What you'll learn
Every cost unit absorbs three kinds of cost: the materials that go into it, the labour that works on it, and a share of the overheads that could not be traced to it directly. This topic covers how each is measured and charged, and the three carry quite different difficulties.
Materials are straightforward to identify but need a pricing rule, because identical units bought at different prices are physically indistinguishable once in the store. Labour is straightforward to price but needs a remuneration method, and the method chosen changes both the cost per unit and the behaviour of the workforce. Overheads are the hard case: they cannot be traced at all, so they must be shared out by a route that is defensible rather than correct, and that sharing is where most of the marks in this topic sit.
By the end you should be able to value issues and closing inventory under FIFO and AVCO, calculate pay under time rates, piece rates and a bonus scheme, distinguish allocation from apportionment from absorption, compute an overhead absorption rate, and account for under- and over-absorption.
Key terms and definitions
FIFO — first in, first out. Issues are priced at the cost of the oldest inventory held.
AVCO — weighted average cost. Issues and closing inventory are priced at the average cost of all units available.
Time rate — payment per hour worked, regardless of output.
Piece rate — payment per unit produced, regardless of time taken.
Guaranteed minimum — a floor below which a piece-rate worker's pay cannot fall, protecting them against causes outside their control.
Allocation — charging a whole overhead to the single cost centre that caused it.
Apportionment — sharing an overhead across several cost centres on a fair basis.
Reapportionment — redistributing service cost centre totals to the production centres they serve.
Overhead absorption rate (OAR) — the rate at which overhead is charged to cost units, set from budgeted figures before the period begins.
Under- or over-absorption — the difference between overhead absorbed into units and overhead actually incurred.
Core concepts
Pricing material issues
Once identical units bought at different prices are mixed in a store, no one can say which physical unit was issued. A pricing rule is therefore required, and it is a convention rather than a fact.
FIFO assumes the oldest units go first. In a period of rising prices this charges the older, cheaper costs to production, so cost of sales is lower and reported profit higher, while closing inventory is valued at recent prices and is therefore closer to current cost.
AVCO recalculates an average and applies it to both issues and closing inventory. It smooths price fluctuations and is easier to operate where deliveries are frequent.
Neither is more correct. What matters for marks is knowing the consequence of each in a period of rising prices, because that is what questions test. Note also that LIFO is not permitted under IFRS, so a question asking which method a business "should" use is not asking about it.
Labour remuneration
A time rate is simple, suits work where quality matters more than speed, and gives the worker income security — but it provides no direct incentive to produce more, so supervision carries the load.
A piece rate ties pay to output and raises productivity, but it risks quality being sacrificed for speed and leaves the worker exposed to a machine breakdown or a shortage of materials, which is why a guaranteed minimum is usually attached.
A bonus scheme sits between them: a basic rate plus a share of the time saved against a standard. It rewards efficiency without removing income security, which is why it is common in practice.
Under a time rate, labour behaves as a fixed or stepped cost within a shift. Under a piece rate, it behaves as a variable cost. The remuneration method therefore changes the cost behaviour, which matters for every technique built on the fixed/variable split.
Overheads: allocation, apportionment, absorption
Three distinct steps, and confusing them is the commonest error in the topic.
Allocation charges a whole overhead to one cost centre, because that centre caused all of it — the salary of a supervisor who works only in packing.
Apportionment shares an overhead across centres on a basis that reflects how it is consumed: rent by floor area, heating by volume, machine insurance by machine value. The basis must be defensible; there is no correct answer, only a more or less reasonable one.
Reapportionment then pushes the service centre totals — maintenance, stores, canteen — out to the production centres, since only production centres make units to absorb cost. Canteen costs typically go by number of employees, maintenance by machine hours.
Absorption finally charges the accumulated production centre overhead into the cost units, using the OAR.
Setting and applying the absorption rate
The OAR is calculated from budgeted figures before the period starts, because a product has to be costed and priced before the actual results are known. The rate is budgeted overhead divided by the budgeted level of the absorption base.
The base should reflect what drives the overhead. A machine-intensive department uses machine hours; a labour-intensive one uses direct labour hours. Using units of output only works where every unit is identical.
Under- and over-absorption
Because the rate is set on budget and applied to actual activity, absorbed overhead almost never equals actual overhead.
Over-absorption means more was charged to units than was incurred; the excess is credited to the income statement. Under-absorption means too little was charged; the shortfall is debited.
Two causes, and a good answer separates them: actual overhead differed from budget, or actual activity differed from budget. Naming which one drove the variance is worth more than computing it.
Worked examples
Example 1 — FIFO and AVCO compared (7 marks)
Opening inventory 200 units at $12 = $2,400. A purchase of 300 units at $15 = $4,500. Total available: 500 units costing $6,900. Then 400 units are issued to production.
FIFO: the issue takes the oldest first — 200 at $12 = $2,400, then 200 at $15 = $3,000. Issue value = $5,400. Closing inventory = 100 at $15 = $1,500.
AVCO: average cost = $6,900 ÷ 500 = $13.80 per unit. Issue value = 400 × $13.80 = $5,520. Closing inventory = 100 × $13.80 = $1,380.
Check both ways: $5,400 + $1,500 = $6,900 and $5,520 + $1,380 = $6,900. The total cost is identical under either method — only its split between production and inventory differs.
Prices rose here, so FIFO charges less to production ($5,400 against $5,520) and reports the higher profit, while valuing closing inventory closer to current cost.
Example 2 — Piece rate with a guaranteed minimum (5 marks)
A worker is paid $3.20 per unit with a guaranteed minimum of $1,000 per week. In week one they produce 340 units; in week two, a machine fault limits them to 260 units.
Week one: 340 × $3.20 = $1,088. This exceeds the minimum, so pay is $1,088. Week two: 260 × $3.20 = $832. This is below the minimum, so pay is $1,000.
The $168 shortfall made up in week two is the cost of the guarantee. It protects the worker from a cause outside their control, and it is why labour under a piece rate is not purely variable in practice.
Example 3 — Overhead absorption rate (5 marks)
A department budgets overhead of $240,000 and 30,000 direct labour hours.
OAR = $240,000 ÷ 30,000 = $8.00 per direct labour hour.
A job taking 45 labour hours therefore absorbs 45 × $8.00 = $360 of overhead, which is added to its direct materials and direct labour to give the full production cost.
Example 4 — Under- and over-absorption (6 marks)
Using the $8.00 rate, actual overhead for the period was $252,000 and actual hours worked were 32,000.
Overhead absorbed = 32,000 × $8.00 = $256,000. Overhead incurred = $252,000. Difference = $256,000 − $252,000 = $4,000 over-absorbed, credited to the income statement.
Now explain it. Activity exceeded budget by 2,000 hours, which alone would have absorbed an extra $16,000; actual overhead exceeded budget by $12,000, pulling in the other direction. The net $4,000 over-absorption is the two effects combining.
Check: $16,000 − $12,000 = $4,000. Splitting the variance into its two causes is what lifts an answer above the arithmetic.
Common mistakes and how to avoid them
Confusing allocation with apportionment. Allocation charges a whole cost to one centre; apportionment shares one cost across several.
Absorbing overhead into service cost centres. Only production centres absorb, which is why service centre totals are reapportioned first.
Using actual figures to set the OAR. The rate is set from budget, before the period, so products can be costed and priced.
Calling over-absorption a profit. It is an adjustment correcting an over-charge to units, not earnings.
Getting the FIFO profit effect backwards. With rising prices, FIFO charges older cheaper costs to production, so profit is higher.
Assuming piece-rate labour is purely variable. A guaranteed minimum puts a floor under it.
Choosing an absorption base that does not drive the cost. Machine hours for a machine-intensive department, labour hours for a labour-intensive one.
How this links to your Internal Assessment
If the business you studied produces anything, overhead absorption is the single most useful analysis you can offer, because small businesses very often price on materials and labour alone and have no idea what their overheads add per unit.
Work out a defensible OAR from the records you have, state the base you chose and why it reflects how the overhead is consumed, then apply it to one real product and compare the full cost with the price actually charged. If the product is being sold below full cost, that is a genuine finding with a recommendation attached.
Be explicit that your apportionment bases are judgements. Saying "rent was apportioned by floor area, which assumes each square metre consumes rent equally — reasonable here because both areas are similar in use" shows exactly the awareness the mark scheme is looking for, and it is more honest than presenting an apportionment as fact.
Exam technique for material, labour and overhead costs
Inventory questions want a ruled store ledger card with receipts, issues and balance columns. Keep a running balance after every transaction under AVCO, because the average changes with each receipt — recalculating only at the end is the classic error.
Overhead questions are usually staged: allocate, apportion, reapportion, then absorb. Do them in that order and label each stage, because the marks are allocated stage by stage and a labelled partial answer still scores.
State the basis of every apportionment. A figure with no basis shown cannot earn the method mark even when it is right.
Command words matter. Calculate the OAR wants the budgeted figures and the division. Explain the difference between allocation and apportionment wants the contrast, not two definitions side by side. Distinguish between under- and over-absorption wants the direction and the accounting treatment. Discuss the merits of piece rates wants productivity against quality and income security, with a conclusion.
Where a question asks which inventory method a business should use, do not answer LIFO — it is not permitted under IFRS.
Quick revision summary
- FIFO prices issues at the oldest costs; AVCO uses a weighted average recalculated on each receipt.
- With rising prices, FIFO gives lower cost of sales, higher profit and closing inventory nearer current cost.
- Total cost is identical under either method; only its split between production and inventory differs.
- LIFO is not permitted under IFRS.
- Time rate: security, no output incentive, behaves as a fixed cost within a shift.
- Piece rate: output incentive, quality risk, behaves as a variable cost — but a guaranteed minimum puts a floor under it.
- Allocation = whole cost to one centre. Apportionment = shared across centres on a fair basis. Reapportionment = service centres out to production centres. Absorption = into cost units.
- OAR = budgeted overhead ÷ budgeted base, set before the period begins.
- Absorbed = actual activity × OAR. Absorbed above incurred is over-absorption, credited to the income statement.
- Two causes of a variance: actual overhead differed from budget, or actual activity did. Name which.