Revise Absorption costing for Cambridge 9706 (2.2.2)

Absorption costing, also known as full costing, is a method where all manufacturing costs, both direct and indirect, are included in the cost of a product. Its fundamental principle is that all production overheads are 'absorbed' by the units produced. This is essential for creating a full cost per unit, which is used for inventory valuation in financial statements, as mandated by IAS 2 Inventories. The main challenge in absorption costing is the fair allocation of indirect production costs (overheads) to different products or departments. This is achieved by calculating a predetermined overhead absorption rate (OAR) at the beginning of an accounting period, ensuring that each unit of output carries a share of the factory's indirect costs.

Before an OAR can be calculated for a production department, all factory overheads must be assigned to it. This is a three-stage process:

1. Allocation: This is the process of charging an entire overhead cost directly to a specific cost centre. This is only possible if the cost was incurred solely for that cost centre (e.g., the salary of a supervisor in the Machining department).
2. Apportionment: This involves sharing general overheads that cannot be directly allocated to a single cost centre. These costs are shared out on a basis that is fair and reflects the benefit received by each cost centre. For example, factory rent could be apportioned based on the floor area occupied by each department.
3. Reapportionment: Production cannot happen without support from service departments (e.g., maintenance, stores, canteen). The costs of these service cost centres must be shared out among the production cost centres they support. This is called reapportionment. Common bases include the number of maintenance requests or the number of employees. Once this is done, each production cost centre has its total overhead, which can be used to calculate its departmental OAR.

The Overhead Absorption Rate (OAR) is a predetermined rate used to assign production overheads to cost units. It is calculated at the start of a period using the formula: OAR = Budgeted Production Overheads ÷ Budgeted Activity Level. The choice of activity level, or 'absorption basis', is critical for accuracy. Common bases include direct labour hours, machine hours, or units of production. The most appropriate basis is the one that is the main driver of overhead costs in a particular cost centre. For instance, a machine-intensive department should use machine hours, while a labour-intensive department should use direct labour hours. Once calculated, this rate is used throughout the period to charge overheads to production.

To determine the full production cost of a single unit, you combine its direct costs with a share of the indirect production costs. The calculation starts with the prime cost, which is the sum of direct materials and direct labour. To this, you add the absorbed production overhead. This is calculated by multiplying the predetermined OAR by the amount of the activity base required to produce one unit (e.g., OAR per hour × hours per unit). The resulting figure is the total absorbed cost per unit. This cost is crucial for valuing closing inventory and calculating the cost of goods sold. Remember, non-production overheads like marketing or administration costs are excluded from this calculation.

Over or under absorption arises because the OAR is based on budgeted data, whereas actual overhead costs and activity levels will inevitably differ. We compare the 'Absorbed Overheads' (OAR × Actual Activity Level) with the 'Actual Overheads' for the period. If absorbed overheads are less than actual overheads, it results in under-absorption, meaning not enough cost was charged to production. Conversely, if absorbed overheads are greater than actual overheads, it results in over-absorption. The resulting under- or over-absorbed amount is an adjustment in the Income Statement, usually to the cost of sales, to ensure the period's profit is calculated using the actual overheads incurred.