162 ACCOUNTING FOR MANAGERS
products/services is variable (or marginal) costing. Undervariable costing,the
product cost only includes variable production costs. Fixed production costs are
treated as period costs and charged to the Profit and Loss account. This method
avoids much of the overhead allocation problem, as most production overheads
tend to be fixed rather than variable in nature.
However, variable costing does not comply with SSAP9, the UK accounting
profession’sStatement of Standard Accounting Practiceon Stocks. SSAP9 requires
that the cost of stock should:
comprise that expenditure which has been incurred in the normal course
of business in bringing the product or service to its present location and
condition. Such costs will include all related production overheads.The effect of SSAP9 is to require companies to account – for financial reporting
purposes – on an absorption costing basis, as ‘all related production overheads’
include both fixed and variable production costs.
Absorption costing
Absorption costingis a system in which all (fixed and variable) production
overhead costs are charged to product/services using anallocation base(a measure
of activity or volume such as labour hours, machine hours, or the number of units
produced etc.). The allocation base used in absorption costing is often regarded
as arbitrary.
Under absorption costing, abudgeted overhead ratecan be calculated as either:
ža business-wide rate, or
ža cost centre overhead rate.
Abusiness-wide budgeted overhead rateis calculated by dividing the production
overheads for the total business by some measure of activity. Overhead rates can
also be calculated for each cost centre separately. Acost centreis a location within
the organization to which costs are assigned (it may be a department or a group of
activities within a department, see Chapter 2). Acost centre budgeted overhead rate
is a result of determining the overheads that are charged to each cost centre and
the activity of that cost centre. It is preferable to calculate a separate overhead rate
for each cost centre, as the costs and activity of each may be quite different.
The overhead charged to each cost centre must then be recovered as a rate based
on the principal unit of activity within a cost centre, typically direct labour hours,
machine hours or the number of units produced. We therefore calculate adirect
labour hour rateor amachinehourrateor arate per unit producedfor each production
cost centre, or for the business as a whole.
Under both methods, the budgeted overhead rate is:
estimated overhead expenditure for the period
estimated activity for the period