Notes · AccountingUK · A-Levels

Absorption and activity based costing

This chapter is about how overheads - costs that cannot be traced directly to a unit - are charged to products. It covers the allocation, apportionment and reapportionment of overheads to cost centres, the calculation of absorption rates and of under- and over-absorption, the contrast between absorption and marginal costing and its effect on profit, and activity based costing as a more refined alternative.

4 sections~18 min reading time3 competenciesLevel Standard 1 · Advanced 3

T·141414 / 18

Exam profile

AO1 · Understand overhead absorption and activity based costingAO2 · Apportion and absorb overheads, calculate under/over absorption and compute unit cost and profit under absorption, marginal and ABC methodsAO3 · Analyse and evaluate the choice of costing method and its effect on decisions

Operators:calculateapportionexplainreconcileanalyseevaluate

basic level

AS-Level introduces the idea of overheads and simple absorption.

higher level

The full A-Level expects apportionment, absorption rates, under/over absorption, the absorption-versus-marginal reconciliation and activity based costing.

Depth

Text

Contents · 4 sections

Absorption and activity based costing

Allocation, apportionment and reapportionment of overheads#

StandardAQA 7127 3.12

The flow of overheads to units

Fig. 1Overheads flow from allocation and apportionment into cost centres, service centres are reapportioned to production centres, and production-centre overheads are absorbed into units.

Overheads are indirect costs that cannot be traced directly to a single unit of output - factory rent, supervisors' salaries, machine depreciation, heating - yet a business that wants to know the full cost of each product must find a way of charging them to units. Absorption costing does this in a series of steps. First, overheads that belong wholly to one cost centre are allocated to it (a machine's depreciation to the machining department). Overheads shared between cost centres are then apportioned between them on a fair basis - rent by floor area, depreciation by the value of equipment, heating by volume or floor area - so that each cost centre bears a reasonable share.

Cost centres are of two kinds: production cost centres, where the product is actually made (machining, assembly), and service cost centres, which support production but do not make the product (stores, maintenance, the canteen). Because the product only passes through the production centres, the overheads gathered in the service centres must be reapportioned to the production centres on a suitable basis (stores overheads by the number of requisitions, maintenance by machine hours). After reapportionment, all the overheads have been gathered into the production cost centres, ready to be charged to units. Where service centres serve each other, reapportionment can involve repeated or simultaneous calculation, but the principle is unchanged.

The distinction between allocation and apportionment is worth stating precisely because examiners test it. Allocation charges a whole overhead to one cost centre because it belongs entirely to that centre; apportionment shares an overhead between several cost centres because it is common to them, using a basis that reflects how each centre causes or benefits from the cost. Choosing a sensible, cause-related basis for apportionment matters, because an arbitrary basis distorts the cost of each centre - and therefore of each product - and can lead to poor pricing and decision-making. The aim throughout is a fair, cause-and-effect sharing of costs.

This whole process rests on a chain of judgements about how costs relate to cost centres and to products, and that is both its strength and its weakness. Absorption costing produces a full cost per unit that includes a share of every overhead, which is useful for pricing (to ensure all costs are covered), for inventory valuation (which must include production overheads under IAS 2), and for meeting external reporting requirements. But the apportionment bases are approximations, and a product's 'full cost' is only as good as those bases - a point that activity based costing, later in the chapter, is designed to address. The flow of overheads from allocation, through apportionment and reapportionment, to absorption into units is the backbone of the method.

Worked example

Apportioning an overhead

Factory rent of £24,000 is shared between the machining department (occupying 400 square metres) and the assembly department (200 square metres). Apportion the rent and justify the basis.

Choose the basis
Rent is a cost of occupying space, so floor area is a fair, cause-related basis. Total area = 400 + 200 = 600 square metres.
Apportion
Machining share = 400/600 x £24,000 = £16,000. Assembly share = 200/600 x £24,000 = £8,000.
Justify
Floor area reflects how much of the rented space each department uses, so it shares the cost in proportion to the benefit each derives - a fairer basis than, say, splitting equally regardless of size.

Result: Rent is apportioned £16,000 to machining and £8,000 to assembly by floor area (400:200), a basis that shares the cost in proportion to the space each department occupies.

Typical mistakes

Confusing allocation (whole overhead to one centre) with apportionment (sharing a common overhead).
Failing to reapportion service-centre overheads, so some overheads are never charged to units.

Active revision

Factory rent of £24,000 is to be apportioned between machining and assembly by floor area (2:1). Calculate each department's share and explain why this basis is appropriate.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Absorption rates and under/over absorption#

AdvancedAQA 7127 3.12

Under-absorption of overheads

Fig. 2A predetermined rate of £5 per machine hour absorbs £51,000 on 10,200 actual hours; with actual overheads of £52,000, overhead is under-absorbed by £1,000 (an extra expense).

Once all the overheads have been gathered into a production cost centre, they are charged to units through an overhead absorption rate (OAR). The rate is calculated in advance (a predetermined rate) by dividing the budgeted overheads of the cost centre by the budgeted level of activity - most commonly budgeted labour hours or budgeted machine hours, whichever better reflects what drives the overhead. A machine-intensive department uses a machine-hour rate; a labour-intensive one a labour-hour rate. Each unit then absorbs overhead equal to the rate multiplied by the hours it takes, so the full cost of a unit is its direct materials, direct labour and absorbed overhead.

Because the absorption rate is predetermined - set from budgeted figures before the period begins - the overhead actually absorbed by production will almost never equal the overhead actually incurred, and the difference is under- or over-absorption. Overhead is absorbed as (actual activity x predetermined rate); if this is less than the actual overhead incurred, overhead has been under-absorbed (too little was charged to production), and the shortfall is an additional expense in the income statement. If the absorbed figure exceeds the actual overhead, overhead has been over-absorbed (too much was charged), and the excess is credited back. Under- or over-absorption arises whenever actual activity or actual overhead differs from budget.

A worked example makes it concrete. Suppose budgeted overheads are £50,000 and budgeted machine hours 10,000, giving a predetermined machine-hour rate of £50,000 / 10,000 = £5 per machine hour. During the period the actual machine hours are 10,200 and the actual overheads £52,000. Overhead absorbed = 10,200 x £5 = £51,000. Because the actual overhead (£52,000) exceeds the amount absorbed (£51,000), overhead is under-absorbed by £1,000, which is charged as an extra expense in the income statement. Had the absorbed figure exceeded the actual, the over-absorption would have been credited to the income statement instead.

Interpreting under- or over-absorption points to what went differently from budget. Under-absorption can arise because activity was lower than budgeted (fewer hours worked, so less overhead absorbed) or because overheads were higher than budgeted, or both; over-absorption from the reverse. It is not, in itself, a measure of efficiency - it is a consequence of using a predetermined rate - but a large or persistent under-absorption warns that the budget assumptions (the overhead estimate or the activity level) were wrong and should be revisited, which matters because those same assumptions feed into pricing. The technique is precise, but it depends on the budgeted rate being realistic, echoing the standard-costing lesson that a benchmark is only as good as its assumptions.

\text{Overhead absorption rate} = \frac{\text{Budgeted overheads}}{\text{Budgeted activity (hours)}}

Absorption rate (OAR)

Predetermined from budget. Here 50,000 / 10,000 = 5 per machine hour.

\text{Under/over absorption} = (\text{Actual activity} \times \text{OAR}) - \text{Actual overheads}

Under/over absorption

Negative = under-absorbed (extra expense); positive = over-absorbed (credit). Here 51,000 - 52,000 = -1,000, under-absorbed.

Worked example

Calculating under-absorption

A department budgets overheads of £50,000 and 10,000 machine hours. Actual machine hours are 10,200 and actual overheads £52,000. Calculate the predetermined absorption rate, the overhead absorbed and the under- or over-absorption.

Absorption rate
OAR = budgeted overheads / budgeted machine hours = £50,000 / 10,000 = £5 per machine hour.
Overhead absorbed
Absorbed = actual hours x rate = 10,200 x £5 = £51,000.
Under/over absorption
Absorbed £51,000 is less than actual overheads £52,000, so overhead is under-absorbed by £1,000, charged as an additional expense in the income statement.

Result: The rate is £5 per machine hour; £51,000 of overhead is absorbed against £52,000 incurred, so overhead is under-absorbed by £1,000 - an extra charge to the income statement.

Typical mistakes

Using actual overheads (not budgeted) to calculate the predetermined absorption rate.
Getting the direction wrong - absorbed less than actual is under-absorption (an extra expense), not over.

Active revision

Budgeted overheads £50,000, budgeted machine hours 10,000. Actual hours 10,200, actual overheads £52,000. Calculate the absorption rate, overhead absorbed and the under- or over-absorption.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Absorption versus marginal costing#

AdvancedAQA 7127 3.12

Reconciling marginal and absorption profit

Fig. 3When inventory rises by 1,000 units, absorption profit exceeds marginal profit by the fixed overhead carried in that inventory (1,000 x £8 = £8,000).

Absorption and marginal costing treat fixed production overheads differently, and this single difference explains everything else. Under absorption costing, each unit carries a share of the fixed production overhead (through the absorption rate), so fixed overhead is included in the cost of a unit and therefore in the value of inventory. Under marginal costing, only variable costs are charged to units; the fixed overhead is treated as a period cost and written off in full against the period's contribution, so inventory is valued at variable cost only. The methods value inventory differently, and this is why they report different profits whenever the level of inventory changes.

The relationship between the two profits is precise and examinable: the difference between absorption and marginal profit equals the fixed overhead contained in the change in inventory. When inventory rises over the period (production exceeds sales), absorption costing carries some fixed overhead forward in the closing inventory rather than charging it this period, so absorption profit is higher than marginal profit by that amount. When inventory falls (sales exceed production), the reverse holds and marginal profit is higher. When inventory is unchanged, the two profits are equal. This lets you reconcile the two figures and check your work.

A worked comparison shows the mechanism. A product sells for £50 with a variable cost of £35; fixed overheads are £40,000 and normal production is 5,000 units, giving a fixed overhead absorption rate of £40,000 / 5,000 = £8 per unit and an absorption cost of £43 per unit. Suppose 5,000 units are produced but only 4,000 sold, so closing inventory rises by 1,000 units. Under marginal costing, contribution is 4,000 x £15 = £60,000, less fixed overheads £40,000, giving a profit of £20,000. Under absorption costing, cost of sales is 4,000 x £43 = £172,000, so profit is £200,000 - £172,000 = £28,000 (with no under/over absorption, as 5,000 units absorbed exactly the £40,000). Absorption profit is £8,000 higher, exactly the 1,000 units of closing inventory times the £8 fixed overhead per unit.

Each method suits a different purpose, which is the basis for evaluation. Absorption costing is required for external financial reporting and inventory valuation (IAS 2 requires production overheads to be included) and ensures pricing covers all costs. Marginal costing is better for internal short-term decision-making, because contribution isolates the effect of a decision and fixed costs are not arbitrarily spread. The danger of absorption costing for decisions is that its 'full cost' includes apportioned fixed overheads that may not change with the decision, so relying on it can lead to rejecting profitable business (as in the special-order case). The sophisticated view is that the two methods answer different questions - marginal for short-term decisions, absorption for reporting and full-cost pricing - and a good accountant uses each where it fits.

\text{Absorption profit} - \text{Marginal profit} = \text{Fixed overhead in the change in inventory}

Reconciling the two profits

Inventory rising -> absorption profit higher; inventory falling -> marginal profit higher; unchanged -> equal. Here 1,000 units x 8 = 8,000.

Worked example

Marginal versus absorption profit

A product sells for £50 with a variable cost of £35. Fixed overheads are £40,000 and normal output is 5,000 units. In the period 5,000 units are produced and 4,000 sold. Calculate the profit under marginal and absorption costing and reconcile.

Marginal costing profit
Contribution = 4,000 x (£50 - £35) = 4,000 x £15 = £60,000. Profit = £60,000 - fixed overheads £40,000 = £20,000.
Absorption costing profit
Fixed overhead rate = £40,000 / 5,000 = £8; absorption cost = £35 + £8 = £43. Cost of sales = 4,000 x £43 = £172,000. Profit = £200,000 - £172,000 = £28,000 (5,000 units absorbed the full £40,000, so no under/over absorption).
Reconcile
Closing inventory rose by 1,000 units, each carrying £8 of fixed overhead = £8,000. Marginal profit £20,000 + £8,000 = £28,000 = absorption profit - the two reconcile.

Result: Marginal profit £20,000, absorption profit £28,000; the £8,000 difference is the fixed overhead (1,000 units x £8) carried forward in the increased closing inventory under absorption costing.

Typical mistakes

Including fixed overhead in the marginal-costing unit cost, or omitting it from the absorption unit cost.
Forgetting that the profit difference equals the fixed overhead in the inventory change, not the whole inventory value.

Active revision

SP £50, variable cost £35, fixed overheads £40,000, normal output 5,000 units. 5,000 are produced, 4,000 sold. Calculate the profit under marginal and absorption costing and reconcile the difference.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Activity based costing#

AdvancedAQA 7127 3.12

Traditional absorption versus ABC

Fig. 4ABC traces set-up costs to the products that cause them, shifting £19,000 from the simple high-volume product X onto the complex low-volume product Y.

Traditional absorption costing charges all overheads to units using a single volume-based measure such as labour or machine hours. This was reasonable when overheads were small and mostly volume-driven, but in modern businesses overheads are large and are driven by activities that have little to do with volume - machine set-ups, quality inspections, materials handling, order processing. Charging these on labour hours over-costs high-volume, simple products (which use many labour hours but cause few set-ups) and under-costs low-volume, complex products (which use few labour hours but cause many set-ups). Activity based costing (ABC) was developed to give a more accurate full cost by tracing overheads to the activities that cause them.

ABC works by identifying the main activities that consume resources, grouping the overheads of each into a cost pool, and finding for each pool the cost driver - the factor that causes that cost (the number of set-ups for set-up costs, the number of inspections for inspection costs, the number of orders for ordering costs). A cost-driver rate is calculated for each pool (pool cost divided by the total quantity of the driver), and each product is charged overhead according to how much of each driver it actually consumes. Instead of one blanket rate, ABC uses several activity-based rates, so a product that causes a lot of an activity bears a lot of that activity's cost.

A worked comparison shows the effect. Suppose total overheads of £90,000 fall into two pools: set-up costs of £45,000 (driver: number of set-ups, 90 in total, so £500 per set-up) and machining costs of £45,000 (driver: machine hours, 15,000 in total, so £3 per machine hour). Product X causes 10 set-ups and uses 8,000 machine hours; product Y causes 80 set-ups and uses 7,000 machine hours. Under ABC, X absorbs (10 x £500) + (8,000 x £3) = £5,000 + £24,000 = £29,000, and Y absorbs (80 x £500) + (7,000 x £3) = £40,000 + £21,000 = £61,000. Under a traditional machine-hour rate (£90,000 / 15,000 = £6 per hour), X would absorb 8,000 x £6 = £48,000 and Y 7,000 x £6 = £42,000. ABC shifts £19,000 of cost from the simple high-volume product X onto the complex low-volume product Y, which its many set-ups actually cause.

Evaluating ABC weighs its greater accuracy against its greater cost and complexity. Its advantages are more accurate product costs (which improve pricing, product-mix and profitability decisions), better insight into what drives overheads (which supports cost control by managing the activities), and the exposure of unprofitable low-volume products that traditional costing hides. Its disadvantages are that it is time-consuming and expensive to set up and run, that identifying activities and drivers involves judgement and can be arbitrary, and that for a business with few, simple products and small overheads the extra accuracy may not justify the cost. ABC is therefore most worthwhile where overheads are large and diverse and products differ greatly in the demands they place on activities - the modern manufacturing or service environment for which it was designed - and a sound answer judges its suitability to the specific business rather than declaring it universally better.

\text{Cost-driver rate} = \frac{\text{Cost pool}}{\text{Total quantity of the cost driver}}

Cost-driver rate

One rate per activity. Here set-ups 45,000 / 90 = 500 per set-up; machining 45,000 / 15,000 = 3 per machine hour.

\text{Overhead to a product} = \sum (\text{Driver rate} \times \text{Driver units used by the product})

ABC overhead

Each product bears overhead in proportion to the activities it actually consumes, not just its volume.

Worked example

Traditional absorption versus ABC

Total overheads of £90,000 comprise set-up costs of £45,000 (90 set-ups in total) and machining costs of £45,000 (15,000 machine hours). Product X causes 10 set-ups and uses 8,000 machine hours; product Y causes 80 set-ups and uses 7,000 machine hours. Calculate each product's overhead under ABC and under a machine-hour rate, and comment.

Cost-driver rates
Set-ups: £45,000 / 90 = £500 per set-up. Machining: £45,000 / 15,000 = £3 per machine hour.
ABC overhead
X = (10 x £500) + (8,000 x £3) = £5,000 + £24,000 = £29,000. Y = (80 x £500) + (7,000 x £3) = £40,000 + £21,000 = £61,000.
Traditional and comparison
Machine-hour rate = £90,000 / 15,000 = £6. X = 8,000 x £6 = £48,000; Y = 7,000 x £6 = £42,000. ABC moves £19,000 of cost from X to Y, because Y's 80 set-ups (not its machine hours) drive most of the set-up cost.

Result: Under ABC, X bears £29,000 and Y £61,000, versus £48,000 and £42,000 traditionally - ABC reveals that the low-volume, set-up-heavy product Y is far more costly than volume-based absorption suggested, with implications for its pricing and profitability.

Typical mistakes

Using volume (units or labour hours) as the ABC driver for an activity that is not volume-driven, such as set-ups.
Declaring ABC always superior without weighing its cost against the benefit for the specific business.

Active revision

Overheads of £90,000 split into set-up costs £45,000 (90 set-ups) and machining £45,000 (15,000 machine hours). Product Y causes 80 set-ups and uses 7,000 machine hours. Calculate Y's overhead under ABC and under a machine-hour rate, and comment.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA) · Ofqual - GCE AS and A level qualifications (Ofqual)

References & sources

Sources

AQA

AQA A-level Accounting 7127 specification

Ofqual

Ofqual - GCE AS and A level qualifications

Absorption and activity based costing

4 sections~18 min reading time3 competenciesLevel Standard 1 · Advanced 3

Absorption and activity based costing

Key points

Apportioning an overhead

Key points

Calculating under-absorption

Key points

Marginal versus absorption profit

Key points

Traditional absorption versus ABC

Sources

Absorption and activity based costing

Key points

Apportioning an overhead

Key points

Calculating under-absorption

Key points

Marginal versus absorption profit

Key points

Traditional absorption versus ABC

Sources