5.5 Overhead absorption rates – ABC

In activity-based costing (ABC), the concept of overhead absorption rates is not typically used as it is in traditional absorption costing. Traditional absorption costing calculates a predetermined overhead rate based on a single cost driver, such as direct labor hours or machine hours, and applies it to allocate overhead costs to products or services.

In ABC, the focus is on identifying and understanding the activities that drive costs within an organization, rather than relying on a predetermined rate. ABC allocates costs to products or services based on their actual consumption of activities and resources. It involves identifying cost drivers specific to each activity and measuring the resources consumed by those activities.

Instead of using an overhead absorption rate, ABC uses a more detailed and specific approach to allocate overhead costs. The steps involved in allocating overhead costs in ABC include:

1. Identifying activities: Activities that contribute to the production or delivery of products or services are identified.
2. Determining cost drivers: For each activity, cost drivers are identified. These are the factors that cause the activity to occur and consume resources. Cost drivers can be different for each activity and may include metrics such as machine hours, labor hours, number of setups, or square footage utilized.
3. Measuring activity consumption: The actual consumption of activities by products or services is measured. This can be done through direct observation, time studies, or other data collection methods.
4. Allocating costs: Based on the consumption of activities by products or services, costs are allocated to them. The costs are distributed based on the proportionate usage of the identified cost drivers.

QUESTION ONE

Wangu Manufacturing Company Ltd. is located at the industrial area in Nairobi.  The company uses four different machine groups, A, B, C and D in its manufacturing process.

The overhead costs budget for the year ending 31 December 2003 is as follows:

	Sh. ‘000’
Indirect wages Holiday pay and national insurance Supervision Machine maintenance (wages) Supplies Power Tooling costs Insurance of machinery Insurance of buildings Depreciation Rent and rates	12,000 10,200 16,680 14,000 2,600 4,200 13,300 2,520 1,600 10,500 12,400
	100,000

At present, overheads are absorbed into the cost of the company’s products by means of a single direct wages percentage of 70 percent.  The company wishes to change to machine hour overhead absorption rate for each of its four different machine groups. The following data is available for each of the four machine groups:

	Machine groups
	A	B	C	D	Total
	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’
Tooling costs Supervision Supplies Cost of machines   Machine maintenance hours Number of direct workers Total number of workers Floor space (square feet) Machine running hours Machine power rating (kilowatts)	5,400 5,170 1,200 32,000   3,000 6 26 3,000 30 55,000	4,100 4,720 800 24,000   2,000 6 34 2,400 60 27,000	2,600 3,630 200 10,000   4,000 2 15 1,600 25 8,000	1,200 3,160 400 18,000   1,000 2 10 1,000 10 15,000	13,300 16,680 2,600 84,000   10,000 16 85 8,000 125 105,000

Required:

a.Machine hour overhead absorption rate for each of the four groups of machines.

b.The overhead cost to be absorbed by product XY123 if:

i)It utilizes the following time resources of the indicated machine groups:

Hours                                  Machine group

8                    A

 3        B

   1                                         C

    4                                         D

ii)Direct labour cost is Sh. 22,000,000 and the direct wages percentage

Solution:

a)Computation of Overhead Absorption Rates per Machine Hour

Overhead	Absorption basis	A Sh.’000’	B Sh.’000’	C Sh.’000’	D Sh.’000’	Total Sh.’000’
Indirect wages	No. of indirect workers	3,478	4,870	2,261	1,391	12,000
Holiday pay & National Insurance	No. of workers (Total)	3,210	4,080	1,800	1,200	10,200
Supervision	Actual	5,170	4,720	3,630	3,160	16,680
Machine maintenance (wages)	Machine maintenance hours	4,200	2,800	5,600	1,400	14,000
Supplies	Actual	1,200	800	200	400	2,600
Power	Machine power	2,200	1,080	320	600	4,200
Tooling costs	Actual	5,400	4,100	2,600	1,200	13,300
Insurance – Machinery	Cost of machines	960	720	300	540	2,520
Insurance – buildings	Floor space	600	480	320	200	1,600
Depreciation	Cost of machines	4,000	3,000	1,250	2,250	10,500
Rent & rates	Floor space	4,650	3,720	2,480	1,550	12,400
Total		34,978	30,370	20,761	13,891	100,000
Therefore No. of machine hours:		30	60	25	10
Absorption rate per machine hour		1,165.93	506.17	830.44	1,389.1

b) Product XY 123

(i)			Absorption rate	No. of Hours	Overhead Absorbed Sh.’000’
		A B C D	1,165.93    506.17    830.44 1,389.10	8 3 1 4	9,327.44 1,518.51 830.44   5,556.40
					17,232.79

(ii)            Overhead:

                                        =          70% of direct wages

                                        =         70% x 22,000,000 = 15,400,000