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Posted on March 28th, 2013, by

i. Overhead recovery approach
First of all, it is necessary to calculate the unit production cost and selling price, using the overhead recovery (absorption) approach. Unit production cost has two components: variable cost and overhead cost. In order to determine overhead cost for each product, absorption of overhead costs should be used. Direct labor cost percentage is used to determine the overhead absorption rates.

Table 1 shows the calculation of overhead absorption rates for all three products:
Basic Super Deluxe

Production time:direct labour hours per component.
at £12 per hour 12 20 40

Production labour cost per component £144 £240 £480
Production and sales in units 10000 2000 4000

Total labour cost per component £1 440 000 £480 000 £1 920 000

Total labour cost £3 840 000
Overhead absorption rates (direct labour cost percentage) 37.5% 12.5% 50.0%

Total overhead £1 380 000
Absorption costs per components £517 500.0 £172 500.0 £690 000.0
Absorption costs per unit £51.75 £86.25 £172.50

Table 1. Absorption costs per components and per unit using overhead absorption
In this table, production labour cost per component is calculated as production time (direct labour hours) multiplied by £12; total labour cost per component is calculated as production and sales in units multiplied by production labour cost per component. Total labour cost is the sum of labour costs for all three components; finally, overhead absorption rates per components are calculated as direct labor cost for the component divided by the total labor cost.

According to the overhead absorption rates, absorption costs per component (overhead absorption rate multiplied by total overhead) and absorption costs per unit (absorption costs per component divided by the number of units).

Table 2 illustrates the process of calculating unit production cost and selling price for every component using the recovery approach.
Basic Super Deluxe
Production labour cost per component £144.00 £240.00 £480.00
Material cost £ per component £10.00 £30.00 £50.00
Overhead cost per unit £51.75 £86.25 £172.50
Unit production cost £205.75 £356.25 £702.50
Selling price £246.90 £427.50 £843.00
Table 2. Unit production cost and selling price according to the absorption cost approach
Unit production cost is calculated as the sum of direct costs (labor and material) plus overhead cost per unit. Selling price is determined as unit production cost plus 20% of unit production cost.
ii. Activity-based costing (ABC) approach
For activity-based costing, it is necessary to determine the cost driver rates for all activities. They can be determined by dividing the activity cost pool by the annual number of cost drivers. Table 3 contains these rates.
Activity Cost driver Activity cost pool (£) Annual number of cost drivers Cost driver rates (£)
Preparation Component weight in kg £720 000.00 120000 £6.00
Pressing Component weight in kg £240 000.00 120000 £2.00
Testing Number of tests £100 000.00 100 £1 000.00
Finishing Number of components £320 000.00 16000 £20.00
Table 3. Cost driver rates for all activities
After this, it is necessary to calculate the number of cost drivers associated with every component and activity. Table 4 contains the calculations for all three components.
Basic Super Deluxe
Preparation 46153.85 18461.54 55384.62
Pressing 46153.85 18461.54 55384.62
Testing 30 10 60
Finishing 10000 2000 4000

Weight of finished components in kg 2 4 6
Production and sales in units 10000 2000 4000
Total weight of components in kg 20000 8000 24000
Allocation percentage 38.46% 15.38% 46.15%
Table 4. Cost drivers associated with every component
For finishing, cost driver is the number of components, which is already determined in the initial budget. For testing, all 100 tests will be applied to components in this way: Basic 30%, Super 10%, Deluxe 60%. Thus, for 100 tests, 30 of them will be done for Basic products, 10 tests for Super products, and 60 tests for Deluxe products.
For preparation and pressing, there is another allocation issue: cost driver for these activities is component weight (in kg), estimated as 120000 cost drivers per year. At the same time, total weight of ready components in kg is 52000. This shows that initial component weight might be larger than the weight of a finished component; however, there is no information whether this reduction of weight is different for different components. In Table 4, it is suggested that initial component weight is proportional to the weight of ready components. Calculations in the bottom of Table 4 show the allocation percentage (calculated as total weight of components divided by the weight of each component). This percentage is used to determine the amount of cost drivers for preparation and testing; to get these values, overall number of cost drivers (120000) was multiplied by the allocation percentage for every component.
Using the results of Table 4, it is possible to allocate overhead costs using the activity-based costing method. Table 5 shows these calculations.

Basic Super Deluxe

Activity Cost driver rate Number of cost drivers Total cost. £ Number of cost drivers Total cost. £ Number of cost drivers Total cost. £
Preparation £6.00 46153.85 £276 923.08 18461.54 £110 769.23 55384.62 £332 307.69
Pressing £2.00 46153.85 £92 307.69 18461.54 £36 923.08 55384.62 £110 769.23
Testing £1 000.00 30 £30 000.00 10 £10 000.00 60 £60 000.00
Finishing £20.00 10000 £200 000.00 2000 £40 000.00 4000 £80 000.00
Total cost £599 230.77 £197 692.31 £583 076.92
Total cost per unit £59.92 £98.85 £145.77
Table 5. Overhead cost calculations using the ABC-based costing
Using the overhead cost per unit, it is possible to determine total unit cost, according to ABC-based costing (as direct costs labor and material plus overhead), and selling price (unit cost plus 20% of the unit cost). Table 6 shows the results of these calculations.
Basic Super Deluxe
Production labour cost per component £144.00 £240.00 £480.00
Material cost. £ per component £10.00 £30.00 £50.00
Overhead cost per unit £60.00 £99.00 £146.00
Unit production cost £214.00 £369.00 £676.00
Selling price £256.80 £442.80 £811.20
Table 6. Unit production cost and selling price according to the ABC-based costing approach

B. Limitations of absorption costing (361 words)
Absorption of overhead costing is based on the allocation of resources according to cost centers and generally uses one or several factors (for different cost centers) in order to include overhead costs into the cost of production. This approach is good for stock valuation and control of costs (Coombs & Hobbs & Jenkins, 2005); however, there are certain deficiencies of this method of costing.
First of all, absorption costing suggests that fixed overhead costs are not changing during a given time period, and should be estimated at the start of this period (Weygandt & Kimmel & Kieso, 2009). This can be true for a short period of time, but for longer periods this assumption is not true, and then absorption costing might yield incorrect results. Moreover, using one factor (e.g. labor, material or other resource) as a basis for costing is not appropriate, since the activities of cost centers might significantly differ from each other. For example, in the case of Poor Parts Limited, the main cost driver for preparation and pressing departments is the weight of components, and for finishing departments the main factor is the number of components. Thus, absorption costing should be applied to every department using a separate cost driver. This method does not address non-factory overheads, which is also a significant deficiency (Weygandt & Kimmel & Kieso, 2009).
Moreover, overhead recovery costing technique can provide incorrect information for decision-making, since this approach uses broad averages for determining unit product costs. The case of Poor Parts Limited shows that under absorption costing, two products (Basic and Super) were overvalued, and Deluxe product was overvalued. The above-mentioned example shows that absorption costing might lead to incorrect pricing. In addition to this, the effectiveness of absorption costing depends on the successful choice of cost centers (Coombs & Hobbs & Jenkins, 2005). Overhead costs are associated with production departments, which does not adequately reflect the preparatory processes. If there are flaws in the identification of cost centers or their budgets, the price of the products will be flawed. ABC-based costing method represents a more correct and flexible procedure of determining unit price, and gives more accurate information for managerial decision-making.

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