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BF1122 - Foundations in Financial and

Management Accounting
Term 1 Management Accounting

Week 3 - Fixed Overhead Absorption Rates

(FOAR)

Monina Hurl

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Week 3 – FOAR’s:
Learning Outcomes:
• Create accurate costs for budgeting purposes and resource allocation
• How to use costs to set selling prices for products and ensure
profitability
• Possible bases for absorption of overheads apart from labour hours
• The choice of using actual or standard cost data in these calculations

Total overhead is absorbed across products regardless of the basis,

but different products have different costs depending on the basis.
Choose the basis that most reflects the driver of overhead (what causes it).

More accurate costings lead to, potentially, better pricing and profitability.

Example:

Company X Ltd produces two products:

Product A Product B
Sales Volume 1,000 units 3,000 units
Labour hours per unit 0.2 hours 0.1 hours
Material per unit 5kg 2kg
Machine hours per unit 3 hours 0.5 hours

Manufacturing Overhead £9,000

Labour rate £20 per hour
Material £0.50 per kg

What bases can we use to calculate FOAR and absorb the £9,000 of overheads into
our products A and B?

Solution:

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Example:
Let’s revisit last week’s example of Henley Ltd (page 4 WB Week 2):
We now have some new information (in italics below):
Production Production Service Service Total
Dept 1 Dept 2 Dept 1 Dept 2
2
Area (m ) 8,000 6,000 4,000 2,000 20,000
Machinery Value (£) 500,000 100,000 150,000 50,000 800,000
Number of Staff 20 40 5 5 70
Direct Labour Hrs pa 20,000 30,000 50,000
Machine Hours 100,000 15,000
Each unit of Alpha spends 0 labour hours in Prod Dept 1 and ½ labour hour in Prod Dept 2.
Each unit of Gamma spends 1 labour hour in Prod Dept 1 and ½ labour hour in Prod Dept 2.
Each unit of Alpha spends 2 machine hours in Prod Dept 1 and ¼ machine hours in Prod
Dept 2.
Each unit of Gamma spends 1 machine hour in Prod Dept 1 and ¼ machine hours in Prod
Dept 2.
Prod Dept 1 is highly automated.
Prod Dept 2 is largely labour intensive.

Selling prices have been set at £25 per unit of Alpha and £50 per unit of Gamma.

Calculate a more realistic unit cost for each product.

Solution:

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CEO of Henley Ltd has made the following announcement:

‘We can’t make Alphas fast enough. They are flying out the door. Yet the accountant tells me
that we are making little or no profit! If you ask me, we should quit making Gammas. We’ve
sold virtually none of them.’

Discuss the comments made.

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The Use of Standard or Budgeted Information:

In a perfect world the costing calculations we have carried out so far would be undertaken
using actual costs and actual hours worked.

This is problematic because product cost calculations would have to be delayed to the end
of an accounting period when these actual amounts are known.

In the real-world, information on product costing is required more quickly than this as it
needs to be used for profit calculations, inventory valuations etc.

Solution: base overhead absorption rates on budgeted amounts and activity levels as
estimated at the beginning of a period. This results in timely cost information for decision
making.

Problem: budgeted costs and activity levels are likely to be different from actuals....

Example:

Prestbury Limited has one production department with a budgeted manufacturing overhead
allocated to it of £58,800. The budgeted labour hours for that department were 1,960 hours.
Each unit uses 5kg of material costing £2 per kg. Labour is paid £25 per hour and each unit
needs 0.5 hours.

During the year the volume of production was actually 3,800 units, resulting in actual labour
hours worked being 1,900 hours. Actual overhead incurred was £58,000.

a) What is the budgeted cost of a unit?

b) Have we accounted for the correct level of overheads?

Solution:

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Q3.16 Drury page 78

Based on the data below, what is the amount of the overhead under/over absorbed?

Budgeted overheads £493,200

Budgeted machine hours 10,960
Actual machine hours 10,493
Actual overhead £514,157

Solution:

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Pricing:

Setting a strong selling price can make the difference between a successful profit-making
business and a failing business.

You will look at this more in Year 2.

There are many ways to come up with a selling price, taking account of:
- Competitors (we must be aware of their selling prices so that we can decide what
our selling price should be)
- Customers (what are they willing to pay?)
- Market Research (if it is a new product, carry out market research to see what
customers consider a fair price to be)
- Cost of a product or service (to ensure this is covered and a profit is made).

Let’s examine the Cost method:

One way is to create a mark-up. We can take the cost of a product and mark it up:

Let’s say we mark the cost up by 20%: this means that the profit is 20% of the cost, and so
the selling price is 120% of the cost.
£
Selling Price 120
Less Cost (100)
Profit 20

Another way is to create a margin:

Let’s say we have a profit margin of 20%: this means that the profit is 20% of the selling
price, and so the cost is 80% of the selling price.
£
Selling Price 100
Less Cost (80)
Profit 20

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Example:

A product costs £72 to produce. The manager is estimating a selling price based on either
mark-up or margin.

What is the selling price based on:

a) A mark-up of 25%?
b) A margin of 17%?

Solution:

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