This lesson covers the fundamentals of absorption (or full) costing. It explains the process of allocating, apportioning, and absorbing overheads to determine the total cost of a product or service, a method traditionally required for external financial reporting .

• What is Absorption Costing? Absorption costing is a method of costing that assigns all manufacturing costs (direct materials, direct labour, and both variable and fixed overheads) to products. It is also known as full costing.

• Steps in Overhead Allocation and Apportionment: The process involves three main steps:

  1. Allocation: The direct assignment of an overhead cost to a specific cost centre (e.g., the cost of a maintenance department’s supplies is allocated directly to the maintenance cost centre).

  2. Apportionment: The process of spreading overhead costs across multiple cost centres on a fair and reasonable basis (e.g., the cost of factory rent is apportioned to production and service departments based on floor area) .

  3. Reapportionment: The final step where overheads accumulated in service departments (e.g., maintenance, HR) are then apportioned to production departments to arrive at a total overhead figure for each production centre.

• Overhead Absorption Rates: Once the total overhead for a production cost centre is calculated, a predetermined overhead absorption rate (OAR) is established . The OAR is calculated as budgeted overheads divided by a chosen activity level, such as direct labour hours, machine hours, or units of production. This rate is then used to ‘absorb’ overhead into the cost of individual products.

• Over/Under Absorption of Overheads: At the end of a period, the actual overhead incurred is compared to the overhead absorbed into products. If actual overhead exceeds absorbed overhead, this is under-absorption. If absorbed overhead exceeds actual overhead, this is over-absorption. This difference is often charged or credited to the profit and loss account, representing a variance between actual and budgeted costs .