Overheads, Absorption and Activity-Based Costing

Weightage: Chapter 4 of ICAI's Paper 4 syllabus, roughly 14 marks. The chapter that turns the classification discipline from the method chapter into an actual, multi-step computational sequence.

The problem overheads pose

Direct material and direct labour can be traced to a specific unit or job. Overheads, by definition, cannot — factory rent, supervisory salaries, depreciation on shared machinery serve the whole factory, not any one product. Yet a full cost per unit is needed for pricing, inventory valuation and profitability analysis, which means overheads must somehow be spread across products even though no single, unambiguous, objectively correct way of doing so exists. Everything in this chapter is a set of increasingly refined answers to that one problem.

The three-stage sequence: allocation, apportionment, absorption

Allocation — an overhead that can be identified wholly and directly with one specific cost centre is charged to it in full, with no division required. Depreciation on a single machine located entirely within one department is allocated to that department alone.

Apportionment — an overhead that is shared across several cost centres, and cannot be identified wholly with any one, is divided among them on some reasonable basis reflecting how the cost centres actually benefit from or cause the cost. Factory rent is apportioned across departments on the basis of floor area occupied; a canteen's cost is apportioned on the basis of number of employees in each department.

Reapportionment (secondary apportionment). Costs first apportioned to service cost centres (maintenance, stores, canteen) must then be reapportioned to production cost centres, since a service centre does not itself make any saleable output and its cost must ultimately be recovered through the products passing through the production centres it serves. Where service centres serve each other reciprocally (maintenance services the canteen, and the canteen services maintenance staff), reapportionment requires either the repeated distribution method (cycling the reapportionment back and forth until the residual amounts become negligible) or the simultaneous equation method (solving the mutual service relationship algebraically in one step) — both are examinable, and the simultaneous equation method is generally faster and more precise where only two or three service centres are reciprocally related.

Absorption — once all overhead is apportioned into the production cost centres, it is finally absorbed into the cost of the units, jobs or products that pass through each centre, using an absorption rate.

Overhead absorption rates

$\text{Overhead Absorption Rate}=\frac{\text{Total overhead of the cost centre}}{\text{Total base (units, hours, or cost, as chosen)}}$

Common bases, each suited to different situations: rate per unit (where output is homogeneous); percentage of direct material cost; percentage of direct labour cost; percentage of prime cost; direct labour hour rate; machine hour rate. The choice of base should reflect what actually drives the overhead in that cost centre — a highly automated department's overhead is usually better absorbed on a machine hour basis, since the overhead (power, depreciation, maintenance) is driven by machine running time, while a labour-intensive department's overhead is usually better absorbed on a labour hour basis.

Machine hour rate, examined in particular depth, is computed by dividing the total overhead attributable to a machine (or group of machines) by the machine hours it is expected to run — and where a machine has both standing charges (rent, insurance, independent of running hours) and running charges (power, consumable stores, dependent on hours actually run), the two are usually computed and analysed separately before being combined into a composite rate.

Under- and over-absorption

Because the absorption rate is computed in advance, using budgeted overhead and a budgeted level of activity, actual overhead incurred and actual activity achieved will almost never exactly match the budget, producing a difference between overhead absorbed (rate × actual activity) and overhead actually incurred.

Under-absorption — overhead absorbed is less than actual overhead incurred (either because actual overhead was higher than budgeted, or actual activity was lower than budgeted, absorbing less than was actually spent).

Over-absorption — overhead absorbed exceeds actual overhead incurred.

Treatment. Where the difference is small or attributable to normal fluctuations, it is written off to the costing profit and loss account. Where the difference is significant and arises from a faulty estimate (a genuine, ongoing error in the budgeted rate rather than a normal, expected short-term fluctuation), it may instead be dealt with through a supplementary rate, adjusting the cost of the units already produced (and their closing stock and cost of goods sold) to reflect the corrected figure, so that costs are not permanently misstated going forward on the same erroneous basis.

Activity-Based Costing (ABC)

Why it exists

Traditional absorption, using a single volume-based rate such as machine hours or labour hours, works reasonably well when overheads genuinely vary in proportion to volume. But a great deal of modern overhead — machine setup costs, quality inspection, order processing, engineering changes — does not vary with volume at all; it varies with the number of setups, inspections, orders or changes, regardless of how many units each setup or batch produces. Absorbing such costs on a volume basis systematically overcosts high-volume, simple products (which cause few setups relative to their volume) and undercosts low-volume, complex products (which cause many setups relative to their volume), distorting product profitability and potentially leading to bad pricing and product-mix decisions.

The mechanism

ABC identifies cost pools grouped by activity (machine setups, quality inspections, purchase order processing, material handling), identifies a cost driver for each pool — the factor that genuinely causes that cost to be incurred (number of setups, number of inspections, number of purchase orders, number of material movements) — computes a cost driver rate for each pool (pool cost ÷ total driver volume), and then absorbs cost into each product based on the number of times that product actually consumes each driver, rather than on its share of total production volume.

$\text{Cost Driver Rate}=\frac{\text{Total cost of the activity pool}}{\text{Total volume of the cost driver}}$

$\text{Overhead charged to a product}=\sum (\text{Cost Driver Rate for each activity}\times \text{Driver units consumed by that product})$

The consequence for a low-volume, complex product that requires frequent setups is that ABC charges it a proportionately larger share of setup-related overhead than a volume-based rate ever would, because ABC counts the setups that product actually causes rather than spreading setup cost thinly across every unit regardless of which product caused the setup activity to occur.

When ABC is worth adopting

ABC's own implementation is itself costly — identifying activities, cost pools and drivers, and maintaining the data needed to track driver consumption, is a substantial exercise. It is most worth adopting where a company has a diverse product mix (some high-volume/simple, some low-volume/complex), where overheads are a large proportion of total cost (so a distorted allocation has a large absolute effect on reported product cost), and where traditional volume-based absorption is producing product costs that management does not trust or that are producing evidently poor pricing and mix decisions — where none of these conditions hold strongly, the cost of implementing ABC may exceed the benefit of the more accurate costing it produces.