Cost Allocation & Cost Absorption
One of the essential functions of cost accounting is to relate the costs to its various elements forming part of the cost of production. This necessarily involves the following steps:
(1) Allocation of costs
(2) Apportionment of costs
(3) Absorption of costs
Cost Allocation: Cost Allocation means the allotment of proportions of cost to cost centers or cost units. Cost centre has been defined as “a location, person or item of equipment for which costs may be ascertained and used for the purpose of cost control”. Whereas a cost unit is a “unit of quantity of product service or time in relation to which costs may be ascertained and or expressed”. Cost allocation includes choosing the object of costing, accumulating the costs that relate to the object of costing and choosing the method to identify those costs. Usually, the allocation of costs would be done based on machine-hours, direct-labor hours etc.
Example: Say a manufacturing company has to allocate the total manufacturing overheads of $30,000 to its’ Products A, B and C and uses the traditional method of allocating based on the direct-labor hours. The direct labor hours for Products A, B and C are 2000, 1000 and 3000 respectively.
Solution: Total labor hours = 6000
Cost allocation:
Overheads allocated for Product A = 30000*2000/6000 =$10,000
Overheads allocated for Product B = 30000*1000/6000 = $5,000
Overheads allocated for Product C = 30000*3000/6000 = $15,000
Cost Apportionment: Cost allocation is also referred to as Cost apportionment. Cost apportionment means the allotment of proportions of items of cost of cost centers or cost units.
Cost Absorption: Cost absorption means allotment of overhead expenses to cost units. Overhead absorption is usually achieved by the use of one or a combination of overhead recovery rates. An example of cost absorption would be the application of factory overhead costs to processing departments using a pre-determined overhead rate.
Example: Say a company follows a practice of allocating the factory overheads based on a pre-determined overhead rate of $12 per unit produced. The number of units produced during the period is 5000.
Solution: Cost absorbed would be = 5000 units * $12 per unit= $60,000. This amount would be finally compared with the actual overheads incurred during the end of the period and under-applied or over-applied overheads will be calculated and adjusted accordingly.
Pre-determined overhead rate is a rate based on the budgeted overhead and yearly/period budgeted activity either in direct labor hours, machine hours or number of units etc.
Pre-determined Over head rate = Budgeted Yearly Factory Overhead costs/Budgeted yearly activity either in direct labor hours, machine hours or number of units produced etc.
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