## Manufacturing Overheads — The Absorption Process
### Process Flow
```
Estimate → Collect → Allocate/Apportion → Re-apportion → Absorb into Products → Treat Over/Under Absorption
```
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### Step 1: Estimation of Overheads
- Based on past figures adjusted for known future changes
- Done in advance — pre-determined rates allow timely product costing without waiting for period-end actuals
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### Step 2: Collection via Standing Orders
- Sources: Invoices, stores requisitions, wage analysis book, journal entries
- Standing Orders (= Service Orders): Authorise indirect expenditures by category
- Each category gets a unique standing order number continued year-to-year
- Management determines the level of analysis and naming based on industry needs
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### Step 3: Allocation vs. Apportionment
| Method | When Used | Basis |
|---|---|---|
| Cost Allocation | When cost can be directly traced to one cost centre | Whole cost assigned to that centre |
| Cost Apportionment | When cost cannot be directly traced (benefits multiple centres) | Rational basis (e.g., floor area, number of workers, machine hours) |
Example of apportionment: Works manager's salary cannot be traced to one department → apportion it across departments based on number of workers or time spent.
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### Step 4: Re-apportionment (Secondary Distribution)
- Service departments (canteen, maintenance, power house, stores) do not produce output
- Their costs must be transferred to production departments, since products are only made in production departments
- Various methods: Direct Method, Step Ladder Method, Repeated Distribution Method, Simultaneous Equation Method
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### Step 5: Absorption using Pre-Determined OAR
$$\text{Overhead Absorption Rate (OAR)} = \frac{\text{Budgeted Overhead}}{\text{Budgeted Activity Level (hours or units)}}$$
Each unit produced absorbs its share of factory overheads automatically through the OAR.
Common bases for OAR:
- Direct Labour Hours
- Machine Hours
- Units of Output
- Percentage of Direct Wages
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### Step 6: Treatment of Over/Under Absorption
| Situation | Meaning | Treatment |
|---|---|---|
| Over-absorption | Absorbed OH > Actual OH | Credit to Costing P&L (profit) |
| Under-absorption | Absorbed OH < Actual OH | Debit to Costing P&L (loss) |
Investigate reasons: volume variance (actual ≠ budgeted hours), expenditure variance (actual cost ≠ budgeted cost)
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### Purpose of the Entire Process
1. Equitable charging — every product bears its fair share of total factory overheads
2. Timely costing — predetermined rates allow products to be costed during the year without waiting for actual figures