Absorption Costing

Comprehensive practice questions covering the principles, formulas, and common exam pitfalls of absorption costing based on the lecture notes.

What is the definition of absorption costing?

Absorption costing is a full costing method that includes direct costs plus production overheads in the cost of a product or job.

What is the primary aim of using absorption costing?

The aim is to find the full production/factory cost so that the business can make pricing, planning, and inventory valuation decisions.

What are the three components that make up the full production cost (factory cost)?

$$\text{Direct materials} + \text{Direct labour} + \text{Production overheads}$$

How do direct costs differ from indirect costs (overheads)?

Direct costs (e.g., direct materials, direct labour) are traceable directly to a product or service, while indirect costs cannot be traced directly and must be allocated, apportioned, or absorbed.

What is the formula for the Overhead Absorption Rate (OAR)?

$$OAR = \frac{\text{Total budgeted overheads}}{\text{Total budgeted activity}}$$

Why should budgeted figures be used for OAR calculation instead of actual figures?

The business needs the OAR at the start of the year to price jobs before actual overheads are known.

When is it suitable to use 'Labour hours' as the activity base for OAR?

When production is labour-intensive and labour time drives overhead use.

When is 'Machine hours' the preferred activity base for OAR?

When production is machine-intensive and machines drive overhead use.

In overhead analysis, what is the difference between allocation and apportionment?

Allocation means charging a cost directly to one department that clearly caused it, while apportionment means sharing a cost between departments using a fair basis.

What is the common apportionment basis for 'Rent and rates' and 'Heating / light and heat'?

Floor space.

What is the common apportionment basis for 'Electricity / power'?

$kWh$ used.

What is the common apportionment basis for 'Machinery depreciation'?

Machinery value / gross book value.

What is the formula to calculate a department's overhead share during apportionment?

$$\text{Department overhead} = \frac{\text{Department basis}}{\text{Total basis}} \times \text{Total overhead}$$

What is the purpose of a service department in an organization's context?

A service department supports production departments but does not directly make the product.

What must happen to service department costs before calculating the production department OARs?

Service department costs must be reapportioned to production departments until the service department total is usually zero ($£0$).

How is the absorbed overhead for a specific job calculated?

$$\text{Absorbed overhead} = OAR \times \text{job activity}$$

What is the formula for calculating Selling Price using a Mark-up?

$$\text{Selling price} = \text{Cost} \times (1 + \text{mark-up \%})$$

What is the formula for calculating Selling Price using a Margin?

$$\text{Selling price} = \frac{\text{Cost}}{1 - \text{margin \%}}$$

How does the treatment of fixed production overheads differ between Absorption and Marginal costing?

In absorption costing, fixed production overheads are treated as product costs; in marginal costing, they are treated as period costs.

How does inventory valuation differ between Absorption and Marginal costing?

Absorption costing inventory includes variable production costs plus fixed production overheads, whereas marginal costing inventory includes variable production costs only.

Why can absorption costing be considered less precise than other methods?

Because overhead apportionment may be arbitrary.

According to the 'Exam answer layout to memorise', what is the final step in the process?

Calculate selling price using either mark-up or margin.

What are two common exam mistakes regarding OAR and department types?

Using labour hours when the department uses machine hours, and using actual figures instead of budgeted figures for the OAR.