Overheads and Absorption Costing
In accounting, there are various methods in dealing with direct and indirect costs,
some of which have been explained in previous articles, such as direct/indirect
materials and labor costs. The following series of articles aim to define and explain
the different methods of dealing with overheads.
Overheads are by nature, indirect costs. They are defined as a cost incurred in making
a product or a service, but cannot be traced directly and in full to the product or
Overheads may be classified as manufacturing or non-manufacturing overheads for
the purpose of this article.
Manufacturing overheads being those costs related to the product or service as defined
above, and non-manufacturing overheads are those that cannot be directly allocated to
particular units of output.
In absorption costing, overheads will be added to each unit of output of products
manufactured and sold. It is a method for sharing overheads between different
products on a fair basis.
In other words, it says, look at all those manufacturing overheads incurred, and let’s
add them to the cost of sales!
SSAP 9 recommends this method because cost of all stocks should consist of all costs
incurred in the normal course of business in bringing the product to its ‘present
location and condition.’ Overhead costs are incurred to produce the finished
product(s) including administration and directors’ wages, without them the products
wouldn’t exist! Therefore it is justifiable to charge each unit of output with some of
the overhead costs.
There are also various practical reasons for using absorption costing:
1. Stock Valuations – Closing and Opening Stock would consist of manufacturing
overheads, as such, increasing the value of gross profit, by carrying forward the cost in
the balance sheet as a current asset, rather than writing it off as an expense in the
profit and loss account.
2. Pricing Decisions – If you were to provide a service or a product for a customer, you
would like to know the full cost to be incurred, including no manufacturing costs as
well. This will enable you to determine how much of this cost should be bared by the
3. Profitability of different products – Since overheads are shared on a fair basis and
charged to the cost of sales of each product/department/service, one could ascertain
the profitability of each product/department/service.
The Process of Absorption Costing
Simply, there are three stages:
1. Allocation 2. Apportionment
Allocation involves allocating manufacturing and non-manufacturing overheads to
various cost units or cost centers. Apportionment is the process by which general
overheads are shared out on a fair basis between each cost center. In other words, it’s
a process of taking all the non-manufacturing overheads and distributing them to
those involved in production. Absorption is the process by which the costs calculated
for each cost center is finally added to unit, job or batch costs. Thus, establishing the
cost per each unit produced, which would enable us to value both opening and closing
stocks, the cost of sales, and the gross profit of the business.
this step is very simple. First we establish the various cost centers within the
business, e.g. Production Department A and B, Services Department C and D. We
then allocate all relative costs to each of these departments.
The process of apportioning overheads is based on what is called Basis of
Apportionment. This means that overhead costs are shared out on a fair basis which
could be the floor area occupied by each cost center, when rent, rates heating and light
repairs are concerned, or cost or book value of equipment when depreciation of
equipment is concerned, etc.
Once a basis for apportionment for each service or non-manufacturing cost is
established, the overheads should be apportioned in either one of the following ways:
1. Direct Apportionment
2. Reciprocal method of apportionment
3. Step Method of Apportionment
Direct Method of Apportionment
Suppose that we have four departments within an organization, two of which are
production departments, whereas the other two are non-manufacturing departments,
they provide a service for example, such as repairs, etc. Production department A
requisitioned materials from department C to the value 12,000 and B requisitioned
materials worth 8000. Service department D provided 500 hours of work to
department A and 750 hours to department B. The following costs are incurred:
Production Departments Service Departments A B C D
Allocated Costs 6000 4000 1000 2000
Apportioned Costs 2000 1000 1000 500