S OLUTION
(a) Prepare a statement showing the total overhead cost budgeted for each department
Market
Research
Department
Graphic
Design
Department
Advertising &
Promotions
Department
900
1,200
1,100
Direct Labour (hours)
3,200
€
€
45,000
60,000
55,000
150,000
6,000
4,000
10,000
20,000
26,100
20,880
13,020
60,000
sq m
Staff Training
4,219
5,625
5,156
15,000
DLH
IT Costs
3,170
5,000
1,830
10,000
IT Hours
Admin and support staff
salaries
22,500
30,000
27,500
80,000
DLH
Total Indirect Costs
(Overheads)
61,989
65,505
57,506
185,000
Direct labour (@€50 per hr)
€
Total
€
Indirect Costs (Overheads)
Direct Allocation
Rent
(b) Calculate an overhead absorption rate for each department based on the budgeted
direct professional hours (Direct Labour).
Market
Research
Department
Graphic
Design
Department
Advertising &
Promotions
Department
Overhead
61,989
65,505
57,506
DLH
900
1,200
1,100
OHAR =
OHAR based on DLH =
€68.88
€54.59
€52.28
(c) Briefly outline the advantages and disadvantages of using predetermined overhead
absorption rates.
Advantages

Absorption costing recognises that selling price must cover all costs incurred. If
absorption costing is used, then organisations should ensure that all costs are included
when setting selling prices.

Production cannot be achieved without incurring overheads, therefore all such costs,
should be included in stock valuations. This is in accordance with the requirements of
the accounting standard (SSAP 9) which requires that production cost should include all
costs incurred (including fixed overhead) in bringing the product to its current
condition and location.

Absorption costing recognises the importance of working at full capacity. The underand over-absorption (recovery) explained above can focus attention on the cost effect of
actual activity being different to the budget or capacity levels established prior to the
period. If an organisation fails to work to full capacity, then the overhead cost per unit
may be higher than necessary. This is because overhead cost is charged out to fewer
units.
Disadvantages

Absorption costing involves the apportionment of overhead, which can be subjective.
The resulting information can be misleading for management decision-making.

Profits can be manipulated in a manufacturing organisation by simply increasing
production without actually selling the additional items. Because fixed overhead is
included in stock valuation, increasing production without increasing sales will result in
a higher closing stock figure and hence a lower cost of sales and a higher profit figure.
Fixed overhead is transferred from the current period’s cost (reducing costs in the
profit statements) to a future period. Although this approach complies with accounting
concepts, it may encourage management to build excessive stock levels to achieve a
short-term profit increase.