Depending on the type of allocation desired, some
costs may be included in overhead and others may not. For example,
overhead absorption for a productwould not include marketing costs, but
marketing costs might be included in an internal costreport for a
distribution channel.
2. Aggregatecosts. Shift the identified costs into costpools. Each costpool
should have a different allocation base. Thus, the indirect costs related to
a facility might be aggregated into a costpoolthat is allocated based on
square footage used.
3. Determine allocation base. This is the basis upon which overhead is
assigned to a costobject. Forexample, facility costs may be assigned
based on square footage used, while labor-related indirect costs may be
assigned based on direct labor used.
4. Assign overhead. Divide the allocation baseinto the total amount of
overhead included in a costpoolto arrive at the overhead rate.

3. 1. AbsorptionCosting
Absorption costing includes anything that is a direct costin producing a good in
its costbase. Absorptioncosting also includes fixed overhead charges as part of
the productcosts. Someof the costs associated with manufacturing a product
include wages for employees physically working on the product, the raw
materials used in producing the product, and all of the overhead costs (suchas
all utility costs)used in production.
Assets, such as inventory, remain on the entity’s balance sheet at the end of the
period. Because absorptioncosting allocates fixed overhead costs to both costof
goods sold and inventory, the costs associated with items still in ending
inventory will not be captured in the expenses on the current period’s income
statement. Absorption costing reflects more fixed costs attributable to ending
inventory.
Absorption costing ensures more accurate accounting for ending inventory
because the expenses associated with that inventory are linked to the full costof
the inventory still on hand. In addition, more expenses are accounted for in
unsold products, which reduces actual expenses reported in the current period
on the income statement. This results in a higher net income calculation
compared with variable costing calculations.
The main advantage of absorption costing is that it complies with generally
accepted accounting principles (GAAP), which are required by the Internal
Revenue Service (IRS). Furthermore, it takes into account all of the costs of
production (including fixed costs), notjust the direct costs, and more accurately
tracks profit during an accounting period.
So Formula for the total costin absorption costing is given by:
 TotalCost= TotalDirectCost+ Total OverheadCost
 TotalDirect Cost= DirectMaterial Cost+ DirectLabor
 TotalOverhead Cost= Variable Overheads + Fixed Overheads
2. Absorption Costing vs. Variable Costing
Absorption costing includes all the costs associated with the manufacturing of a
product, while variable costing only includes the variable costs directly incurred
in production but not any of the fixed costs. Absorptioncosting is required
under the Financial Accounting Standards Board’s Generally Accepted
Accounting Principles (GAAP).

4. Absorption vs. variable costing will only be a factor for companies that expense
costs ofgoods sold (COGS)on their income statement. Absorption vs. variable
costing is not optional for public companies because they are required to use
absorption costing due to their GAAP accounting obligations.
 Absorption costing includes all of the direct costs associated with
manufacturing a product, while variable costing can exclude some direct
fixed costs.
 Absorption costing, also known as full costing, entails allocating fixed
overhead costs across all units produced forthe period, resulting in a per-
unit cost.
 Variable costing includes all of the variable direct costs in COGS but
excludes direct, fixed overhead costs.
The difference between the absorption and variable costing methods centers on
the treatment of fixed manufacturing overhead costs. Absorptioncosting
“absorbs”all of the costs used in manufacturing and includes fixed
manufacturing overhead as productcosts. Absorptioncosting is in accordance
with GAAP, because the productcostincludes fixed overhead. Variable costing
considers the variable overhead costs and does not consider fixed overhead as
part of a product’scost. It is not in accordancewith GAAP, because fixed
overhead is treated as a period costand is not included in the costof the
product.
Absorption costing considers all fixed overhead as part of a product’s costand
assigns it to the product. This treatment means that as inventories increase and
are possibly carried over from the year of production to actual sales of the units
in the next year, the company allocates a portion of the fixed manufacturing
overhead costs from the current period to future periods.
Carrying over inventories and overhead costs is reflected in the ending
inventory balances at the end of the production period, which become the
beginning inventory balances at the start of the next period. It is anticipated that
the units that were carried over will be sold in the next period. If the units are
not sold, the costs will continue to be included in the costs of producing the
units until they are sold. Finally, at the point of sale, whenever it happens, these
deferred productioncosts, suchas fixed overhead, become part of the costs of
goods sold and flow through to the income statement in the period of the sale.

5. 3. Calculation of overhead absorptionrates
JHONSON Company had the following information for May:
 Direct materials $15,000
 Direct labor $17,000
 Variable overhead $7,000
 Fixed overhead $8,000
 Fixed selling expenses $17,000
 Variable selling expenses $0.20 per unit
 Administrative expenses $14,000
 10,000 units produced
 9,000 units sold (1,000 remain in ending finished goods inventory)
 Sales price $9 per unit
Direct Materials $ 15,000
+ Direct Labor $ 17,000
+ Variable Overhead $ 7,000
+ Fixed Overhead $ 8,000
= Total ProductCost $47,000
÷ Total Units Produced ÷ 10,000
= Product costper unit $ 4.70
JHONSON Company
Income Statement(absorption)
For Month Ended May
Sales (9,000x $9 per unit) $ 81,000
– Costof Goods Sold (9,000 x $4.70 perunit) 42,300
= Gross Profit 38,700

6. Operating Expenses:
Selling Expenses (17,000+ 0.20 x 9,000 ) 18,800
+ Generaland Admin. Expenses 14,000
= TotalExpenses 32,800
= Net Operating Income $5,900
4. Overhead absorptionin big companies (Tesla)
Production
dept. Alpha
Production
dept. Betta
Budget figures
Overheadcost $29,500 $6,000
Direct materials cost $25,000
Direct labour cost $35,000
Machine hours 20,000
Direct labour hours 5,000
Units of production 2,000
Production dept. Alpha
Percentage of direct material cost 29500/25000*100%=105.36%
Percentage of direct labour cost 29500/35000*100%=84%
Percentage of prime cost 29500/55000*100%=54%
Rate per machine hour 29500/20000=1.5 $
Rate per direct labour hour 29500/5000=5.9 $
Production dept. Betta
6000/2000=3$ per unit
Material cost=70$ labour hours=20
Labour cost=75$

7. machine hours=18
percentage of direct material cost, the overhead cost
105.36%x $70 = $73.75
percentage of direct labour cost, the overhead cost
84% x $75 = $63
percentage of prime cost, the overhead cost
54% x $145 = $78.30
machine hour of absorption, the overhead cost
$1.50 x 18 = $27
labour hour basis, the overhead cost
$2*20 = $40.00
5.Reasons for under/over absorption
Underabsorbed factory overheads: this situation arises if the overheads
absorbed are less than the actual overheads. It arises when the amount of
overhead that has been incurred exceeds the amount of overhead that has been
absorbed. It is also termed as ‘under-recovery’. Following factors would create
tinder absorbed factory overheads:
 Actual overheads being more than the estimated overheads,
 The actual output is less than those estimated.
For example; if the overheads absorbed ona predetermined basis are $ 10,000
and the actual overheads incurred are $ 12,000, there is under-absorption to the
extent of $ 2000.
Over absorbed factory overheads: this situation arises if the overheads
absorbed are more than the actual overheads. It arises when the amount of
overhead that has been absorbed exceeds the amount of overhead that has been
incurred. Following factors would create over absorbed factory overheads:
 Actual overheads being less than the estimated overheads,
 The actual output is more than the estimated.

8. For example, the overheads recovered are $ 30,000 and the actual production
overheads are $ 27,500 then there will be over-absorption of $ 2500. ($30,000 –
$27,500)

9. Summary.
Absorption costing enables precise accounting for the overall costof
production, unlike in variable costing, which considers only variable costs. The
method of absorptioncosting enables reporting of high profit with a high value
of closing inventory. This is because the costof production is completely
absorbed.
The method of absorptioncosting is specified in the generally
accepted accounting principles (GAAP) for reporting of accounts under various
statutes. In this method, the fixed cost per unit produced decreases with
incremental production. This is contrary to variable costing, where incremental
production bears the same variable costs ofproduction. Also, the method of
variable costing does not depict a correct picture of the accounting profits or
losses.

10. Bibliography
1. "cleartax.in
2. Principles of Accounting, Volume 2: ManagerialAccounting
3. corporatefinanceinstitute.com.
4. https://www.tesla.com