The Traditional Method of Cost Absorption

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Summary

Budgeting enables an organization to plan for future financial activities. Budgets show the income an organization expects and the total expenses to be incurred. They are prepared based on the past financial activities of the entity and the future plans of the organization. In most cases, entities do not carry out their financial activities exactly as planned. There is the likelihood of spending more than or less than the budget thus causing variance. Analysis of these variances is vital in an entity. This paper attempts to carry out an analysis of actual costs and the absorbed costs of a production firm using the traditional method of cost absorption. It further discusses the drawback of using predetermined rates and suggests other alternative methods of absorption of costs.

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Apportioning service overhead costs

Overheads are costs incurred in an organization that cannot be directly attributed to any products. Therefore, the costs should be shared across the products. The overheads need to be shared fairly so as to ensure that the gains from the sale of the product are not understated. There are three main steps of sharing the production overheads. These processes are the allocation of costs, apportionment and absorption of costs (Jawahar-Lal 2009). The table below shows the production overhead for the production and service cost centers for the coming year.

Cost center Amount (£)
1 Machining 360,000
2 Assembly 320,000
3 Paint shop 260,000
4 Engineering shop 168,000
5 Stores 104,000
6 Canteen 150,000
Total 1,362,000

Service centers support the main production lines of the business. And therefore cannot be directly charged to a single product. Therefore, it is of essence to distribute costs in the service centers to the main production line. The service cost centers are engineering shops, stores and canteen. The table below shows the total cost for the service cost centers.

Service center Costs
1 Engineering shop 168,000
2 Stores 104,000
3 Canteen 150,000
Total 422,000

Budgeted overhead absorption rates

The budgeted overhead absorption rate is computed based on the budgeted values. It is necessary to obtain the cost drivers for each production cost center.

Basis of apportioning

The production process has three production centers these are manufacturing, assembly and paint shop. It is important to point out the cost drivers for apportioning service costs to the production unit. The costs relating to the engineering shop will be apportioned based on the engineering service cost for each production department. Stores’ overhead costs will be apportioned based on the number of orders for each department. Finally, the canteen overhead will be apportioned based on the number of employees in each production unit (Vanderbeck 2008). The table below shows the number of various cost drivers that are used to apportion various service costs to the production centers.

Data Machining Assembly Paint shop Total
Number of employees 162.00 102.00 78.00 342.00
Eng Shop- service 36,000.00 24,000.00 20,000.00 80,000.00
Stores (orders) 360.00 270.00 180.00 810.00

Proportion

The table below shows the proportion of the service costs that will be apportioned to the production department.

Data Machining Assembly Paint shop Total
No of employees 0.47 0.30 0.23 1.00
Eng Shop- service 0.45 0.30 0.25 1.00
Stores (orders) 0.44 0.33 0.22 1.00

Cost apportionment

The apportioning of overhead entails distributing the total overhead costs across various cost centers, departments or production units of an entity. Therefore, a management accountant needs to come up with the rate of apportioning the overheads. The table below shows the value of costs apportioned to each production department.

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Data Machining Assembly Paint shop Total
Engineering shop 79,578.95 50,105.26 38,315.79 168,000.00
Stores 46,800.00 31,200.00 26,000.00 104,000.00
Canteen 66,666.67 50,000.00 33,333.33 150,000.00
Total 193,045.61 131,305.26 97,649.12 422,000.00

Based on the service cost apportionment above, £193,045.61 of the total service cost is apportioned to machining department, £131,305.26 of the total service cost is apportioned to assembly department and £97,649.12 of the total service cost to paint shop. This gives the total of £422,000.

Budgeted overhead absorption rates

These are predetermined rates of absorbing various overhead costs. They are based on the budgeted overheads. Therefore, they form the standard rates for absorbing various overheads. Budgeted overhead absorption rates are computed based on budgeted units of output and budgeted time. The basic method of computing the budgeted overhead absorption rate is through the division of budgeted overhead costs with budgeted output or time. The table below shows the budgeted overhead absorption rates for the various production overhead.

Overhead absorption rates
1 Machining = Budgeted machining costs / machine hours 360,000/18,400 19.5652174
2 Assembly = Budgeted assembly costs / labor hours 320,000/22,500 14.2222222
3 Paint shop = Budgeted paint shop overhead / labor cost 260,000/90,000 2.88888889

Over and under absorption

Overhead absorption entails charging of the various production costs to a particular activity based on the cost drivers. Total cost absorbed comprises the total production overhead absorbed and the reapportioned service center costs. The value is then compared with the actual cost incurred for each production cost center to ascertain if there is over or under absorption. The table below shows the total overhead absorbed in each production cost center.

Production unit Actual units produced Production overhead Service costs Total cost absorbed
Machining 19.5652174 * 20,000 391,304.348 193,045.61 584,349.96
Assembly 14.2222222 * 15,600 221,866.67 131,305.26 353,171.93
Paint shop 2.88888889 * 70,000 202,222.22 97,649.12 299,871.34

The table above shows the total costs absorbed in each production unit. £584,349.96 of the total overhead was absorbed in the machining department, £353,171.93 of the total overhead was absorbed in the assembly and £299,871.34 of the total overhead was absorbed in the paint shop. The table below shows under or over absorption of the various cost of production.

Production unit Actual cost incurred Total cost absorbed Difference
(Actual – absorbed)
Comments
Machining 580,000 584,349.96 (4,349.96) Over absorption
Assembly 334,000 353,171.93 (19,171.93) Over absorption
Paint shop 310,000 299,871.34 10,128.66 Under absorption

The above table shows the costs absorbed in each production unit and the actual cost incurred. Over and under absorption results when the actual cost incurred in production differs from the costs absorbed. In the machining department, the total overhead absorbed amounted to £584,349.96 while the actual cost incurred amounted to £580,000. It implies that the machining unit incurred less than the amount absorbed by £4,349.96. It is an over absorption. In the assembly unit, the total overheads absorbed amounted to £353,171.93 while the actual amount incurred totaled £334,000. This shows an over absorption amounting to £19,171.93. Finally, in the paint shop unit, the total overheads absorbed amounted to £299,871.34 while the actual amount incurred totaled £310,000. This shows an under absorption amounting to £10,128.66. Based on the table below, the production costs were over absorbed in two production units and over absorbed in one unit.

The over absorption amounted to £23,521.89. The amount over absorbed is favorable to a business since it is added back to the profits thus increasing the profitability. Under absorption totaled £10,128.66. Under absorption is not favorable since the value is treated as a charge thus reducing the profitability of the business. The net effect of cost allocation is a gain of £13,393.23. The amount is added back to the profits of the organization. The net effect is increased profitability.

Reasons why overheads are absorbed based on the predetermined rates

Predetermined rates are computed by dividing the budgeted overhead and budgeted level of activity. In the calculations above, it is evident that absorption is done using predetermined rates. These predetermined (standard) rates are obtained from the planned level of activity for future years, these are the budgets for the coming years. The budgets are prepared based on the previous level of activity. These rates are essential since they facilitate the computation of the costs of the product once the production process is completed. The absorption of overhead is based on the predetermined rates and the actual units consumed. Without the rates, it might not be possible to ascertain the product cost at the end of the production. Secondly, the predetermined rates facilitate planning and control of the production process. Budgets provide a guideline for spending money and they also help an entity to ascertain whether spendings are on or off-budget. In addition, the predetermined rates enable managers to have estimates of the profits they expect at year-end. It is important in decision-making. Thirdly, predetermined rates offer a simpler way of keeping records of the organization because they have records for a whole year. Finally, the standard rates are essential in circumstances where the business experiences seasonal activities. In such cases, the use of actual costs provides fluctuating costs for the units of output produced. For instance, the cost of electricity is likely to go up during cold seasons and low in warm seasons. Therefore, units of output can be assigned different production overheads in different seasons (Tulsian 2007).

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Appropriateness of the predetermined rates

Use of the predetermined rates has a number of drawbacks. These shortcomings cast doubts about the appropriateness of the rates. A common drawback is the lack of accuracy. Since budgeted values are used in the computation of the standard rates, there is the likelihood that the budgeted values would be different from the actual values. This creates variances that result in over absorption and under absorption of the costs thus resulting in overstated or understated unit costs. Therefore, this method offers inaccurate results. The inaccuracies might also originate from the economic swings these are boom, recession, trough, and growth. Management may not precisely know how the economic variables would respond in the coming years. This leads to inaccurate results. Charging of inaccurate costs for the goods and services contributes to inaccurate pricing of goods. This might make the company lose customers in the event that they overcharge output produced. Also, the company may end up having higher costs per unit of output than its competitors. It might lead to lower profitability or losses. Another reason why the method is inappropriate is that the products are charged costs that they do not use. Fixed costs are spread over all the number of units produced and in cases where the level of activity in an entity goes down, the overhead cost per unit rises since all units produced are shoulder’s the overhead cost. Various groups of people argue that products should be charged only costs they use in production. Finally, even though the method is simple to compute, it is often misinterpreted. Management often finds it hard to interpret the results arising from this method (Rajasekaran & Lalitha 2011).

Alternative methods

With the changing technology and competition in the contemporary business world, it is important that an organization moves away from the traditional methods of costing. Management needs to use accurate methods that would give accurate product costing. The use of the actual rate for absorbing costs is a simple method that is commonly used by managers. The method makes use of the actual costs incurred in producing the commodities. This method also has a number of shortcomings though it eliminates the problem of inaccuracy. Costs per unit are computed based on the actual costs of production and not the budgeted costs. This eliminates the inaccuracies arising from over absorption or under absorption (Debarshi 2011).

Another method that can be used to allocate costs is activity-based costing. The methods provide a superior way of allocating costs to the use of the predetermined rates approach or the traditional method. The method provides a rational approach of allocating overhead production overhead to the units of output produced. The method first allocates production overheads to the activities which are the real cause of the overhead. The second step involves assigning the costs to the products that actually demanded the costs. The method is quite popular since it takes into account the fact that there is a rapid change in technology. Also, it considers the fact that the production overheads have drastically increased over the years (Drury 2008).

Further, it takes into account the fact that since the production overheads have increased considerably, they do not directly relate to the machine or labor hours used. In the contemporary world, the production overhead relates to a number of several other variables. Thirdly, companies no longer venture into the production of a single or few products. Companies have greatly diversified their line of production (Debarshi 2011). They produce quite a number of differentiated products. In addition, they attend to quite a number of customers. This calls for the need for a more complex approach to absorbing the costs. Activity-based costing solves this problem (Drury 2008). Also, activity-based costing solves the problem where commodities are produced in different batches. Therefore, this method aligns the cost of production to the specific products. It also helps in eliminating the idle cost of production in the per unit product cost. Therefore, this method offers the management a better way of analyzing the cost of production in an organization. It is necessary to point out that the method makes use of the traditional cost separation methods. A major limitation of this approach is that it is not in agreement with the generally accepted accounting principles. In addition, it is very complex and difficult to compute (Drury 2008).

References

Debarshi, B 2011, Management accounting, Dorling Kindersley Pvt. Ltd., South Asia.

Drury, C 2008, Management and cost accounting, South-Western Cengage Learning, Canada.

Jawahar-Lal, A 2009, Cost accounting, McGraw-Hill Company Limited, New Delhi.

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Rajasekaran, V & Lalitha, R 2011, Cost accounting, Dorling Kindersley Pvt. Ltd., South Asia.

Tulsian, P 2007, Cost accounting, McGraw-Hill Publishing Company Limited, New Delhi.

Vanderbeck, E 2008, Principles of cost accounting, Thomson Learning, Inc., Canada.

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