3.4 Overhead Absorption and Activity-Based Costing

3.4 Overhead Absorption and Activity-Based Costing

Once production department overheads are fully aggregated (following allocation, primary apportionment, and service department reapportionment), they must be incorporated into the total unit cost of products. In AAT Level 3 Management Accounting Techniques (MATS), candidates learn how to calculate traditional Overhead Absorption Rates (OAR), analyze under- and over-absorption, and contrast traditional absorption costing with modern Activity-Based Costing (ABC).

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Traditional Overhead Absorption Rate (OAR)

Under traditional absorption costing, overheads are absorbed into units of product using a predetermined rate calculated prior to the financial period:

$\text{Predetermined OAR} = \frac{\text{Budgeted Production Overheads}}{\text{Budgeted Activity Level}}$

Common Activity Bases for OAR

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Under- and Over-Absorption of Overheads

Because predetermined OARs are calculated using budgeted figures, the total overhead absorbed into production during a period will rarely equal the actual overhead expenditure incurred.

$\text{Overhead Absorbed} = \text{Actual Activity Level Achieved} \times \text{Predetermined OAR}$ $\text{Absorbed vs Actual Variance} = \text{Overhead Absorbed} - \text{Actual Overhead Incurred}$

• Over-Absorption: Occurs when Absorbed Overhead > Actual Overhead Incurred. (Favourable impact: excess overhead charged to products is credited back to profit).
• Under-Absorption: Occurs when Absorbed Overhead < Actual Overhead Incurred. (Adverse impact: insufficient overhead charged to products is debited as an additional expense to profit).

Causes of Under/Over-Absorption

1. Actual overhead expenditure differed from budgeted overhead expenditure.
2. Actual activity hours worked differed from budgeted activity hours.

Worked Example: Under/Over Absorption Calculation

Scenario: For August, the Machining Department budgeted overheads of £60,000 and 15,000 machine hours. Actual results were £63,500 actual overheads incurred and 15,500 actual machine hours worked.

1. Predetermined OAR: $\text{OAR} = \frac{\pounds 60,000}{15,000 \text{ machine hrs}} = \mathbf{\pounds 4.00 / \text{machine hour}}$
2. Overhead Absorbed: $\text{Absorbed Overhead} = 15,500 \text{ actual hrs} \times \pounds 4.00 = \mathbf{\pounds 62,000}$
3. Absorption Variance: $\text{Variance} = \text{Absorbed (\pounds 62,000)} - \text{Actual (\pounds 63,500)} = -\mathbf{\pounds 1,500 \quad (Under-absorbed)}$

Interpretation: The department under-absorbed overheads by £1,500 because actual expenditure exceeded absorbed amounts. This £1,500 under-absorption is charged as an expense in the monthly profit statement.

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Activity-Based Costing (ABC)

Traditional volume-based absorption costing (using direct labour or machine hours) was developed when direct labour dominated production costs. In modern manufacturing, automation and complex product ranges mean that indirect overheads form a huge proportion of cost, driven by activities rather than simple volume.

Core ABC Terminology

• Cost Pool: An aggregation of indirect costs associated with a specific business activity (e.g., Machine Setup Cost Pool, Quality Inspection Cost Pool, Order Processing Cost Pool).
• Cost Driver: The factor or event that causes the cost of a specific activity to increase (e.g., Number of Setups, Number of Inspections, Number of Purchase Orders).
• Activity Driver Rate: $\text{Activity Driver Rate} = \frac{\text{Total Cost Pool Expenditure}}{\text{Total Volume of Cost Driver}}$

Product Cost Distortion Under Traditional Costing vs ABC

• Traditional Costing Distortion: High-volume, simple products consume many direct hours and are assigned an unfairly high proportion of overheads. Low-volume, complex bespoke products require frequent setups and inspections, but consume few direct hours and are severely under-costed.
• ABC Solution: ABC attributes overheads based on actual activity consumption, providing accurate product costing for pricing and profitability decisions.

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Worked Numerical Example: Traditional Absorption vs ABC

Scenario: Enterprise Ltd manufactures Product X (High Volume Standard) and Product Y (Low Volume Complex).

• Total Overheads = £120,000, consisting of:

  • Machine Setups Pool: £60,000 (Cost Driver: Number of Setups; Total = 100 setups)
  • Quality Inspection Pool: £60,000 (Cost Driver: Number of Inspections; Total = 200 inspections)

• Operational Data:

1. Traditional OAR Method (based on Labour Hours)

• $\text{OAR} = \frac{\pounds 120,000}{12,000 \text{ labour hrs}} = \mathbf{\pounds 10.00 / \text{labour hour}}$.
• Overhead per Unit of Product X: $1.0 \text{ hr} \times \pounds 10.00 = \mathbf{\pounds 10.00 / \text{unit}}$.
• Overhead per Unit of Product Y: $2.0 \text{ hrs} \times \pounds 10.00 = \mathbf{\pounds 20.00 / \text{unit}}$.

2. Activity-Based Costing (ABC) Method

• Setup Driver Rate: $\frac{\pounds 60,000}{100 \text{ setups}} = \mathbf{\pounds 600 / \text{setup}}$.
• Inspection Driver Rate: $\frac{\pounds 60,000}{200 \text{ inspections}} = \mathbf{\pounds 300 / \text{inspection}}$.

Overhead Allocation via ABC:

• Product X (10,000 units):
  • Setups: $20 \times \pounds 600 = \pounds 12,000$
  • Inspections: $50 \times \pounds 300 = \pounds 15,000$
  • Total ABC Overhead = £27,000 $\rightarrow \mathbf{\pounds 2.70 / \text{unit}}$.
• Product Y (1,000 units):
  • Setups: $80 \times \pounds 600 = \pounds 48,000$
  • Inspections: $150 \times \pounds 300 = \pounds 45,000$
  • Total ABC Overhead = £93,000 $\rightarrow \mathbf{\pounds 93.00 / \text{unit}}$.

Conclusion & Comparison

Under traditional absorption, Product Y was dramatically under-costed (£20 vs £93), while Product X was over-costed (£10 vs £2.70). ABC reveals that Product Y consumes 80% of setups and 75% of inspections despite low unit volume.