AC4410: ACCOUNTING AND FINANCE
Semester 2
Assignment 1
I confirm that this assignment which I have submitted is all my own work and the source of any information or material I have used (including the internet) has been fully identified and properly acknowledged as required in the school guidelines I have received.
Module Tutor
Steve Singleton
Student Number
G20724762
Word Count
Number of pages
Date of submission
10/03/2017
‘Overhead absorption calculations are a waste of time as it’s all guess work anyway. These costs aren’t incurred each time we make a unit so what’s the point of trying to calculate them ‘per unit’. To be honest, we know what the customers will pay so accurately calculating the cost of our units is pointless.’
This paper will critically evaluate the meaning of overhead absorption calculations, different ways of calculating overhead absorptions and purpose of overhead absorptions. This essay will also give clear idea whether the statement is correct or not. Also it will explain about the net present value and different ways projects can be undertaken.
OVERHEAD ABSORPTION:
Overhead absorption is a procedure where overheads include total aggregate cost of a product. Overhead absorption can be described as transferring of fixed assets into final products or goods. Absorption overhead is nothing but manufacturing overhead which are applicable to final products. when the actual amount of overhead is less than that of sum allotted to a product, it is called as over absorbed. Similarly, when actual amount of overhead is higher than the amount allocated, it is called as under absorbed. In other words, Overhead absorption is the amount of costs that are not directly traceable to an activity implied to items for which cost are complied. Overhead absorption rates are mostly pre-determined. Overhead absorption involves classifying indirect costs, aggregate costs, determining allocation base and assigning overheads.
Overhead to be absorbed can be calculated with reference of two variables:
(a) the overheads owing to a given cost center: and
(b) the quantity of units of absorption base i.e. work hours, direct cost, machine hours, etc.
Therefore, overhead absorption rate (OAR) =
Total production overheads
Quantity of absorption basis activity level applicable to cost center
The goal of overhead absorption process is to incorporate into the aggregate cost of an item a proper share of a company's aggregate overheads. Different bases to absorb overheads have been created.
These bases are:
(i) Direct labour hour method: This base of overhead absorption is most suitable for labour intensive cost center. Also this method is very easy to use. It can be calculated as overhead cost/ direct labour hours.
But today most production methods use machinery so the direct labour cost method may turn out improper.
(ii) Machine hour rate method: This method of absorption is a very good substitute to direct labour hour method. We can easily calculate the total numbers of hours machine worked. It is calculated as:
Total overhead cost/ total machine hours.
This method is best used where a large part of overhead is utilized by machinery.
(iii) Direct labour cost method or Direct wages method: This method is most commonly used. It is easy to work. This method considers time factor and it calculate overheads on the basis of actual past cost of wages and actual past overheads.
Actual overhead cost/ direct labour cost or wages * 100.
(iv) Direct material cost: This strategy for overhead absorption is not very good since its utilization prompts to some foolish inconsistencies. Direct material cost is calculated as
Total overheads/ direct materials used.
(v) Prime cost method: This strategy combines the aggregate of direct work cost and direct material cost. This method is easy to understand and also simple to operate. Prime cost is calculated as
Total overheads/ Prime Cost x 100.
Lets understand overhead absorption calculations by an examples:
The Shotham Ltd company's cost accountant wants to calculate the cost unit of one unit of output. The cost accountant realizes that direct costs are required to remain the same but associates that using different methods of absorbing overheads may produce different unit costs. Hence, he has decided to calculate total unit cost using; a per unit basis, a labour hour basis and a machine hour basis when absorbing overheads.
Total activity at Shotham Ltd is as follows:
Units 24,000
Labour hours 30,000
Machine hours 40,000
Overheads ”720,000
Finish the table below to figure the Overhead Absorption Rate utilizing the three absorption bases. Demonstrate your responses to two decimal spots.
absorption-1
The solution here is to use the Overhead Absorption Rate formula and divide Shotham Ltd’s overheads by every given component. For instance, overhead amount given above in the question is to ”720,000 and if we calculate for the first component i.e. for units, the Overhead Absorption Rate for units will be ”720,000/24,000 units similarly it would be applied for the calculations of other components like labour and machining keeping in mind that these rates are on hourly basis.
Solution:
Unit
Labour Hour
Machine Hour
Overheads (”)
720,000
720,000
720,000
Activity
24,000
30,000
40,000
Absorption rate (”)
30.00
24.00
18.00
Calculations:
For unit the calculations are ”720,000/24,000 = ”30.00
For Labour hour calculations are ”720,000/30,000 = ”24.00
For Machine hour calculations are ”720,000/40,000 = ”18.00
The above table demonstrates that ”30.00 worth of overheads will be absorbed into the aggregate unit cost if a unit activity is used. This is contrasted with just ”18.00 every hour utilizing a machine hour Overhead Absorption Rate and ”24.00 every hour for a work hour absorption rate. Obviously, the overheads of ”720,000 are same but they are divided into various activity levels.
As seen from above detailed methods of costing
‘Traditional costing assigns manufacturing overhead based on the volume of a cost driver, such as the number of units produced or the amount of direct labour hours needed to produce an item.
‘ABC allocates and apportions costs to various activities and then absorbs costs into products via the cost driver rates i.e. absorbed based on its consumption
‘
‘Recognises the relationship between costs, activities and products.
‘I’ve no idea what an ‘net present value’ figure is supposed to mean. Why don’t the accounts team just give us a profit figure to assess?’
Lakmal, D., 2014. Cost Analysis for Decision Making and Control: Marginal Costing versus Absorption Costing. Browser Download This Paper.