Absorption

HadynB

Hi

I have my ECR exam next week and even though I'm pretty confident, there is just one issue that confuses me over absorption costing.

Businesses need to cover all their overheads, hence the OAR calcualtions - but am I correct in thinking this is all overheads including non-production. When this OAR rate is applied, i.e. by machine or labour hours - is this amount then transferred to the Production Overhead account?

I'm basically wondering where it comes into play in respect to Manufacturing & P&L as I know all non-production overheads are charged to the P&L. Is this why the over/under absorption is performed and either cr/dr to the P&L.

Hope someone can help

SandyHood

When you work out your overhead to absorb into production, only look at the production overhead.

Before the accounting period starts, you set a rate to charge overheads into the goods being produced.
At the end of the accounting period you compare what was absorbed with the actual cost and adjust the P&L with the under/over absorption.

Don't confuse the issue by looking at non-production overheads - they are not usually absorbed on the same basis, and paper based exams have not tested the inclusion of non-production overheads in product costs.

HadynB

Thanks for your reply. Is the rate you chose to charge not the OAR then? (obviously not using pre-determined rates). It's all soooo confusing. The Osborne text books seem to suggest, and specifically say all overheads must be covered, and go on to look at apportioning service cost centre overheads into production cost centres in order to get your OAR. I was then under the impression that when the OAR rate is applied, you credit the Production Overhead acc and debit the WIP by this amount which is then re-assessed at the end of the period for your under/over absorption. Am I being simple here and this is simply for costing information, and not part of the costing book-keeping?

I then have read that for stock valuations, you have to use absorption costs, but exclude non-production overheads. I'm missing something really obvious and it will all click into place when I get it, and even though it probably wont be assessed, I hate not fully understanding.

SandyHood

1. Is the rate you chose to charge not the OAR then.
   The R of OAR is the rate. You charge overheads into products on the basis of the hours worked making the product and the OAR per hour.
2. when the OAR rate is applied, you credit the Production Overhead acc and debit the WIP by this amount
   True - this is cost bookkeeping

HadynB

Ok, but that's what I'm trying to say about the rate of OAR - examples I have done have included what I thought were non-production overheads - service centres such as canteens etc, which are apportioned to the production cost centres in order to arrive at the OAR. As this figure is then used in the production overheads then surely the non-production overheads have been accounted for in the stock values? ? ?

SandyHood

The "production" word does have a slightly different meaning when we look at absorption codting compared to financial accounting .

All aspects of production including canteen, stores, maintenance and quality control are included as part of production from the point of view of calculating the absorption rates and the overhead included in finished goods.

When we carry out overhead analysis we need to split the production departments into two types: those where products are actually made and those that service the departments where they are made. So the ones listed above are called "service" departments.
Service department costs are re-apportioned into the production departments to calculate the overhead absorption rates.

The idea of non-production departments in a general sense tend to be those departments that have nothing to do with production or servicing the production departments, e.g. administration and sales.

HadynB

Ah I see. Thanks for that, it doesn't explain that at all well in the text books.

SandyHood

Try my overheads blog number 1