Reasons for Absorption of Overheads
The following are a list of situations where analysis of overheads will be useful in evaluation of the relevant cost data. These situations include:
a. The control of overhead expenditures
There must be a link between overhead costs and the manager responsible for its control. This is best achieved by having the planned level of overhead costs for each cost center compared to the actual cost incurred in order that any differences may be investigated and corrective measures taken.
b. Charging of overheads to cost units
Overheads relating to a specific job must be charged to that product, job or process in order to come up with the correct cost of the cost object or unit. Each product or job should share a part of indirect costs of the business.
c. Valuation of work in progress
Work in progress is partly completed goods in manufacturing industries. Such work in progress must be valued at the end of an accounting period to enable calculate profit and derive a balance sheet. For manufacturing firms, work in progress (work in process) forms part of the inventory. Therefore, it becomes necessary to deter- mine with accuracy the value of the work in process which comprises prime cost and manufacturing overheads.
d. Valuation of abnormal losses
Abnormal losses arise when the actual output given the budgeted input yields less than the expected output. (Abnormal loss = Expected output – actual output). That is, the actual loss incurred exceeds the expected or normal loss. (Abnormal loss
= Actual loss – Normal loss). They arise due to unanticipated inefficiencies in production. Such losses need to be charged to the departments that incur them for efficiency analysis purposes.
e. Profit measurement
The valuation of work in progress and finished goods stock will affect the profit reported. The basis on which production overhead has been absorbed by cost units will, therefore, have a direct influence on the level of profit reported during the period.
f. Decision making
Relevant costs are the only ones that trigger decision making process. Production overhead costs may be allocated to a department (cost center) or apportioned to it using some arbitrary apportionment basis. In other cases, overhead cost may be a fixed or variable behavior pattern as activity changes. The total costs associated with cost center and the organization as a whole affect the kind of decisions made by the management. But such relevant costs need to be incremental and future costs (not sunk costs) that are controllable by management.
