What are the different methods for allocating overhead costs in absorption costing?

1 Direct labor hours

One of the simplest methods for allocating overhead costs in absorption costing is to use direct labor hours as the allocation base. This means that you divide the total overhead costs by the total direct labor hours worked during the period, and then multiply the result by the number of direct labor hours used for each product or department. This method assumes that the overhead costs are proportional to the direct labor hours, and that products or departments that use more labor also consume more overhead resources. However, this method may not be accurate or fair if the overhead costs are driven by other factors, such as machine usage, material handling, or product complexity.

2 Machine hours

Another method for allocating overhead costs in absorption costing is to use machine hours as the allocation base. This means that you divide the total overhead costs by the total machine hours operated during the period, and then multiply the result by the number of machine hours used for each product or department. This method assumes that the overhead costs are proportional to the machine hours, and that products or departments that use more machines also consume more overhead resources. This method may be more appropriate than direct labor hours if the production process is capital-intensive and automated, and if the overhead costs are related to machine maintenance, depreciation, or power consumption. However, this method may not capture the differences in the types and costs of machines used for different products or departments.

3 Activity-based costing

A more sophisticated method for allocating overhead costs in absorption costing is to use activity-based costing (ABC). This means that you identify the main activities that generate overhead costs, such as ordering materials, setting up machines, inspecting quality, or delivering products. Then, you assign the overhead costs to each activity based on the resources they consume, such as labor, materials, or space. Next, you determine the cost drivers for each activity, such as number of orders, number of setups, number of inspections, or number of deliveries. Finally, you allocate the overhead costs to each product or department based on the cost drivers they use for each activity. This method assumes that the overhead costs are driven by the activities performed, and that products or departments that use more activities also consume more overhead resources. This method may be more accurate and fair than direct labor hours or machine hours if the production process is complex and diverse, and if the overhead costs vary significantly by activity and product.

4 Budgeted versus actual

Another aspect to consider when allocating overhead costs in absorption costing is whether to use budgeted or actual figures. Budgeted figures are based on the planned or expected level of production and overhead costs for the period, while actual figures are based on the realized or actual level of production and overhead costs for the period. Using budgeted figures can help to avoid fluctuations and distortions in the cost of goods sold and the inventory value due to changes in the overhead costs or the production volume. However, using actual figures can help to reflect the true cost of production and the efficiency of the operations. The choice between budgeted and actual figures depends on the purpose and frequency of the costing reports, and the degree of control and responsibility over the overhead costs.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?