Management Accounting

Absorption Costing

Absorption costing is the original technique to deal with indirect costs, therefore, it is also called “Traditional Costing”. This method is an easy way to allocate overheads to products and services in practice although it can give inaccurate figures allocated to different products and services in complex manufacturing scenarios. In my experience, students find this method confusing as there is no hard and fast rule to deal with overheads. Accountants in different organisations use their own judgement on how best to divide the common costs i.e., overheads among different products and services.

To understand absorption costing, imagine that overheads are a bucket full of water and products/services being produced are sponges on a moving line. Each sponge (unit) will absorb some water in such a way that the last sponge produced will absorb the last bit of water from the bucket. How much each sponge absorbs will depend on the size of the sponge (material), how long it stays in the bucket (hours) and other issues like absorbability of the sponge (skills required, quality of material, quality control, machinery required and so on).

Absorption costing uses a hypothetical “basis” to absorb the overheads into different products. An assumption is made that all indirect costs are incurred due to a reason called “basis of absorption (BOA).” Total units of BOA (e.g. unit, hours etc) are established which are used to calculate “Overheads Absorption Rate (OAR).” An OAR is a unit with a monetary value (£, $ etc) in which total overheads are divided. The following formula is used to calculate OAR

OAR = (Total Overheads)/(Total units of BOA )

The most obvious basis (reason) is the “number of units” i.e. the business has spent money on rent, rates, electricity, cleaning, maintenance etc because it was producing units (e.g. cars) in its production facility.

Departmental Basis of Absorptions

Modern production facilities usually have multiple departments e.g., stores, cutting, assembly, finishing and packaging etc. for a furniture making factory. The working methods can vary and a production factor can have different significance in different departments. Therefore, a different BOA should be chosen for each department. For example,

-Stores can absorb its overheads on the basis of how much space material takes,

-Cutting department can be based on machine hours assuming it is automated or primarily machine based,

-Assembly department can be based on direct labour hours if majority of work is carried out by human

-Finishing department overheads could be absorbed on the basis of skilled labour hours

-Packaging department can absorb its overheads on the basis of cost of packaging material, if that is significant, or labour cost if packaging is carried out by labour

Departmental Overhead Absorption Rates

A different BOA in each department which will lead to a different departmental OARs. The formula to calculate OAR will slightly change as below

Departmental OAR = (Departmental total Overheads)/(Departmental BOA)

The above formula suggests that we need to understand how departmental Overheads are calculated so we can have both variables for the formula.

Apportionment of common overheads to different departments

In the previous section, we modified the formula to calculate departmental OAR and replaced total overheads with total departmental overheads in the numerator. Calculating total factory overheads can be a simple task as it can be done by adding up all the bills etc. However, calculating departmental overheads can be a big challenge in real life. This is not just because of arithmetical issues but there are also social issues which makes this task burdensome. Although there will be many items of costs which can be directly associated and allocated to different departments, e.g., departmental managers and staff salaries, maintenance and depreciation of department’s assets etc, there are always costs which are for the whole factory or business which will require dividing and allocation to different departments e.g., rent, rates, building insurance, lighting and heating, security staff, etc. This process is called “apportionment of common overheads” which is carried out by using a basis of apportionment.

This apportionment should be fair however, fairness is quite a subjective thing. A basis deemed reasonable by one manager may not be suitable for another manager. As departmental managers always try to keep their departmental costs low, any basis which would increase their departments costs in a bigger proportion then other departments will not be acceptable. Below are the examples of common overheads which may require apportionment to different departments. We will discuss how these should be apportioned and why a basis may be more suitable in each case.

Rent, rates, lighting and heating/air conditioning:

These costs arise due to the size of the building. It will be logical to apportion these costs on the basis of how much space e.g., square meters or square feet, each department is occupying. This can enhance efficiency in space usage and can reduce these costs in the long run as all managers would try to use as less space as possible to avoid getting extra costs. It is assumed here that heating and air conditioning is centralised in this case. Some departments may require extra air conditioning costs, for example, IT as servers require cooling down, therefore, this cost may be apportioned on the electricity usage basis rather than area occupied.


This cost should be apportioned on the basis usage which can be measured by installing internal meters. However, if that is not possible then a good estimate should be made. Departments which are machinery intense will use a lot more electricity even if it occupies less area.

Machine Depreciation:

This is one of the biggest indirect cost in the businesses where production is automated. The total cost of installing the machines is spread over the life of the machines and a portion of the total cost is included in the yearly costs over the life of the machines. It is logical to spread this cost on the basis of value of the machines in each department. Departments which rely heavily on machines will get a bigger proportion of this cost.


There are various types of insurance which a business may have to pay for e.g., Building insurance, contents/ Machinery and equipment insurance, employee and customers insurance etc.

Each insurance cost should be apportioned on the level of risk basis e.g., which departments can cause more damage to the building due to vibrations, fire etc? Which department has expensive equipment? Or which department involves riskier work for employee insurance. Accidents records can be used to determine the percentage insurance which can encourage managers to take actions to reduce accidents as this will reduce the cost apportionment to their department.

There will be many other costs needs apportionment and different organisations may have different basis for all of the costs. The discussion above should be enough to give you an idea of the issue and why this exercise may be a critical part of a manager’s job.

After determining BOA and calculating total overheads for each department, OARs can be calculated. Departmental overheads will be absorbed into each product as we have done above for the whole factory. The cost card will change to reflect absorption of overheads by different departments.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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