technical
overhead absorption
relevant to CAT Scheme Papers 2 and 4
allocate, apportion,
absorb
This article focuses on production overhead
absorption using, as an illustration, a question
from the December 2005 CAT Scheme
Paper 4 examination. It also considers
the wider context of overhead allocation,
apportionment, and absorption.
The cost accounting for overheads
(indirect costs) is an element in the CAT
Paper 2 Study Guide. Sub-section 8(g) states
that students are required to ‘explain and
illustrate the process of cost apportionment
and absorption for indirect costs (excluding
reciprocal services)’. This topic is explored
further in CAT Scheme Paper 4, where two
sections of the Study Guide are devoted
to overhead allocation, apportionment and
absorption, including Sub-section 9(a), which
states that students are required to ‘justify,
calculate, and apply production cost centre
overhead absorption rates using labour hour
and machine hour methods’.
OVERHEAD COST SHARING
Overheads are those costs that cannot be
directly allocated to any of the products
or services provided by a business to its
customers. These costs, therefore, have to be
shared out in some way among the various
products or services in order to establish
product/service costs. Overhead costs must
be shared:
as fairly as possible over the different
cost centres and cost units that use the
particular resources in question
in ways that are administratively feasible
so that the benefits from having and using
the information (ideally) exceed the cost of
its provision.
50 student accountant August 2006
PRODUCTION OVERHEAD ALLOCATION,
APPORTIONMENT, AND ABSORPTION
Production overheads are a popular topic in
study materials and examination questions. At
the very least, costs have to be shared among
products in order to value work-in-progress
and finished goods stocks. By refining what
may otherwise be an arbitrary process,
accountants can provide useful information
that will help management in cost control and
profitability analysis.
An important part of such refinement
involves the establishment of cost centres
(both production cost centres and service cost
centres) in order to:
delegate management responsibility for
costs incurred
increase the accuracy of cost sharing
by allocating costs at a lower level and
sharing them on different bases.
A further refinement is the use of budgets to
facilitate cost control and the sharing of costs
in advance.
There are three main steps in the
process of production overhead cost sharing:
allocation, apportionment, and absorption.
Allocation
collection of costs by type
allocation of as many costs as possible
directly to cost centres.
Apportionment
apportionment to cost centres of
establishment costs – those costs that
cannot be allocated directly to individual
cost centres
re-apportionment of service cost centre
overheads to production cost centres.
Products/services pick up overhead costs
out of the production cost centres via
overhead absorption, as production occurs.
Absorption
establishing an absorption rate for each
production cost centre
absorption of overheads into cost units.
The key issue in establishing how to apportion,
re-apportion, and absorb overheads is fairness.
When considering cost apportionment/
re-apportionment for each overhead cost type
(or service cost centre) that has to be shared,
the important principle is to identify the key
driver of the cost. In other words, what is the
main cause of the cost incurred?
The same general principle applies
to overhead absorption. There are many
different causes, and thus many drivers,
that traditionally have been encapsulated
(for each production cost centre) in a single
basis for overhead absorption. Typically, this
is achieved by using an activity measure
based on direct labour hours or machine
hours, because the production activity of
each product can be measured in this way
and used to absorb overheads. More than
one basis could be used in each cost centre if
there are clearly different drivers.
If overhead cost budgets are prepared,
then predetermined absorption rates can
be established and used. This gives rise
to production overhead over-absorption or
under-absorption in each production cost
centre resulting from the comparison of
the actual overhead costs allocated and Production cost centre Production cost centre
apportioned with the total costs absorbed. X Y X Y
Budget £161,820 £97,110 Machine hours:
QUESTION Actual £163,190 £96,330 Budget 8,700 1,760
Question 2(b), in Section B of the December Actual 8,960 1,725
2005 Paper 4 examination, tested candidates’ Overheads are absorbed using predetermined Direct labour hours:
ability to calculate and use predetermined rates. A machine hour rate is used in production Budget 6,220 8,300
production overhead absorption rates when the cost centre X and a direct labour hour rate in Actual 6,276 7,870
allocation and apportionment of the overheads production cost centre Y. Machine and direct
had already taken place. Part (b) of the labour activity in each production cost centre is: Required:
question was as follows: Calculate for each production cost centre for
the period:
Overheads allocated, apportioned, and i the predetermined production overhead
re-apportioned to the two production cost absorption rate
centres in a factory for a period were: ii the production overheads absorbed

August 2006 student accountant 51

 technical
iii the over/under-absorption of production
overhead.
Answer (with explanation)
The first stage in production overhead
absorption is to calculate absorption rates
using budgeted data (ie predetermined rates).
The question states that a machine hour rate
is to be applied in production cost centre X,
and a direct labour hour rate in production
cost centre Y. Thus:
Production cost centre X:
£161,820 ÷ 8,700 machine hours = £18.60
per machine hour
Production cost centre Y:
£97,110 ÷ 8,300 direct labour hours =
£11.70 per direct labour hour
These predetermined rates are then used
throughout the budget period to absorb
overheads on the basis of actual hours worked;
overheads are transferred (absorbed) from the
production overhead accounts to the
work-in-progress accounts on a regular
basis. Over the whole period, the total of the
production overhead absorbed from each cost
centre is:
Production cost centre X:
8,960 machine hours @ £18.60 per machine
hour = £166,656
Production cost centre Y:
7,870 direct labour hours @ £11.70 per
direct labour hour = £92,079
The amount of overheads have therefore
been transferred into the cost of the different
products manufactured (along with the
allocated direct materials and direct labour
costs), and subsequently into cost of sales
when the products are sold.
Ultimately, however, it is the actual
production overhead costs incurred that are
charged against sales, along with all the other
actual costs, to determine profit. The final
stage in the overhead absorption process is,
therefore, to make a comparison between the
actual costs incurred (debited to individual
cost centres and, in total, to the production
52 student accountant August 2006
The key issue in establishing how
to apportion, re-apportion, and
absorb overheads is fairness. When
considering cost apportionment/
re-apportionment for each overhead
cost type (or service cost centre)
that has to be shared, the important
principle is to identify the key driver
of the cost.
overhead control account) and the overheads
absorbed into product costs in
work-in-progress (credited to individual
cost centres and, in total, to the production
overhead control account). Any difference will
be either an under-absorption or an
over-absorption depending on whether more or
less has been incurred than absorbed. So:
Production cost centre X:
actual £163,190 - absorbed £166,656 =
£3,466 over-absorbed (less incurred than
absorbed)
Production cost centre Y:
actual £96,330 - absorbed £92,079 =
£4,251 under-absorbed (more incurred than
absorbed)
Any under-absorption is a further charge that
reduces profit: any over-absorption is added
back to increase profit.
Examiner’s comments
A number of candidates were well-prepared
and scored full marks on this question.
However, a serious lack of understanding of
absorption costing was demonstrated by many.
Candidates need to appreciate that overhead
absorption rates are typically established in
advance of a period on the basis of budgeted
data. Overheads are then absorbed during
the period using the predetermined rates
but this time on the basis of actual activity.
Over/under-absorption of overheads arises
due to differences between overheads actually
incurred in the period and those absorbed into
the cost of work done in the period.
Many candidates were able to calculate
the required overhead absorption rates in Part
(i), although several calculated other rates
as well (for example, labour hour rate and
machine hour rate for each cost centre and/or
on actual costs and hours). Apart from not
answering the question, which clearly stated
the basis for calculating the predetermined
rate to be used in each of the cost centres,
a lot of time was wasted on unnecessary
calculations. This was often carried over to
Parts (ii) and (iii) where further incorrect and
unnecessary calculations were made. There
were also many scripts where candidates
added hours to £ or added labour hours and
machine hours together.
Where candidates calculated the correct
rates in Part (i), and no further rates, they
were frequently unable to apply the rates to
answer Parts (ii) and (iii). Many, seemingly,
could not calculate the overheads that would
be absorbed in each cost centre. A common
error in Part (ii) was the calculation of further
absorption rates, this time on the actual
data (costs and hours). A very common error
to Part (iii) was the comparison of actual
and budgeted costs. A few candidates even
compared actual and budgeted hours.
Not infrequently, candidates calculated
absorption rates in answer to Part (i) using
the actual figures, rather than the budgeted
figures, and got an answer for each cost
centre which they rounded. In answer to Part
(ii), they then simply multiplied the actual
absorption rate by the number of hours they
had divided by in Part (i) – the resulting
number was inevitably very similar to the
actual costs they had started with in Part (i).
Finally, in Part (iii), candidates compared the
two numbers (actual and absorbed) to produce
a very small over/under-absorption due to the
rounding in Part (i).
It is disappointing that coverage of this
topic in Paper 2, as well as Paper 4, did not
produce good results in the Paper 4 exam. I
hope that candidates now have a better idea
about production overhead absorption and its
role in the overhead allocation, apportionment
and absorption process.
Nigel Coulthurst is examiner for CAT Scheme
Papers 2 and 4