Study smart | Instant expert
How do different budgeted overhead absorption rates affect unit cost?
Cost accounting involves asking ‘what if’ questions, calculating options and comparing the results, then making well-informed decisions that will best support the performance of an organisation. Sometimes, what seems like a simple question turns out to be more complicated as it is part of a bigger question and requires the application of less obvious knowledge and understanding
Words Gill Myers, Evolve Illustration Shutterstock
Let’s make up a scenario in order to work through how to answer the question posed in the title.
Myers Manufacturing is about to start producing a new product, about which the following estimates have been made:
What will the selling price be?
It is likely that the question in the title is being asked so that the total cost of producing one unit of the product can be determined. That’s because once the expected cost per unit is known, the selling price can be calculated by adding on an additional amount to generate some profit.
How is the total cost per unit calculated?
The total cost per unit is a combination of direct costs, such as raw materials and direct labour, and indirect costs, which are the day-to-day administrative costs of an organisation known as overheads.
A manufacturing organisation, like the one in the scenario, will have a variety of overheads – for example, rent, insurance, electricity and salaries for staff who do not produce products directly but might be in management, sales or accounts. Money to pay for the overhead costs will need to be generated by the sale of products, so a budgeted overhead absorption rate (OAR) is calculated and used to work out the overhead cost per unit, which is then included in the total unit cost calculations.
How is the budgeted OAR calculated?
There are three possible ways that the budgeted OAR could be calculated: on a unit basis, on labour hours or machine hours. Regardless of which method is used, the purpose of the OAR is the same – to divide the estimated overhead costs between the number of units that will be produced and sold so that enough money is made in order to pay, for example, rent, insurance, and utility bills. Therefore, the calculation is:
Budgeted overhead amount ÷ estimated units or hours = OAR per unit or hour
So the budgeted OARs, rounded to two decimals are:
How is the budgeted OAR used to calculate the overhead cost per unit?
If the overhead absorption method is per unit, the OAR and the overhead cost per unit will be the same. However, if the method is an hourly basis then it is unlikely to take exactly an hour to produce one unit, so the time requirement has to be established. The calculation is:
Estimated hours ÷ estimated units = hours per unit
So the hours per unit are:
In order to calculate the overhead cost per unit, the OAR rate is multiplied by the hours per unit:
Budgeted OAR x hours per unit = Overhead cost per unit
So the overhead costs per unit, rounded to two decimals are:
If direct costs of £38 per unit are added, the cost per unit can be calculated:
Why calculate both the OAR and the overhead cost per unit?
When only a single product is made, the overhead cost per unit is the same regardless of the absorption method. This is because ultimately the full amount needs to be ‘absorbed’ into the total cost of the unit.
But when multiple products are made, there is a difference. If Myers Manufacturing made another product, there would be more units the overheads could be shared between because they are fixed costs and do not change with activity levels.
If the following information related to a second product:
Then the rates to absorb the £25,000 overheads across the two products would be:
And the overhead cost per unit figures for the first product would change to:
Meaning the cost per unit would become:
Conclusion
The title question can now be answered. Different budgeted overhead absorption rates affect unicost but only when the overhead cost is shared between multiple products.
KEY TAKEAWAYS
Questions often require breaking down into sub-questions in order to be fully understood. In this case, knowing that organisations need to generate enough income to cover the indirect costs of running the business, as well as the direct costs of their products and/or services, and generate profit is important. It is also key to understand that because overheads are fixed, so do not change with activity levels, making multiple products will impact the overhead cost per unit, which will have repercussions for the total cost per unit.
The Association of Accounting Technicians. 30 Churchill Place, London E14 5RE. Registered charity no.1050724. A company limited by guarantee (No. 1518983).