Question 2: Liken PLC Has Asked For Your Help In Installing

Question 2liken Plc Has Asked For Your Help In Installing Their New

Question 2liken Plc has asked for your help in installing their new absorption costing system. You have ascertained the following: There are three direct production departments: cutting, machining and painting, and two support departments: stores and maintenance. Allocated costs for each department in the period are: Cutting: £350,000; Stores: £120,000; Machining: £260,000; Maintenance: £90,000; Painting: £140,000. Costs to be apportioned include: Rent (£140,000), Insurance (£70,000), Heat and Light (£65,000). The rent needs to be allocated based on departmental floor area, insurance based on machine value, and heat and light based on departmental cubic capacity. Secondary apportionment is required for Stores (to be calculated) and Maintenance (to be calculated) using relevant drivers. Specific details include floor area, machine costs, cubic capacity, requisites, call outs, direct labor hours, and machine hours for each department.

Your task is to:

a) Calculate the overhead absorption rate for each of the three direct production departments.

b) Critically discuss the limitations and possible solutions to absorption costing.

Paper For Above instruction

Absorption costing remains a fundamental method in managerial accounting, widely used for assigning both fixed and variable manufacturing costs to products. However, implementing an absorption costing system requires careful analysis of overhead allocations, recognition of limitations inherent in the method, and exploration of alternative approaches to improve cost accuracy and decision-making. This paper begins by calculating the overhead absorption rates for the relevant departments, then critically examines the constraints of absorption costing and explores potential solutions to these limitations.

Calculation of Overhead Absorption Rates

The absorption costing system distributes overhead costs based on predetermined rates applied across departments. To calculate these rates, relevant cost drivers and allocated overheads must be considered. For the three direct production departments—cutting, machining, and painting—the primary overheads include rent, insurance, and heat and light. These overheads are allocated based on departmental floor area, machine value, and cubic capacity, respectively, with secondary apportionments made to reflect the support functions of stores and maintenance.

First, calculate the total base figures for each driver:

• Floor area: Total floor area = 2,000 + 4,000 + 3,000 + 17,000 + 3,000 = 29,000 sq ft
• Machine value: Total = 200,000 + 70,000 + 20,000 + 10,000 = 300,000
• Cubic capacity: Total = 20,000 + 60,000 + 30,000 + 17,000 + 3,000 = 130,000 cu ft

Next, allocate the overheads as per the bases:

• Rent (£140,000): Allocate based on floor area
• Insurance (£70,000): Allocate based on machine value
• Heat and light (£65,000): Allocate based on cubic capacity

For rent:

• Cutting: (£140,000 * 2,000 / 29,000) ≈ £9,655
• Machining: (£140,000 * 4,000 / 29,000) ≈ £19,310
• Painting: (£140,000 * 3,000 / 29,000) ≈ £14,482

Similarly, for insurance:

• Cutting: (£70,000 * 200,000 / 300,000) ≈ £46,667
• Machining: (£70,000 * 70,000 / 300,000) ≈ £16,333
• Painting: (£70,000 * 20,000 / 300,000) ≈ £4,667

And for heat and light:

• Cutting: (£65,000 * 20,000 / 130,000) ≈ £10,000
• Machining: (£65,000 * 60,000 / 130,000) ≈ £30,000
• Painting: (£65,000 * 30,000 / 130,000) ≈ £15,000

Once these overheads are allocated to the departments, the total overhead per department can be summed. The overhead absorption rate is then calculated by dividing the total overhead allocated to each department by the relevant cost driver—such as direct labor hours, machine hours, or units of activity used in each department.

Limitations of Absorption Costing

Despite its widespread use, absorption costing has several limitations. One major challenge is the potential for distortion of product costs due to arbitrary allocation of overheads. For example, allocating fixed costs based purely on volume or machine hours does not necessarily reflect the actual consumption of resources by different products or departments, especially in complex production environments. Moreover, absorption costing can obscure the true profitability of products, as it treats fixed manufacturing overhead as inventorial costs, which may lead to overcosting or undercosting based on production levels rather than actual resource use.

Another limitation pertains to management decision-making. Since absorption costing allocates overhead uniformly based on cost drivers, it can mislead managers into making suboptimal decisions. For instance, neglecting the causality between costs and activities might result in inefficient product pricing, misallocation of resources, or unintended cost absorption that hampers strategic planning.

Possible Solutions to Limitations

To address these limitations, several solutions and alternative costing methods have been proposed. Activity-Based Costing (ABC) is one prominent approach that improves accuracy by assigning costs based on activities that directly consume resources. ABC identifies various cost drivers and assigns overheads more precisely, reflecting the true consumption of resources by each product or department.

Implementing ABC typically involves identifying key activities, measuring their costs, and assigning these costs based on the specific activities involved in each product’s production process. Studies have shown that ABC enhances management’s ability to make informed pricing, product mix, and process improvement decisions (Cooper & Kaplan, 1991).

Another solution involves using contribution margin analysis alongside absorption costing to better understand product profitability. This provides a clearer picture of how individual products contribute to fixed costs and profit margins, enabling more strategic decisions.

Furthermore, a mixed costing approach—combining absorption costing with variable costing—can help managers focus on variable costs for short-term decision-making, while maintaining absorption costing for external financial reporting. This dual approach balances accuracy with compliance requirements (Drury, 2018).

Conclusion

In conclusion, while absorption costing remains a standard method for assigning manufacturing costs, its inherent limitations necessitate careful management and potential integration of alternative systems such as Activity-Based Costing. By understanding these limitations and implementing suitable strategies, organizations like Question 2liken Plc can improve cost accuracy, enhance decision-making, and maintain competitive advantage in their manufacturing processes.

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