ACCA MA Syllabus C. Cost Accounting Techniques - Appropriate bases for absorption rates - Notes ^{19 / 22}

Appropriate Bases For Absorption Rates

Stage 3: Absorption of Overheads

Having allocated and apportioned all overheads, the next stage is to absorb them into cost units

Suitable Bases Of Absorption

Overheads can be absorbed into cost units using the following bases of absorption (or 'overhead recovery rates')

A rate per machine hour (for machine intensive departments)
A rate per direct labour hour (for labour intensive departments)
A rate per unit (when production includes identical units)

Calculate the Overhead Absorption Rate (OAR)

Budgeted production overhead
OAR = ------------------------------------
Budgeted level of activity

This OAR is calculated for each department.

Each product which passes through this department will be charged this overhead rate.

Usually, this OAR is calculated at the beginning of an accounting period in order to determine the OAR for products before they are sold to customers, therefore it is also known as a pre-determined O.A.R..

Therefore, budgeted figures will be used for both production overheads and activity levels.

Illustration

Budgeted fixed production overhead = $120,000
Budgeted machine hours 30,000

What is the O.A.R?

Solution

$120,000/30,000 hours = $4 / machine hour

Now that we have this O.A.R. per machine hour, we can absorb our overhead into the products that we produce.

For example, if we produce tables that take 3 machine hours each, then the overhead for each table will be:

3 hours x $4 / hour = $12

Illustration

Cost Card for the Table:

Direct Materials $5
Direct Labour $10
Prime Cost $15

Production overheads
2 hours in Factory A
4 hours in Factory B

Production cost in Factory A is $10,000 and incurs 1,000 labour hours
Production cost in Factory A is $20,000 and incurs 2,000 labour hours

What is the O.A.R. for Factory A and Factory B?

What is the total production cost of the table?

Solution
O.A.R. (Factory A) = 10,000/1,000 = $10/hour
O.A.R. (Factory B) = 20,000/1,000 = $20/hour
Total production cost of table
Direct Materials $5
Direct Labour $10
Prime Cost $15
Factory A overhead (2 hours x $10) = $20
Factory B overhead (4 hours x $20) = $80
Total production cost $115