Absorption Costing

It is one of the most popular cost accounting systems used by the entities to calculate the cost of the product correctly. Under this method, the cost of the product is calculated by adding direct costs and indirect costs.

Direct costs mean cost of raw materials and direct labours. It is also called Prime cost.

Indirect costs mean production overheads such as electricity consumption bill etc.

Direct cost is directly incurred for the production of the product. However, indirect cost is incurred for more than one project and products, so the cost accountant/ management accountant has to allocate the production overhead/ indirect cost over some basis such as direct labour hours, machine hours etc.

Overhead Apportionment

In order to allocate indirect cost, the entity has to decide the cost centres over which it could be charged. There are various bases over which these can be allocated such as direct labour hours, machine hours or numbers of units produced. It is the management’s decision to base its overhead allocation technique. The method of allocated production overheads/ indirect cost is called Overhead Apportionment.

Example Question

The total rent of the factory is $10,000. The factory total area is 9,000 square feet. The floor area is occupied by departments are as follows:

A: 1900 square feet; B: 3500 square feet; C: 3600 square feet

Allocate/ apportion rent to each department on the basis of floor area occupied.

Solution/ Answer

Rent charged to Department A = 1900/9000 x 10,000 = $2,111

Rent charged to Department A = 3500/9000 x 10,000 = $3,889

Rent charged to Department A = 3600/9000 x 10,000 = $4,000