Cost Ascertainment-Overhead Costing
Cost Ascertainment for Overhead cost is the process of identifying cost incurred or paid for the production of a product. There are diverse logistics of handling overhead cost for an absorption rate is necessary to estimate (i.e. absorb) that type of cost to a product
Absorption of Overheads
The term absorption in cost accounting refers to the process estimating the amount of overhead cost to be incurred in production through budgeting. The estimation is done using absorption formula where a rate is computed as follows
Formula (general)
The general formula to estimate the expected overheads to be incurred is as given below;
Overhead Absorption Rate=Total Budgeted Overhead cost
Total budgeted Base to be used
NB1: The total budgeted overhead represents either fixed or variable overhead
NB2: The denominator can assume other aspects depending on the correlation the denominator has with the overhead in question.
This means that once the rate of absorption is established, it will be used to determine the estimated overhead cost to be affiliated to the cost unit or cost product which is compared with the actual overhead incurred at the end of it all.
Example:
The following estimates relate to Deluxe co. Ltd for the year ending on 31st/05/2021
Amt.$
Projected Overhead 78,750
Projected raw materials 46,200
Projected direct labor cost 47,250
Projected direct labor hours 12,600
Projected machine hours 13,125
Projected units of output 2,625
Additional information pertaining 30 units produced on 7th November 2020 are as provided hereunder
Amt.$
Projected material cost 88
Projected direct labor cost 90
Projected direct labor hours 22
Projected machine hours 23
Note the following that; experience portrays that overhead is highly correlated with material cost, direct labor cost and direct labor hours.
Required
- Determine the overhead absorption rate based on the three aspects aforementioned
- Determine the overhead cost to be absorbed in producing the 30 units produced on 7th/Nov 2020
Solution
Overhead Absorption Rate
Based on Projected Material Cost
Overhead Absorption Rate=Total Projected Overhead cost
Projected Material Cost
= 78750 = 1.704*100= 170.4% of projected material cost
46200
Based on Projected Direct Labor Cost Basis
Overhead Absorption Rate=Total Projected Overhead cost
Projected Direct Labor Cost
= 78750 = 1.67*100= 167% of projected labor cost
47,250
Based on Projected Direct Labor Hours Basis
Overhead Absorption Rate=Total Projected Overhead cost
Projected Direct Labor Hours
= 78750 = 6.25 of projected labor hours
Overhead cost to be absorbed in producing the 30 units produced on 7th/Nov 2020
Formula used is Actual Resources utilized for the actual output*Overhead Absorption Rate (OAR)
Therefore;
Based on Projected Material Cost
170.4% *88= 149.952
Based on Projected Direct Labor Cost Basis
167%* 90= 150.3
Based on Projected Direct Labor Hours Basis
6.25* 24= 150
Over Absorption of Overheads
This is a case where by absorbed overheads are more than actual overhead cost incurred or paid.
Under Absorption of Overheads
This is a case where by absorbed overheads are less than actual overhead cost incurred or paid.
Reasons for Over or Under absorption of overhead
The reasons for over or under absorption of overheads are as follows.
1. The actual hours worked is either less or more than the budgeted hours.
2. The actual overhead costs are different from planned overheads.
3. Both actual overhead costs and actual activity level are dissimilar from the planned costs and level.
4. The technique of overhead absorption may be incorrect.
5. Unforeseen expenditures may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.
7. Major changes like standby of manual labor with machines. This leads to increase in capacity levels.
