Management Accounting – Lecture 2b

Job-order costing and cost

assignment with absorption costing
systems
Absorption costing example
Step Down method:
1. The canteen staff are outside contractors
2. The maintenance department provides 12,000 service hours
to Dept. 1 and 10,000 hours to Dept. 2
3. Dept. 1 is machine intensive and Dept. 2 is labour intensive
4. Budgeted machine hours for Dept.1 is 6,320 and budgeted
labour hours for Dept. 2 is 7,850
5. Department.1 spends 2 machine hours on a unit of product X
and 1.5 hours on a unit of product Y
6. Department.2 spends 3 labour hours on a unit of product X
and 4 hours on a unit of product Y
Dept. 1 Dept. 2 Maint. Canteen Total
Floor space (sq. m) 10,000 12,000 5,000 3,000 30,000
Value of machinery (£) 150,000 120,000 20,000 10,000 300,000
No. of employees 40 30 10 80
 Absorption costing example
The service departments do not work on any of the
products so cannot charge or absorb the overhead
costs
The service departments’ overheads will be
reapportioned on the basis of the amount of work
done for the other departments

Basis Dept. 1 Dept. 2 Maint. Canteen Total

£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Canteen to be apportioned first
(Step-down)

As Canteen is serving ALL other departments therefore it

makes sense for its amount to be re-apportioned FIRST to
others on a basis that makes most sense

Canteen overheads must now be reapportioned to dept. 1,

dept. 2 and Maintenance based on number of employees.
Reapportion canteen overheads
Canteen overheads reapportioned to dept. 1, based on
number of employees
£8,000 x 40 / 80 = £4,000
Do distribution of expenses in same fashion to other
departments

Basis Dept. 1 Dept. 2 Maint. Canteen Total

£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Reapportion canteen employees 4,000 (8,000)
 Reapportion canteen overheads

Maintenance overheads recharged to dept. 1, based on

the 12,000 service hours– Given in the question
Basis Dept. 1 Dept. 2 Maint. Canteen Total
£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Reapportion canteen employees 4,000 3,000 1,000 (8,000) 0
41,000 36,000 11,000 0 88,000
Reapportion main.
Reapportion Maintenance overheads

Now reapportion Maintenance overheads to both

production departments based on service hours as
mentioned specifically in the question
 Reapportion maintenance overheads

Maintenance overheads recharged to dept. 1, based on

the 12,000 service hours– Given in the question
Basis Dept. 1 Dept. 2 Maint. Canteen Total
£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Reapportion canteen employees 4,000 3,000 1,000 (8,000) 0
41,000 36,000 11,000 0 88,000
Reapportion main.
 Reapportion maintenance overheads

Maintenance overheads recharged to dept. 1, based on

the 12,000 service hours– Given in the question
Basis Dept. 1 Dept. 2 Maint. Canteen Total
£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Reapportion canteen employees 4,000 3,000 1,000 (8,000) 0
41,000 36,000 11,000 0 88,000
Reapportion main. (12:10) (11,000)
 Reapportion maintenance overheads

Basis Dept. 1 Dept. 2 Maint. Canteen Total

£ £ £ £ £
Food & drink 4,000 4,000
Rent & Rates floor space 6,000 7,200 3,000 1,800 18,000
Heating & Lighting floor space 4,000 4,800 2,000 1,200 12,000
Depreciation £machinery 15,000 12,000 2,000 1,000 30,000
Supervision employees 12,000 9,000 3,000 0 24,000
37,000 33,000 10,000 8,000 88,000
Reapportion canteen employees 4,000 3,000 1,000 (8,000) 0
41,000 36,000 11,000 0 88,000
Reapportion main. (12:10) 6,000 5,000 (11,000)
47,000 41,000 0 0 88,000
Overhead absorption rate (OAR)

The production departments must now charge

(absorb) their overheads to the products they
work on
“Activity” could be the amount of work carried out
such as machine hours or labour hours
To do this we need to calculate an absorption rate
for each department

overhead absorption rate

= budgeted expenditure
budgeted activity
Overhead absorption rate (OAR)

Dept. 1 Dept. 2
£ £
Budgeted expenditure
Budgeted machine hours
Budgeted labour hours
Absorption rate
per mhr per lhr
You are also told the time spent by each department on
each product
Department-1 spends 2 machine hours on a unit of
product X and 1.5 hours on a unit of product Y
Department-2 spends 3 labour hours on a unit of product
X and 4 hours on a unit of product Y
• State total overhead costs (allocated,
apportioned and reapportioned) in each
department

• State total budgeted machine hours and

budgeted labour hours.

Now using the following formula, calculate

OAR;
overhead absorption rate

= budgeted expenditure
budgeted activity
Overhead absorption rate (OAR)
Dept. 1 Dept. 2
£ £
Budgeted expenditure
Budgeted machine hours
Budgeted labour hours
Absorption rate
per mhr per lhr

You are also told the time spent by each department on each
product
Now calculate the overhead absorbed per unit
ABSORPTION RATE SIMPLY TELLS US HOW MUCH ONE HOUR OF
WORK CAUSES OVERHEAD COSTS IN EACH OF THE TWO
DEPARTMENTS
Overhead absorption rate (OAR)

Dept. 1 Dept. 2
£ £
Budgeted expenditure 47,000 41,000 Worked out
Budgeted machine hours 6,320 Given in the question
Budgeted labour hours 7,850 Given in the question
OH Absorption rate 7.44 5.22
per mhr per lhr
You are also told the time spent by each department on each
product
Now calculate the overhead absorbed per unit
OVERHEAD ABSORPTION RATE IS SIMPLY TELLING US HOW
MUCH COST OF OVERHEADS IS CAUSED PER HOUR IN EACH
OF THE TWO DEPARTMENTS
Applying OAR

1. Department.1 spends 2 machine hours on a unit of

product X and 1.5 hours on a unit of product Y
2. Department.2 spends 3 labour hours on a unit of
product X and 4 hours on a unit of product Y
Applying OAR

Now that each department knows its absorption

rate and the amount of work done (measured in
hours) on each product they can absorb (charge) the
overhead to X and Y,

Product X (£) Y (£)

Department 1 (£7.44/m. hr)

Department 2 (£5.22/l. hr)

Total absorbed
 Overhead absorption rate

Now that each department knows its absorption rate

and the amount of work done (measured in hours)
on each product, they can absorb (charge) the
overhead to X and Y

Product X (£) Y (£)

Department 1 (£7.44/m. hr)
= £7.44 x 2 m.hrs (X)
= £7.44 x 1.5 m.hrs (Y)
Department 2 (£5.22/l. hr)
= £5.22 x 3 l.hrs
= £5.22 x 4 l.hrs
Total absorbed
 Overhead absorption rate

Now that each department knows its absorption rate

and the amount of work done (measured in hours)
on each product, they can absorb (charge) the
overhead to X and Y

Product X (£) Y (£)

Department 1 (£7.44/m. hr)
= £7.44 x 2 m.hrs 14.88
= £7.44 x 1.5 m.hrs 11.16
Department 2 (£5.22/l. hr)
= £5.22 x 3 l.hrs 15.66
= £5.22 x 4 l.hrs 20.88
Total absorbed 30.54 32.04
Which absorption basis to choose?

The choice of an absorption basis is a matter of judgement

and common sense. There are no strict rules or formulae
involved. But the basis should realistically reflect the
attributes of a given production centre.

Some examples of absorption basis:

Percentages of direct materials cost, direct labour cost, prime
cost, rate per machine hour, per direct labour hour etc.
 What do we do with the OAR?

Under-absorption
Over-absorption

Total overheads absorbed = OAR x actual activity

Over-absorption = Total overheads absorbed > Total actual overhead

Under-absorption = Total overheads absorbed < Total actual overhead

Absorption costing process
Absorption costing
Direct method

This is the simplest method and is to use

when service cost centres provide
services to production cost centres, but
NOT to each other.
 Absorption costing
Direct method

Service departments Operating departments

Personnel Facilities Assembly Paint
Dept. Dept. Shop Total
Direct departmental
cost
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
(allocated/apportioned
already)
Direct labour hours [h] - - 1,000 3,000 4,000
Headcount
50 115 95 310 570
[no of staff]
Floor space [m2] 440 580 7,200 4,500 12,720
Absorption costing
Direct method

Personnel Facilities Mgmt.

Direct cost: £400,000 Direct cost: £150,000

Assembly Paint Shop

Absorption costing
Direct method

Scenario 1:
• First we will use Total direct labour hours as the ONLY
cost re-apportionment basis for BOTH service
departments

Scenario 2:
• Then (more appropriately) we will use adequate cost re-
apportionment basis for EACH service department
(Depending on which basis suits each department best
in light of its unique attributes/features and type of
service provided to production departments)
 Absorption costing
Direct method
Case: Car manufacturing business.

Service departments Operating departments

Personnel Facilities Assembly Paint
Dept. Dept. Shop Total
Direct departmental
cost
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
(allocated/apportioned
already)
Direct labour hours [h] - - 1,000 3,000 4,000
Headcount
50 115 95 310 570
[no of staff]
Floor space [m2] 440 580 7,200 4,500 12,720
 Absorption costing
Direct method (scenario 1)

Service departments Operating departments Check

Personnel Facilities M. Assembly Paint Shop Total
Direct dept.
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
cost
re-
apportionment
of
(£ 400,000) X
personnel
re-
apportionment
of
X (£ 150,000)
Facilities M.
Total after
re-
- - £980,000
apportionme
nt
Absorption costing
Direct method (scenario 1)

Service departments Operating departments Check

Personnel Facilities M. Assembly Paint Shop Total
Direct dept.
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
cost
re-
(1,000/4,000 ) (3,000/4,000 )
apportionment
of
(£ 400,000) X £400,000 £400,000
personnel = £ 100,000 = £ 300,000
re-
(1,000/4,000 ) (3,000/4,000 )
apportionment
of
X (£ 150,000) £150,000 £150,000
Facilities M. = £ 37,500 = £ 112,500
Total after re-
apportionme - - £337,500 £642,500 £980,000
nt
 Absorption costing
Direct method (scenario 2)
Case: Car manufacturing business.

Service departments Operating departments

Personnel Facilities Assembly Paint
Dept. Dept. Shop Total
Direct departmental
cost
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
(allocated/apportioned
already)
Direct labour hours [h] - - 1,000 3,000 4,000
Headcount
50 115 95 310 570
[no of staff]
Floor space [m2] 440 580 7,200 4,500 12,720
 Absorption costing
Direct method (scenario 2)

 Which ones are the most appropriate re-

apportionment bases for each service department?

 Personnel:

 Facilities Mgmt.:
 Absorption costing
Direct method (scenario 2)

 Which ones are the most appropriate re-apportionment

bases for each service department?

 Personnel: Staff headcount

 Facilities Mgmt.: Floor space occupied
 Absorption costing
Direct method (scenario 2)

Service departments Operating departments Check

Facilities
Personnel M. Assembly Paint Shop Total
Direct dept.
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
cost

re-apportionment
of (£ 400,000) X
personnel

re-apportionment
of X (£ 150,000)
facilities m.
Total after re-
- - £980,000
apportionment

*Note: Rounding differences may occur.

 Absorption costing
Direct method (scenario 2)
Service departments Operating departments Check
Facilities
Personnel M. Assembly Paint Shop Total
Direct dept.
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
cost
re- £400,000x310
£400,000x95
apportionment 95 + 310
(£ 400,000) X 95 + 310
of = £ 93,827* = £ 306,173*
personnel
re-
£150,000 x 7,200 £150,000 X 4,500
apportionment 7,200+ 4,500 7,200+ 4,500
X (£ 150,000)
of = £ 92,308* = £ 57,692*
facilities m.
Total after re-
- - £386,135 £593,865 £980,000
apportionment

*Note: Rounding differences may occur.

Absorption costing
Direct method (scenario 1 & 2 compared)

Allocation basis Assembly Paint shop

Labour hours for both Operating/Production

departments £337,500 £642,500

Headcount for Assembly

Floor Space for Paint Shop £386,135 £593,865

Difference (Higher/lower cost) 48,635 (48,635)

So what is the impact of using
different absorption bases?

• Choice of basis can make a difference.

• By using a blanket rate based on labour hours,
Assembly departmental manager may have been
commended and Paint shop manager
reprimanded for higher costs!
• As the worst case, people’s jobs could be at stake
• Costing methods could potentially be a political
tool within organisations.
• They can affect organisations’ capacity to
understand costs and make appropriate decisions
accordingly.
Absorption costing
Step-down method

• The service cost centre that serves most other

service cost centres should be reapportioned first.

• Or a service department with highest costs is

reapportioned first

• Some service cost centres provide services to other

service cost centres, but these services are not
reciprocated.
Absorption costing
Step-down method

Personnel Facilities Mgmt.

Direct cost: £400,000 Direct cost: £150,000

Assembly Paint Shop

Absorption costing
Step-down method: Example

Service departments Operating departments

Personnel Facilities Assembly Paint
Dept. Dept. Shop Total
Direct departmental
cost
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
(allocated/apportioned
already)
Direct labour hours [h] - - 1,000 3,000 4,000
Headcount
50 115 95 310 570
[no of staff]
Floor space [m2] 440 580 7,200 4,500 12,720
 Absorption costing
Step-down method: Example

Here Personnel department is SERVING ALL like canteen did in a previous

example; so that would be reapportioned first

Service departments Operating departments

Personnel Facilities Assembly Paint
Dept. Dept. Shop Total
Direct departmental
cost
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
(allocated/apportioned
already)
Direct labour hours [h] - - 1,000 3,000 4,000
Headcount
50 115 95 310 570
[no of staff]
Floor space [m2] 440 580 7,200 4,500 12,720
Absorption costing
Step-down method: Example

Personnel Department must be reapportioned first

1) Personnel: Headcount [no of staff]

2) Facilities mgmt.: Floor space [m2]
 Absorption costing
Step-down method: Example

Personnel reapportionment Basis : Headcount

Service departments Operating departments Check
Personnel Facilities M. Assembly Paint Shop Total
Direct dept.
£ 400,000 £ 150,000 £ 200,000 £ 230,000 £ 980,000
cost
£400,000 £400,000 £400,000
Reapportion 115 + 95 + 310115 115 + 95 + 310 95 115 + 95 + 310310
Personnel (£ 400,000)
Department = £ 88,462 = £ 73,077 = £ 238,462

New totals - £ 238,462 £ 273,077 £ 468,462 £ 980,001*

*Note: There may be minor rounding differences.

 Absorption costing
Step-down method: Example

 Facilities mgmt. reapportionment basis: Floor space [m2]

Service departments Operating departments Check

Personnel Facilities M. Assembly Paint Shop Total

New totals - £ 238,462 £ 273,077 £ 468,462

£238,462 £238,462
Reapportion 2
7,200 m + 4,500 m2  7,200 m2 + 4,500 m2 
Personnel X (£ 238,462) 7,200 4,500
Department = £ 146,746 = £ 91,716
Total after re-
- - £ 419,822 £ 560,178 £ 980,000*
apportionment

*Note: There may be minor rounding differences.

Advantages of absorption costing

Improved managerial awareness of total costs

sustained by cost centre
Selling prices can be established to cover full
“product” cost
Absorption costing must be used to value closing
inventory for financial accounts
Overhead absorption rate is used for budgeting
purposes (discussed in later lectures)
Problems with absorption costing
Arbitrary re-apportionment of overheads can lead to
incorrect decisions being taken

Costs are absorbed based on the budgeted overhead

absorption rate and therefore an under/over
absorption adjustment must be made

Ignores the distinction between fixed and variable

costs
Costing in a service sector
business

Assuming an audit firm such as PwC decides to

use the traditional Absorption costing method to
work out its cost on one audit assignment. How can
they work out the budgeted cost of an audit for say
Bank of America or Goldman Sachs (two of their
known clients)?
 Costing in a service sector
business
In addition to the direct costs of the audit:

Establish the indirect costs – e.g. Audit support including

secretarial, databases charges etc.

Use budgeted chargeable audit hours as budgeted activity

(denominator for OAR). Numerator being the overhead costs.

Calculate OAR –
Total budgeted overheads/Total chargeable hours

Budgeted cost of one audit “job”:

(Overhead absorption rate x number of professional hours) +
Traceable direct professional audit team hours
Undercharging Job orders by Big four
accounting firms - Cost overruns in 50% of
audits
• Following the accounting scandals of BHS,
Carillion, Tesco and Patisserie Valerie etc.
Parliament’s business, energy and industrial strategy
(BEIS) select committee released correspondence
with PWC, Deloitte, KPMG and EY.

• The full cost of auditing company accounts was not

always charged to clients.

• The audit engagements were taken as “loss

leadership” to gain more lucrative non-audit
services.
https://www.parliament.uk/business/committees/committees-a-z/commons-select/business-energy-
industrial-strategy/inquiries/parliament-2017/future-of-audit-17-19/
https://www.theguardian.com/business/2019/apr/01/big-four-accountancy-firms-cost-overruns-audits
Lecture takeaways

• Absorption costing is the traditional approach to dealing

with overheads.
• Used in financial accounting, but in some situations can
be misleading.
• The three stages of absorption costing are allocation,
apportionment and absorption.
• After apportionment, overheads are absorbed into
products using an appropriate absorption rate.
• The choice of approach between Direct and Step-down
methods depends on the level of service by the service
departments to each other.
• Difference between the actual overhead costs and the
total absorbed overhead costs leads to overhead
over/under absorption.
 Self study exercises
Recommended self-assessment exercise:
Exercise 4.5: Bookdon plc (Ch 4 A&M textbook)

Relevant class questions

Class 1 (week 2):

Introductory discussion questions this week including opportunity cost and sunk cost

Class 2 (week 3):

• Marylebone Ltd (Step-down covering allocation, apportionment and reapportionment)
• Kingsway Ltd – Overhead bases and job-order costing
Class 6:
• Edgware Insight – Direct vs Stepdown method (A company serving Pvt. crops and Govt clients)

Recommended academic reading

Fekrat, M. A. (1972). The conceptual foundations of absorption costing. The Accounting Review, 47(2), 351-355.

Job costing - Undercharging by the top Audit firms:

https://www.parliament.uk/business/committees/committees-a-z/commons-select/business-energy-industrial-
strategy/inquiries/parliament-2017/future-of-audit-17-19/

https://www.theguardian.com/business/2019/apr/01/big-four-accountancy-firms-cost-overruns-audits