ICAI Notes- Overheads: Absorption Costing Method | Cost and Management Accounting for CA Intermediate PDF Download

 Page 1


 
    
 
 
CHAPTER 
4 
 
 OVERHEADS-
 ABSORPTION 
 COSTING METHOD 
 
After studying this chapter, you would be able to- 
? Discuss the meaning of Overheads-Production, 
Administrative and Selling & Distribution. 
? Discuss the meaning and methods of allocation, 
apportionment and absorption of overheads. 
? Discuss the meaning and treatment of under-absorption 
and over-absorption of overheads and apply the same in 
cost computation. 
? State the accounting and control of administrative, selling 
and distribution overheads.  
? Discuss and apply the various methods to calculate 
overhead rate. 
 
 
 
LEARNING OUTCOMES 
© The Institute of Chartered Accountants of India
Page 2


 
    
 
 
CHAPTER 
4 
 
 OVERHEADS-
 ABSORPTION 
 COSTING METHOD 
 
After studying this chapter, you would be able to- 
? Discuss the meaning of Overheads-Production, 
Administrative and Selling & Distribution. 
? Discuss the meaning and methods of allocation, 
apportionment and absorption of overheads. 
? Discuss the meaning and treatment of under-absorption 
and over-absorption of overheads and apply the same in 
cost computation. 
? State the accounting and control of administrative, selling 
and distribution overheads.  
? Discuss and apply the various methods to calculate 
overhead rate. 
 
 
 
LEARNING OUTCOMES 
© The Institute of Chartered Accountants of India
 
 
 
4.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION  
Overheads are the expenditure which cannot be conveniently traced to or 
identified with any particular cost unit. Such expenses are incurred for output 
generally and not for a particular work order e.g., wages paid to watch and ward 
staff, heating and lighting expenses of factory etc. Overheads are also very 
important cost element along with direct materials and direct employees. Often in 
a manufacturing concern, overheads exceed direct wages or direct materials and 
at times even both put together. On this account, it would be a grave mistake to 
ignore overheads either for the purpose of arriving at the cost of a job or a 
product or for controlling total expenditure. 
Overheads also represent expenses that have been incurred in providing certain 
ancillary facilities or services which facilitate or make possible the carrying out of 
the production process; by themselves these services are not of any use. For 
instance, a boiler house produces steam so that machines may run and, without 
the generation of steam, production would be seriously hampered. But if 
machines do not run or do not require steam, the boiler house would be useless 
and the expenses incurred would be a waste. 
Overheads are incurred not only in the factory of production but also on 
administration, selling and distribution. 
 1. 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
Page 3


 
    
 
 
CHAPTER 
4 
 
 OVERHEADS-
 ABSORPTION 
 COSTING METHOD 
 
After studying this chapter, you would be able to- 
? Discuss the meaning of Overheads-Production, 
Administrative and Selling & Distribution. 
? Discuss the meaning and methods of allocation, 
apportionment and absorption of overheads. 
? Discuss the meaning and treatment of under-absorption 
and over-absorption of overheads and apply the same in 
cost computation. 
? State the accounting and control of administrative, selling 
and distribution overheads.  
? Discuss and apply the various methods to calculate 
overhead rate. 
 
 
 
LEARNING OUTCOMES 
© The Institute of Chartered Accountants of India
 
 
 
4.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION  
Overheads are the expenditure which cannot be conveniently traced to or 
identified with any particular cost unit. Such expenses are incurred for output 
generally and not for a particular work order e.g., wages paid to watch and ward 
staff, heating and lighting expenses of factory etc. Overheads are also very 
important cost element along with direct materials and direct employees. Often in 
a manufacturing concern, overheads exceed direct wages or direct materials and 
at times even both put together. On this account, it would be a grave mistake to 
ignore overheads either for the purpose of arriving at the cost of a job or a 
product or for controlling total expenditure. 
Overheads also represent expenses that have been incurred in providing certain 
ancillary facilities or services which facilitate or make possible the carrying out of 
the production process; by themselves these services are not of any use. For 
instance, a boiler house produces steam so that machines may run and, without 
the generation of steam, production would be seriously hampered. But if 
machines do not run or do not require steam, the boiler house would be useless 
and the expenses incurred would be a waste. 
Overheads are incurred not only in the factory of production but also on 
administration, selling and distribution. 
 1. 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
OVERHEADS-ABSORPTION COSTING METHOD 
    
 4.3 
 2. CLASSIFICATION OF OVERHEADS 
 Description Example 
By Function   
Factory or 
Manufacturing 
or Production 
Overhead 
Manufacturing overhead is 
the indirect cost incurred for 
manufacturing or production 
activity in a factory. 
Manufacturing overhead 
includes all expenditures 
incurred from the 
procurement of materials to 
the completion of finished 
product. 
(i) Stock keeping expenses, 
(ii)  Repairs and 
maintenance of plant,  
(iii) Depreciation of factory 
building,  
(iv) Indirect labour,  
(v) cost of primary packing  
(vi) Insurance of plant and 
machinery etc. 
Production overhead 
include administration 
costs relating to 
production, factory, 
works or manufacturing. 
Office and 
Administrative 
Overheads 
Office and Administrative 
overheads are expenditures 
incurred on all activities 
relating to general 
management and 
administration of an 
organisation. It includes 
formulating the policy, 
directing the organisation 
and controlling the 
operations of an undertaking 
which is not related directly 
to production, selling, 
distribution, research or 
development activity or 
function. 
(i) Salary paid to office 
staffs,  
(ii) Repairs and maintenance 
of office building,  
(iii) Depreciation of office 
building  
(iv) postage and stationery,  
(v) Lease rental in case of 
operating lease (in case 
of finance lease, lease 
rental excluding finance 
cost)  
(vi) accounts and audit 
expenses etc.  
 2. 
© The Institute of Chartered Accountants of India
Page 4


 
    
 
 
CHAPTER 
4 
 
 OVERHEADS-
 ABSORPTION 
 COSTING METHOD 
 
After studying this chapter, you would be able to- 
? Discuss the meaning of Overheads-Production, 
Administrative and Selling & Distribution. 
? Discuss the meaning and methods of allocation, 
apportionment and absorption of overheads. 
? Discuss the meaning and treatment of under-absorption 
and over-absorption of overheads and apply the same in 
cost computation. 
? State the accounting and control of administrative, selling 
and distribution overheads.  
? Discuss and apply the various methods to calculate 
overhead rate. 
 
 
 
LEARNING OUTCOMES 
© The Institute of Chartered Accountants of India
 
 
 
4.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION  
Overheads are the expenditure which cannot be conveniently traced to or 
identified with any particular cost unit. Such expenses are incurred for output 
generally and not for a particular work order e.g., wages paid to watch and ward 
staff, heating and lighting expenses of factory etc. Overheads are also very 
important cost element along with direct materials and direct employees. Often in 
a manufacturing concern, overheads exceed direct wages or direct materials and 
at times even both put together. On this account, it would be a grave mistake to 
ignore overheads either for the purpose of arriving at the cost of a job or a 
product or for controlling total expenditure. 
Overheads also represent expenses that have been incurred in providing certain 
ancillary facilities or services which facilitate or make possible the carrying out of 
the production process; by themselves these services are not of any use. For 
instance, a boiler house produces steam so that machines may run and, without 
the generation of steam, production would be seriously hampered. But if 
machines do not run or do not require steam, the boiler house would be useless 
and the expenses incurred would be a waste. 
Overheads are incurred not only in the factory of production but also on 
administration, selling and distribution. 
 1. 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
OVERHEADS-ABSORPTION COSTING METHOD 
    
 4.3 
 2. CLASSIFICATION OF OVERHEADS 
 Description Example 
By Function   
Factory or 
Manufacturing 
or Production 
Overhead 
Manufacturing overhead is 
the indirect cost incurred for 
manufacturing or production 
activity in a factory. 
Manufacturing overhead 
includes all expenditures 
incurred from the 
procurement of materials to 
the completion of finished 
product. 
(i) Stock keeping expenses, 
(ii)  Repairs and 
maintenance of plant,  
(iii) Depreciation of factory 
building,  
(iv) Indirect labour,  
(v) cost of primary packing  
(vi) Insurance of plant and 
machinery etc. 
Production overhead 
include administration 
costs relating to 
production, factory, 
works or manufacturing. 
Office and 
Administrative 
Overheads 
Office and Administrative 
overheads are expenditures 
incurred on all activities 
relating to general 
management and 
administration of an 
organisation. It includes 
formulating the policy, 
directing the organisation 
and controlling the 
operations of an undertaking 
which is not related directly 
to production, selling, 
distribution, research or 
development activity or 
function. 
(i) Salary paid to office 
staffs,  
(ii) Repairs and maintenance 
of office building,  
(iii) Depreciation of office 
building  
(iv) postage and stationery,  
(v) Lease rental in case of 
operating lease (in case 
of finance lease, lease 
rental excluding finance 
cost)  
(vi) accounts and audit 
expenses etc.  
 2. 
© The Institute of Chartered Accountants of India
 
 
 
4.4 
COST AND MANAGEMENT ACCOUNTING 
Selling and 
Distribution 
Overheads 
(i) Selling overhead: 
expenses related to sale 
of products and include 
all indirect expenses in 
sales management for 
the organisation. 
(ii) Distribution overhead: 
cost incurred on making 
product available for sale 
in the market. 
(i) Salesmen commission, 
(ii) Advertisement cost, 
(iii) Sales office expenses etc. 
 
 
(i) Delivery van expenses, 
(ii) Transit insurance, 
(iii) warehouse and cold 
storage expenses, 
(iv) secondary packing 
expenses etc. 
By Nature   
Fixed 
Overhead 
These are the costs which are 
incurred for a period, and 
which, within certain output 
and turnover limits, tend to 
be unaffected by fluctuations 
in the levels of activity 
(output or turnover). They do 
not tend to increase or de-
crease with the changes in 
output.   
(i) Salary paid to permanent 
employees,  
(ii)  Depreciation of building 
and plant and equipment, 
(iii)  Interest on capital, 
(iv)  Insurance.  
 
Variable 
Overhead 
These costs tend to vary with 
the volume of activity.  Any 
increase in the activity results 
in an increase in the variable 
cost and vice-versa.   
(i) Indirect materials, 
(ii) Power and fuel, 
(iii) lubricants, 
(iv) tools and spares etc. 
Semi-Variable 
Overheads 
These costs contain both fixed 
and variable components and 
are thus partly affected by 
fluctuations in the level of 
activity. 
(i) Electricity cost, 
(ii)  water cost, 
(iii) telephone and internet 
expenses etc. 
 
© The Institute of Chartered Accountants of India
Page 5


 
    
 
 
CHAPTER 
4 
 
 OVERHEADS-
 ABSORPTION 
 COSTING METHOD 
 
After studying this chapter, you would be able to- 
? Discuss the meaning of Overheads-Production, 
Administrative and Selling & Distribution. 
? Discuss the meaning and methods of allocation, 
apportionment and absorption of overheads. 
? Discuss the meaning and treatment of under-absorption 
and over-absorption of overheads and apply the same in 
cost computation. 
? State the accounting and control of administrative, selling 
and distribution overheads.  
? Discuss and apply the various methods to calculate 
overhead rate. 
 
 
 
LEARNING OUTCOMES 
© The Institute of Chartered Accountants of India
 
 
 
4.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION  
Overheads are the expenditure which cannot be conveniently traced to or 
identified with any particular cost unit. Such expenses are incurred for output 
generally and not for a particular work order e.g., wages paid to watch and ward 
staff, heating and lighting expenses of factory etc. Overheads are also very 
important cost element along with direct materials and direct employees. Often in 
a manufacturing concern, overheads exceed direct wages or direct materials and 
at times even both put together. On this account, it would be a grave mistake to 
ignore overheads either for the purpose of arriving at the cost of a job or a 
product or for controlling total expenditure. 
Overheads also represent expenses that have been incurred in providing certain 
ancillary facilities or services which facilitate or make possible the carrying out of 
the production process; by themselves these services are not of any use. For 
instance, a boiler house produces steam so that machines may run and, without 
the generation of steam, production would be seriously hampered. But if 
machines do not run or do not require steam, the boiler house would be useless 
and the expenses incurred would be a waste. 
Overheads are incurred not only in the factory of production but also on 
administration, selling and distribution. 
 1. 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
OVERHEADS-ABSORPTION COSTING METHOD 
    
 4.3 
 2. CLASSIFICATION OF OVERHEADS 
 Description Example 
By Function   
Factory or 
Manufacturing 
or Production 
Overhead 
Manufacturing overhead is 
the indirect cost incurred for 
manufacturing or production 
activity in a factory. 
Manufacturing overhead 
includes all expenditures 
incurred from the 
procurement of materials to 
the completion of finished 
product. 
(i) Stock keeping expenses, 
(ii)  Repairs and 
maintenance of plant,  
(iii) Depreciation of factory 
building,  
(iv) Indirect labour,  
(v) cost of primary packing  
(vi) Insurance of plant and 
machinery etc. 
Production overhead 
include administration 
costs relating to 
production, factory, 
works or manufacturing. 
Office and 
Administrative 
Overheads 
Office and Administrative 
overheads are expenditures 
incurred on all activities 
relating to general 
management and 
administration of an 
organisation. It includes 
formulating the policy, 
directing the organisation 
and controlling the 
operations of an undertaking 
which is not related directly 
to production, selling, 
distribution, research or 
development activity or 
function. 
(i) Salary paid to office 
staffs,  
(ii) Repairs and maintenance 
of office building,  
(iii) Depreciation of office 
building  
(iv) postage and stationery,  
(v) Lease rental in case of 
operating lease (in case 
of finance lease, lease 
rental excluding finance 
cost)  
(vi) accounts and audit 
expenses etc.  
 2. 
© The Institute of Chartered Accountants of India
 
 
 
4.4 
COST AND MANAGEMENT ACCOUNTING 
Selling and 
Distribution 
Overheads 
(i) Selling overhead: 
expenses related to sale 
of products and include 
all indirect expenses in 
sales management for 
the organisation. 
(ii) Distribution overhead: 
cost incurred on making 
product available for sale 
in the market. 
(i) Salesmen commission, 
(ii) Advertisement cost, 
(iii) Sales office expenses etc. 
 
 
(i) Delivery van expenses, 
(ii) Transit insurance, 
(iii) warehouse and cold 
storage expenses, 
(iv) secondary packing 
expenses etc. 
By Nature   
Fixed 
Overhead 
These are the costs which are 
incurred for a period, and 
which, within certain output 
and turnover limits, tend to 
be unaffected by fluctuations 
in the levels of activity 
(output or turnover). They do 
not tend to increase or de-
crease with the changes in 
output.   
(i) Salary paid to permanent 
employees,  
(ii)  Depreciation of building 
and plant and equipment, 
(iii)  Interest on capital, 
(iv)  Insurance.  
 
Variable 
Overhead 
These costs tend to vary with 
the volume of activity.  Any 
increase in the activity results 
in an increase in the variable 
cost and vice-versa.   
(i) Indirect materials, 
(ii) Power and fuel, 
(iii) lubricants, 
(iv) tools and spares etc. 
Semi-Variable 
Overheads 
These costs contain both fixed 
and variable components and 
are thus partly affected by 
fluctuations in the level of 
activity. 
(i) Electricity cost, 
(ii)  water cost, 
(iii) telephone and internet 
expenses etc. 
 
© The Institute of Chartered Accountants of India
OVERHEADS-ABSORPTION COSTING METHOD 
    
 4.5 
By Element   
Indirect 
materials 
Materials which do not 
normally form part of the 
finished product (cost object) 
are known as indirect 
materials.  
(i) Stores used for 
maintaining machines 
and buildings (lubricants, 
cotton waste, bricks etc.)  
(ii) Stores used by service 
departments like power 
house, boiler house, 
canteen etc. 
Indirect 
employee cost 
Employee costs which cannot 
be allocated but can be 
apportioned to or absorbed 
by cost units or cost centres 
is known as indirect 
employee. 
(i) Salary paid to foreman 
and supervisor. 
(ii) Salary paid to 
administration staff etc. 
Indirect 
expenses 
Expenses other than direct 
expenses are known as 
indirect expenses, that 
cannot be directly, 
conveniently and wholly 
allocated to cost centres. 
(i) Rates & taxes,  
(ii)  insurance, 
(iii)  depreciation, 
(iv)  advertisement expenses 
etc. 
By Control   
Controllable 
costs 
These are those costs which 
can be controlled by the 
implementation of 
appropriate managerial 
influence and proper policies.
(i) Materials cost, 
(ii) wages and salary, 
(iii) power and fuel etc. 
Uncontrollable 
costs 
Overhead costs which cannot 
be controlled by the 
management even after the 
implementation of appro-
priate managerial influence 
and proper polices are known 
as uncontrollable costs. 
(i) Rates and taxes, 
(ii) Depreciation, 
(iii) Interest on borrowings. 
© The Institute of Chartered Accountants of India