ABSORPTION COSTING BY

EXAMPLE
EXAMPLE 1

The following is a list of overheads. List down the basis that
they should be apportioned to various cost centres.

- Rent
- Depreciation
- Personnel
- Supervision
- Canteen
- Heat & Light
ACE 1a
- Rent Floor space occupied
- Depreciation Cost or book value of
equipment
- Personnel No. of employees
- Supervision No. of employees
supervised
- Canteen No. of employees
- Heat & Light Floor space occupied
ACE 1b
EXAMPLE 2
McIver plc has two department, M and N. All costs for these departments are indirect and related to
the year ended 31
st
December, 2011.

M N

Indirect materials 90,000 100,000
Indirect labour 200,000 30,000
Equipment and related costs 90,000 275,000
Supervisory salaries 70,000 10,000
450,000 415,000

The following information is available:

M N
Direct labour costs 200,000 50,000
Direct labour hours 150,000 hours 25,000 hours
Machine hours 100,000 hours 415,000 hours

a. Calculate the predetermined overhead recovery rates for the two departments by using the three
methods.

b. Which method would you recommend, and why?
ACE 2
EXAMPLE 2
Answer

a M N
DL costs (450) = 2.25 (415) = 8.30
(200) (50)

DL costs (450) = 3 (415) = 16.60
(150) (25)

Machine hours (450) = 4.50 (415) = 1
(100) (415)

b. Department M is clearly a labour-intensive department, so the method chosen
for the overhead recovery rate must be a labour base. Labour hours are probably
preferred to labour cost, which can vary with the seniority of staff, but that is a
debatable point. Whichever method is chosen, it must be seen to be fair.

Department N is, however, a machine-intensive department and therefore the
machine hour basis is the fairest.
ACE 3
EXAMPLE 3
Compute the cost of project B52 using the data
from Example 4, McIver plc.

Project B52
Direct material 1,000
Direct labour costs 2,500
Direct labour hours M 1,600 hours
N 1,000 hours
Machine hours M 800 hours
N 2,000 hours

ACE 4
Project B52

Direct costs 3,500
Indirect labour costs Department M 4,800
(1,600 x 3)
Department N 2,000
(2,000 x 1)
Cost of project 10,300
ACE5
EXAMPLE 4 Pricing policy
Fergus OBrian is a printer by trade and has been operating for a year from is shop in Belfast. He has a
rather haphazard pricing policy, charging people what he thinks they can afford and what he thinks is
reasonable. His first years accounts are as follows:

Income 25,000
Less expenditure
Salary 12,000
Materials 8,000
Overheads:
Rent and rates 1,000
Depreciation of equipment 2,500
Heat and light 700
Telephone 200
Machine maintenance 600
Other office expenses 2,000
27,000
Net loss 2,000

Fergus cannot think why he should have made a loss: after all, he has been very busy working 48 weeks
a year, five days a week (i.e. 240 days a year). He recons he works an eight-hour day and is fully
occupied. He pays himself 1,000 a month, which he doesnt think is unreasonable.

You are invited as a consultant to investigate the pricing
ACE 6
EXAMPLE 4
You highlight that the problem is simply this: Fergus has no proper pricing policy. You
report that:

i. Price should equal Direct labour + Direct material + Overheads + Profit margin.

ii. Overheads need to be allocated on a labour hour basis, and the trade profit
margin is 50%.

Required:

1. Calculate the overhead recovery rate on a labour hour basis.

2. Set the price for printing the Annual Report of Thomas Mitchell Ltd. given the
following information:

Material cost 200
Labour time 16 hours estimated of OBrians time (say 6.25 per hour)
Plus overheads
ACE 7
Answer

1. Overheads = 7,000
Labour hour (240 x 8) = 1,920
ORR = 7,000 = 3,65
1,920

2. Thomas Mitchell Ltd. Project
Direct materials 200
Direct labour (16 x 6.25) 100
Indirect labour (16 x 3.65) 58
358
Add profit margin (50% price) 179
Price 537
ACE 8
3. With hindsight, you recon that you should
charge a higher overhead rate to allow for
inflation.

When you look back at the accounts for the year
ended 31
st
January, 2011, business has
recovered 1,900 hours worth of time. Actual
overheads are 7,350 (the result of 5%
inflation).

You have priced the work too low (an under-
recovery). Why is this, and how much have you
under-recovered?
ACE 9
3. Actual overheads 7,350
Overheads recovered (1,900 x 3.65) 6,935
Under-recovered 415
ACE10
EXAMPLE 5
A personnel department uses an overhead
recovery rate of 20 per hour. Estimated activity
is 40,000 hours. At the end of the year actual
overheads for the year are 840,000 and 45,000
hours.
ACE11

Overhead incurred (actual) 840,000
Overhead recovered (absorbed) (45,000 x 20) 900,000
Over-absorption of overhead 60,000

In this example, services are charged 60,000 more than was
actually spent.
ACE 12
PAUSE FOR THOUGHT

Q: Do you remember the last time you used a
painter/decorator to decorate your house? You
probably asked them for an estimate or
quotation. Did they use absorption costing
methodology?

A: Probably in many cases the answer is yes. They
estimated the cost of the materials (paint and
wallpaper) and labour time and added on
overheads and sometimes a margin. Others just
quote what they think is the market rate.
ACE 13