Explain the different methods of absorption of administrative overheads. Which method would you prefer and why?

Methods of Absorption of Administrative Overheads:

Administrative overheads are costs incurred in the general administration of a business that cannot be directly attributed to a specific product or department. These overheads need to be absorbed or allocated to the cost of production to determine the total cost of each unit produced. There are several methods used to absorb administrative overheads, including:

1. Direct Method:

• Under the direct method, administrative overheads are directly allocated to the cost centers or production departments based on a predetermined allocation key. This method does not involve any allocation to intermediate service departments.

2. Step Method:

• The step method involves allocating administrative overheads first to intermediate service departments and then to production departments. This method is suitable for organizations with multiple service departments that provide services to each other.

3. Reciprocal Method:

• The reciprocal method takes into account the mutual services provided by different service departments to each other. It allocates overheads based on a simultaneous equation approach, considering the services received and provided by each department.

4. Distribution Method:

• The distribution method involves distributing administrative overheads to production departments based on predetermined allocation keys. This method is simple and easy to implement but may not accurately reflect the actual usage of services by production departments.

5. Activity-Based Costing (ABC):

• ABC is a more sophisticated method that allocates overheads based on the activities performed by each department. It considers the cost drivers of each activity to allocate overheads more accurately.

6. Absorption Rate Method:

• The absorption rate method calculates an overhead absorption rate based on the budgeted or actual overheads and a suitable allocation base, such as labor hours, machine hours, or direct labor costs. This rate is then used to absorb overheads into the cost of production.

7. Production Unit Method:

• Under the production unit method, administrative overheads are absorbed based on the number of units produced. This method assumes that overheads are incurred in direct proportion to the level of production.

8. Standard Cost Method:

• The standard cost method uses predetermined standard rates to absorb overheads into the cost of production. This method allows for better control and management of overhead costs.

Preference of Method:

The preferred method of absorption of administrative overheads depends on the nature and complexity of the organization. However, the Activity-Based Costing (ABC) method is often preferred for its ability to allocate overheads more accurately based on the activities performed by each department. ABC provides a more detailed and precise allocation of overheads, which can lead to better cost control and decision-making.

Conclusion:

In conclusion, the absorption of administrative overheads is an important aspect of cost accounting that requires careful consideration. The method chosen should be based on the specific needs and characteristics of the organization to ensure accurate allocation of overheads and effective cost management.