Overheads, Absorption and Activity-Based Costing — Practice

Question 1

State whether each is allocated or apportioned, and the basis if apportioned: (a) depreciation on a machine located entirely in the machining department; (b) factory rent for a building shared by three departments; (c) canteen cost shared across all factory employees.

Accepted Answer

Item (a) is allocated in full to the machining department, not apportioned, because it can be identified wholly and directly with that single cost centre; there is no sharing or division required, since the machine and its depreciation belong entirely to that department and to no other. Item (b), factory rent for a building shared by three departments, must be apportioned, since it cannot be identified with any single department alone, and the reasonable basis generally used is floor area occupied by each department, on the reasoning that a department occupying a larger share of the building's floor space reasonably bears a larger share of the rent cost for occupying that space, reflecting how the departments actually benefit from the shared facility. Item (c), canteen cost shared across all factory employees, must also be apportioned, and the reasonable basis generally used is the number of employees in each department, on the reasoning that a department with more employees causes a correspondingly larger share of canteen usage and cost, since the canteen serves employees rather than machines or floor space, so headcount is the more relevant driver of that particular cost than, say, floor area would be.

Question 2

Two service departments, Maintenance and Stores, serve each other and two production departments. Maintenance's own cost is Rs.60,000 and it provides 20% of its service to Stores. Stores' own cost is Rs.40,000 and it provides 10% of its service to Maintenance. The remaining service from each goes to the two production departments equally. Using the simultaneous equation method, compute the final total overhead reapportioned to each service department before splitting between production departments, then to production.

Accepted Answer

Let M be the total overhead of Maintenance after receiving its share from Stores, and S be the total overhead of Stores after receiving its share from Maintenance. Maintenance's total is its own cost of 60,000 plus 10% of Stores' total: M equals 60,000 plus 0.10S. Stores' total is its own cost of 40,000 plus 20% of Maintenance's total: S equals 40,000 plus 0.20M. Substituting the second equation into the first: M equals 60,000 plus 0.10 times (40,000 plus 0.20M), that is M equals 60,000 plus 4,000 plus 0.02M, giving 0.98M equals 64,000, so M equals 65,306 approximately. Substituting back into the second equation: S equals 40,000 plus 0.20 times 65,306, that is 40,000 plus 13,061, giving S equals 53,061 approximately. These two figures represent the final total overhead of each service department after fully accounting for their mutual servicing relationship. To complete the reapportionment, the remaining service from each, after the reciprocal shares are accounted for, is split equally between the two production departments: Maintenance's remaining 80% (since 20% went to Stores) of its final total, that is 80% of 65,306, giving 52,245, is split equally, 26,122 to each production department; Stores' remaining 90% (since 10% went to Maintenance) of its final total, that is 90% of 53,061, giving 47,755, is also split equally, 23,877 to each production department. The simultaneous equation method is generally faster and more precise than repeated distribution where, as here, only two service centres are reciprocally related, since it solves the mutual relationship algebraically in one step rather than cycling the reapportionment back and forth until residual amounts become negligible.

Question 3

A machine has annual standing charges of Rs.1,20,000 (rent, insurance, independent of running hours) and annual running charges of Rs.3,60,000 at a budgeted 6,000 machine hours (power and consumable stores, dependent on hours run). Compute the composite machine hour rate, and the overhead to be absorbed into a job requiring 8 machine hours.

Accepted Answer

Standing charges, being independent of running hours, are spread over the full budgeted machine hours regardless of how the running charges behave: 1,20,000 divided by 6,000 budgeted hours gives a standing charge rate of 20 per machine hour. Running charges, being directly dependent on hours actually run, are computed per hour on the same budgeted hours basis for rate-setting purposes: 3,60,000 divided by 6,000 budgeted hours gives a running charge rate of 60 per machine hour. The composite machine hour rate is the sum of the two: 20 plus 60, giving 80 per machine hour. This composite rate reflects the reasoning that standing charges, being incurred regardless of usage, must still be recovered over the machine's expected running hours even though they do not themselves vary with those hours, while running charges are more naturally expressed per hour since they genuinely do vary with usage; combining the two into a single composite rate simplifies job costing while still reflecting both cost behaviours correctly, since the standing charge component was computed by dividing by hours even though the underlying cost itself does not vary with hours. For a job requiring 8 machine hours, overhead absorbed is 8 times the composite rate of 80, giving 640, made up of 8 times 20, that is 160, in standing charges recovered, and 8 times 60, that is 480, in running charges recovered.

Question 4

A department budgeted overhead of Rs.5,00,000 for 25,000 budgeted machine hours, giving an absorption rate of Rs.20 per hour. Actual overhead incurred was Rs.5,40,000, and actual machine hours worked were 24,000. Compute the overhead absorbed, the amount of under- or over-absorption, and state the treatment, distinguishing the case where the variance is a normal fluctuation from the case where it reflects a genuinely faulty budgeted estimate.

Accepted Answer

Overhead absorbed is the predetermined rate multiplied by actual activity achieved, not budgeted activity: 20 per hour times 24,000 actual machine hours, giving 4,80,000 absorbed. Actual overhead incurred was 5,40,000. Since overhead absorbed of 4,80,000 is less than overhead actually incurred of 5,40,000, this is under-absorption, of 5,40,000 less 4,80,000, that is 60,000. The under-absorption here arises from two combined effects worth separating conceptually: actual overhead exceeded the budgeted 5,00,000 by 40,000, and actual hours of 24,000 fell short of the budgeted 25,000 by 1,000 hours, which at the 20 per hour rate accounts for a further 20,000 shortfall in absorption, together explaining the full 60,000 under-absorption. On treatment: if this 60,000 shortfall is considered a normal fluctuation, arising from the ordinary, expected variability between budgeted and actual figures that any forecasting exercise will produce, it is simply written off to the costing profit and loss account for the period, with no adjustment made to the cost of units already produced. If instead the shortfall is considered to reflect a genuinely faulty original estimate, for instance if the budgeted overhead of 5,00,000 was based on outdated cost information that understated the department's true likely overhead from the outset, the more appropriate treatment is to apply a supplementary rate, computed by dividing the under-absorbed amount by actual activity, here 60,000 divided by 24,000, giving 2.50 per hour, and using it to adjust upward the cost already charged to the units produced, and correspondingly to closing stock and cost of goods sold, so that the cost figures are not left permanently understated on the basis of an estimate now known to have been wrong.

Question 5

A factory makes Product A, a simple, high-volume item requiring 2 machine setups per year, and Product B, a complex, low-volume item requiring 40 machine setups per year, despite B accounting for only 5% of total production volume. Total setup-related overhead is Rs.2,10,000. Explain, without full ABC computation, why absorbing this overhead on a machine hour basis would misstate the cost of each product, and describe the direction of the distortion.

Accepted Answer

Absorbing setup-related overhead on a machine hour basis assumes the cost varies with production volume, in proportion to how many machine hours each product consumes, but setup cost by its nature does not behave this way at all: it is driven by the number of setups performed, essentially a fixed cost per setup event, regardless of how many units are subsequently produced in that setup run. Product A, being high-volume and simple, requires very few setups, only 2 per year, so under a volume-based absorption method it would nonetheless be charged a large share of the total setup overhead simply because it consumes a large share of total machine hours, even though it caused very little of the actual setup activity that generates that cost. Product B, being low-volume and complex, requires a disproportionately large number of setups, 40 per year, relative to its share of production volume, only 5%, meaning it is the product genuinely responsible for most of the setup activity and therefore most of the setup cost, yet under volume-based absorption it would be charged only a small share of the overhead, proportionate to its small share of machine hours. The direction of the distortion is therefore that volume-based absorption systematically overcosts Product A, the high-volume simple product that causes few setups, and systematically undercosts Product B, the low-volume complex product that causes many setups relative to its volume; management relying on these distorted costs might incorrectly conclude Product A is less profitable than it truly is and Product B more profitable than it truly is, potentially leading to poor pricing or product-mix decisions, which is exactly the problem activity-based costing exists to correct.

Question 6

A company identifies two activity cost pools: machine setup, total cost Rs.2,40,000, driven by number of setups, total 80 setups across all products; and quality inspection, total cost Rs.1,50,000, driven by number of inspections, total 500 inspections. Product X requires 5 setups and 40 inspections per year; Product Y requires 25 setups and 60 inspections per year. Compute the ABC-based overhead charged to each product from these two pools, and comment on what this reveals relative to a volume-based approach if Product X has far higher production volume than Product Y.

Accepted Answer

The cost driver rate for machine setup is total pool cost divided by total driver volume: 2,40,000 divided by 80 setups, giving 3,000 per setup. The cost driver rate for quality inspection is 1,50,000 divided by 500 inspections, giving 300 per inspection. Overhead charged to Product X from these two pools is its actual consumption of each driver multiplied by the respective rate: 5 setups times 3,000, that is 15,000, plus 40 inspections times 300, that is 12,000, giving a total of 27,000. Overhead charged to Product Y is 25 setups times 3,000, that is 75,000, plus 60 inspections times 300, that is 18,000, giving a total of 93,000. If Product X has far higher production volume than Product Y, this result is striking and reveals exactly the effect activity-based costing is designed to surface: despite producing far fewer units, Product Y is charged more than three times the setup-and-inspection overhead that Product X is charged, 93,000 against 27,000, because Product Y genuinely consumes far more of the activities, five times the setups and one and a half times the inspections, that actually drive this cost, regardless of its comparatively low output. A volume-based approach, spreading the combined 3,90,000 of overhead across total units produced, would instead charge Product X, the high-volume product, a much larger absolute share of this cost simply because it produces more units, understating what Product Y genuinely costs to support and overstating what Product X genuinely costs to support; on a per-unit basis this effect is even more pronounced, since Product Y's far smaller output means its 93,000 of setup and inspection cost is spread over very few units, producing a materially higher activity-driven cost per unit than a volume-based rate would ever reveal.

Question 7

State the conditions under which activity-based costing is generally considered worth adopting over traditional volume-based absorption, and explain why a company with a single, homogeneous product line would gain little from switching to ABC.

Accepted Answer

Activity-based costing is generally worth adopting where three conditions hold together, or at least strongly. First, where the company has a diverse product mix, combining some high-volume, simple products with some low-volume, complex products, since it is precisely this combination that causes traditional volume-based absorption to distort cost significantly, as complex low-volume products consume disproportionately more of activities like setups and inspections relative to their production volume. Second, where overheads form a large proportion of total cost, since a distorted allocation of a small overhead pool has only a small absolute effect on reported product cost, while the same distortion applied to a large overhead pool can materially misstate product profitability and drive genuinely poor decisions. Third, where traditional absorption is already producing product costs that management does not trust, or that appear to be generating evidently poor pricing or product-mix decisions, such as a product management believes is profitable consistently losing market share to competitors pricing it lower, or a product management believes is marginal nonetheless attracting strong demand at its current price, both patterns that can indicate the reported cost is systematically wrong. A company with a single, homogeneous product line would gain little from adopting ABC because the entire problem ABC solves, differential consumption of activities across a diverse product mix, does not arise at all when there is effectively only one product: every unit consumes overhead-driving activities in essentially the same proportion as every other unit, so a simple volume-based absorption rate already allocates overhead reasonably accurately, and the substantial cost of implementing ABC, identifying activities, cost pools and drivers, and maintaining ongoing data on driver consumption, would purchase little or no improvement in costing accuracy for such a company, making the investment difficult to justify.

Question 8

Two service departments, X and Y, serve each other and two production departments. X's own cost is Rs.50,000, providing 10% of its service to Y. Y's own cost is Rs.30,000, providing 20% of its service to X. Using the repeated distribution method, reapportion the costs, cycling until residual amounts become negligible, and compare briefly to the simultaneous equation method's approach.

Accepted Answer

The repeated distribution method cycles the reapportionment back and forth between the two service departments repeatedly, each time distributing the receiving department's newly increased balance onward again, until the residual amounts remaining become negligible enough to distribute in full to production departments. Starting with X at 50,000 and Y at 30,000: distribute X's 50,000, giving 10% to Y, that is 5,000, and the remaining 90% to production departments; Y now holds its original 30,000 plus the 5,000 received, that is 35,000, of which 20% goes back to X, that is 7,000, and the remaining 80% to production departments; X now holds this newly received 7,000, of which 10% goes to Y, that is 700, and 90% to production departments; Y now holds 700, of which 20% goes to X, that is 140, and 80% to production; this cycle continues with rapidly diminishing amounts, 140 to X producing 14 back to Y, and so on, until the residual amount remaining is small enough to be distributed in full to production departments without further cycling, typically after three or four rounds in a problem of this scale. The simultaneous equation method reaches the same final answer directly and in one step, by setting up and solving two equations representing each department's total cost after fully accounting for the reciprocal relationship algebraically, rather than approximating the same result through successive, diminishing rounds of distribution; for a simple two-department reciprocal relationship like this one, the simultaneous equation method is generally faster and avoids the risk of stopping the repeated distribution cycle too early and leaving a materially sized residual undistributed, though both methods converge to the identical final apportionment given enough cycles in the repeated distribution approach.

Question 9

A highly automated department has overhead of Rs.8,00,000, driven mainly by machine depreciation and power. A labour-intensive department has overhead of Rs.5,00,000, driven mainly by supervisory salaries proportional to headcount. Recommend an absorption base for each, and explain why using the same base for both would be poor practice.

Accepted Answer

For the highly automated department, machine hour rate is the appropriate absorption base, since the overhead is driven predominantly by machine depreciation and power consumption, both of which vary with how long the machines actually run rather than with how much direct labour time is applied; a machine hour base directly reflects what is actually causing the overhead to be incurred in this department. For the labour-intensive department, direct labour hour rate, or alternatively a percentage of direct labour cost, is the more appropriate base, since the overhead here is driven predominantly by supervisory salaries and related labour-connected costs that scale with the workforce and the labour time applied rather than with machine running time. Using the same base for both departments, say machine hours throughout the factory, would be poor practice because it would absorb overhead into products based on a factor that does not actually drive the cost in the labour-intensive department at all; a product spending a great deal of labour-intensive-department time but comparatively little machine time would be undercharged for the genuine supervisory overhead its production actually causes, while a product using little labour-intensive-department time but more machine time elsewhere would be correspondingly overcharged. The general principle, examined throughout this chapter, is that the absorption base chosen for each cost centre should reflect what genuinely drives the overhead in that specific centre, which is precisely why different departments within the same factory often use different absorption bases rather than one uniform base applied everywhere.

Question 10

A department has budgeted overhead of Rs.2,40,000 and budgeted prime cost of Rs.6,00,000. Compute the overhead absorption rate as a percentage of prime cost, and apply it to a job with prime cost of Rs.45,000. State one limitation of using prime cost as an absorption base.

Accepted Answer

Overhead absorption rate as a percentage of prime cost is total budgeted overhead divided by total budgeted prime cost, expressed as a percentage: 2,40,000 divided by 6,00,000, giving 40%. Applied to a job with prime cost of 45,000, overhead absorbed into that job is 40% of 45,000, giving 18,000. A limitation of using prime cost as an absorption base is that prime cost combines material and labour cost together, and overhead is rarely genuinely driven equally by both in the same proportion; a job with a high material content and comparatively little labour, such as one using expensive raw materials but requiring minimal processing time, would absorb a large share of overhead under this base purely because of its material cost, even though the overhead, particularly labour-related overhead such as supervision, may have very little to do with material cost as such and would be more fairly absorbed on a labour hour or labour cost basis instead. This distortion is exactly the kind of concern that motivates choosing a more specific, activity-appropriate base, such as direct labour hours or machine hours, wherever overhead is genuinely driven by one particular input rather than by the blended prime cost figure.

Question 11

A department's predetermined absorption rate was based on budgeted overhead of Rs.4,80,000 and budgeted 24,000 hours, giving a rate of Rs.20 per hour. Actual overhead was Rs.4,60,000 and actual hours were 22,000. Compute overhead absorbed, the total under- or over-absorption, and separate the amount attributable to the overhead spending difference from the amount attributable to the activity difference.

Accepted Answer

Overhead absorbed is the predetermined rate applied to actual hours: 20 times 22,000, giving 4,40,000. Actual overhead incurred was 4,60,000. Since overhead absorbed of 4,40,000 is less than overhead actually incurred of 4,60,000, this is under-absorption of 4,60,000 less 4,40,000, that is 20,000. To separate the two contributing causes: the spending effect is the difference between budgeted and actual overhead, 4,80,000 budgeted less 4,60,000 actual, giving a favourable spending effect of 20,000, since less was actually spent than budgeted. The activity effect is the shortfall in hours worked relative to budget, valued at the standard rate: budgeted hours of 24,000 less actual hours of 22,000, that is 2,000 hours short, valued at 20 per hour, giving an adverse activity effect of 40,000, since fewer hours were worked than budgeted, meaning less overhead was absorbed than the spending performance alone would have justified. Combining the two: a favourable spending effect of 20,000 and an adverse activity effect of 40,000 net to an adverse 20,000, exactly matching the total under-absorption computed directly. This decomposition shows that although the department actually spent less than budgeted, a genuinely good outcome from a pure cost-control perspective, the shortfall in hours worked relative to budget more than offset that saving in absorption terms, producing net under-absorption overall despite the underlying spending performance being favourable; a manager reading only the net 20,000 under-absorption figure without this decomposition might wrongly conclude the department overspent, when in fact it underspent but also underutilised its budgeted capacity.

Question 12

A small company with a single, simple product line is considering adopting activity-based costing after reading about its benefits for large manufacturers. Advise the company, explaining why the calculus differs for a business with its profile.

Accepted Answer

The company should generally not adopt activity-based costing given its stated profile, and the reasoning follows directly from the three conditions that make ABC worth its cost: a diverse product mix, overheads forming a large proportion of total cost, and existing volume-based costs being untrustworthy or driving poor decisions. A single, simple product line fails the first and most important condition outright, since ABC's entire value proposition rests on correcting the distortion that arises when different products consume overhead-driving activities in very different proportions to their production volume; with only one product, there is no cross-product distortion for ABC to correct at all, since every unit of the single product necessarily consumes the same activities in the same proportion as every other unit. Implementing ABC nonetheless would require identifying activities, cost pools and drivers, and then maintaining ongoing data collection to track driver consumption, all of which is genuinely costly in time and system investment; for this company, that investment would purchase essentially no improvement in costing accuracy, since a simple volume-based absorption rate already allocates overhead about as accurately as any method could for a single-product business. The advice is that ABC's benefits, reported in the literature for large, diverse manufacturers, do not transfer to a business whose profile is fundamentally different from the one that generates those benefits, and the company would be spending real money and effort to solve a distortion problem it does not actually have.

Question 13

A company identifies three activity pools: machine setup (Rs.1,80,000, driven by 60 setups), material handling (Rs.90,000, driven by 300 material movements), and quality inspection (Rs.1,20,000, driven by 400 inspections). Product M requires 8 setups, 50 material movements, and 60 inspections. Compute the total ABC overhead charged to Product M from all three pools.

Accepted Answer

Compute the cost driver rate for each pool independently before assembling the overhead charged to Product M. Machine setup rate is 1,80,000 divided by 60 setups, giving 3,000 per setup. Material handling rate is 90,000 divided by 300 movements, giving 300 per movement. Quality inspection rate is 1,20,000 divided by 400 inspections, giving 300 per inspection. Overhead charged to Product M from machine setup is its 8 setups times the 3,000 rate, giving 24,000. From material handling, its 50 movements times the 300 rate, giving 15,000. From quality inspection, its 60 inspections times the 300 rate, giving 18,000. Total ABC overhead charged to Product M across all three pools is 24,000 plus 15,000 plus 18,000, giving 57,000. This figure, built entirely from Product M's actual consumption of each of the three distinct activities, is what a traditional single-base volume absorption approach could not replicate, since a single machine-hour or labour-hour rate applied across the whole factory would spread all 3,90,000 of combined pool cost according to Product M's share of that single volume measure alone, regardless of whether Product M genuinely causes a disproportionate share of setups, material handling, or inspections relative to its production volume; the ABC computation instead reflects Product M's actual, independently measured consumption of each cost-driving activity separately.

Question 14

A factory's canteen serves 400 employees. Department A has 150 employees, Department B has 100 employees, and the maintenance department has 150 employees. Canteen cost is Rs.80,000. Apportion the canteen cost, and separately explain why apportioning it on floor area instead would be an unreasonable basis.

Accepted Answer

Canteen cost is apportioned on the basis of number of employees in each department, since the canteen exists to serve employees and the number of employees in each department is the most reasonable available measure of how much canteen service each department actually causes and benefits from. Department A's share is 150 divided by 400 total employees, that is 37.5%, giving 37.5% of 80,000, that is 30,000. Department B's share is 100 divided by 400, that is 25%, giving 20,000. The maintenance department's share is 150 divided by 400, that is 37.5%, giving 30,000, with this last amount then requiring a further reapportionment from the maintenance service centre to the production departments, since maintenance is itself a service centre and does not absorb overhead into any final product directly. Apportioning canteen cost on floor area instead would be unreasonable because floor area has no genuine causal connection to canteen usage at all; a department occupying a large floor area with relatively few employees, perhaps because it houses bulky machinery requiring substantial space per worker, would be charged a disproportionately large share of canteen cost under a floor-area basis despite generating comparatively little actual canteen demand, while a department packed with many employees in a small floor area would be undercharged relative to the canteen usage it actually causes. The general principle this illustrates, examined throughout the apportionment material, is that the basis chosen must reflect what genuinely drives or benefits from the specific cost being apportioned, and floor area is the appropriate driver for costs like rent or building-related insurance, not for a headcount-driven cost like a canteen.

Question 15

A department's overhead was under-absorbed by Rs.36,000 for the year, and this is judged to reflect a genuinely faulty original budget rather than normal fluctuation. Actual activity for the year was 12,000 hours. Compute the supplementary rate, and explain how it is applied to correct the cost of units already produced during the year.

Accepted Answer

The supplementary rate is computed by dividing the under-absorbed amount by actual activity for the period: 36,000 divided by 12,000 hours, giving a supplementary rate of 3 per hour. This rate is then applied to every unit or job already costed during the year using the original, now-recognised-as-faulty predetermined rate, adding a further 3 per hour of actual time to the cost of each of those units, jobs and any related closing stock and cost of goods sold figures, so that the total additional overhead recognised through this supplementary charge across the year's activity exactly equals the 36,000 that was originally under-absorbed. The purpose of this correction is to avoid leaving the year's cost figures permanently understated on the basis of a rate now known to have been wrong from the outset, rather than merely reflecting an ordinary, expected short-term fluctuation between budget and actual that would properly be written off to the costing profit and loss account without disturbing the cost of individual units at all. Applying a supplementary rate is therefore reserved specifically for the case where the original estimate was genuinely faulty, since routinely adjusting unit costs after the fact for every ordinary variance would undermine the practical usefulness of predetermined rates in the first place, which exist precisely so that costs can be assigned to units as production occurs rather than only after the full year's actual results are known.

Practice — Overheads, Absorption and Activity-Based Costing

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