AQA A-Level Accounting: Absorption and activity based costing (7127)

This guide covers section 3.12, Absorption and activity based costing, of the AQA A-level Accounting (7127) specification, version 1.1 (October 2026), for A-level exams from June 2019 onwards. The course is untiered, and section 3.12 is assessed on Paper 2, which draws on sections 1–3, 8–13 and 17–18. Every business and figure below is invented.

Useful links: AQA A-level Accounting hub, printable checklist, revision notes for this topic, practice questions, the free 10-minute diagnostics and exam preparation. Cost behaviour and contribution are in Marginal costing.

What this section covers

Specification content (3.12)	What you must be able to do
Absorption costing to calculate the total cost of a product	Use the terms allocation, apportionment, absorption, under-absorption and over-absorption; allocate direct costs, apportion indirect costs, calculate and apply overhead absorption rates
Activity based costing (ABC) to calculate the total cost of a product	Use the terms cost pool, cost driver and attribution; allocate direct costs and use cost pools and cost drivers to attribute indirect costs to products
Absorption and ABC to calculate selling price	Add a mark-up or margin to total cost
Benefits and limitations of absorption, ABC and marginal costing	Compare inventory valuations and profit under the three methods; evaluate each method

1. Absorption costing

Absorption costing gives each product a full cost: its direct costs plus a share of the production overheads.

Total (full) cost per unit = direct materials + direct labour + direct expenses
                             + production overheads absorbed

The terms

• Allocation: charging a whole cost to the one product or cost centre that caused it. Direct materials and direct labour are allocated to products. An overhead that belongs entirely to one department, such as that department’s supervisor, is allocated to that department.
• Apportionment: sharing an indirect cost between cost centres on a fair basis, because no single centre caused it. Rent is shared on floor area, for example.
• Absorption: charging each department’s overheads to the products that pass through it, using an overhead absorption rate (OAR).
• Under-absorption: overheads absorbed into products are less than the overheads actually incurred.
• Over-absorption: overheads absorbed are more than the overheads actually incurred.

Choosing the apportionment basis

Indirect cost	Usual basis
Rent, rates, heating, building insurance	Floor area
Depreciation and insurance of machinery	Cost or value of machinery
Power for machines	Machine hours (or a power meter reading)
Canteen, staff welfare, personnel costs	Number of employees

Overhead absorption rates

The OAR is set in advance, from budgeted figures:

OAR = budgeted overheads of the cost centre ÷ budgeted level of activity

Pick the activity that drives the department’s costs:

• per machine hour in a machine-intensive department
• per direct labour hour in a labour-intensive department
• per unit only when every unit is identical.

Worked example 1: Brackenfield Furniture

Brackenfield makes dining tables in two production departments, Machining and Assembly. Budgeted overheads for the year:

Overhead	£	Basis
Indirect labour: Machining £38 000, Assembly £51 000	89 000	Allocated
Rent and rates	60 000	Floor area: M 1 200 m², A 1 800 m²
Depreciation of machinery	45 000	Machinery cost: M £180 000, A £45 000
Power	30 000	Machine hours: M 40 000, A 10 000
Canteen	18 000	Employees: M 10, A 20
Total	242 000

Step 1: allocate and apportion.

	Machining £	Assembly £
Indirect labour (allocated)	38 000	51 000
Rent (1 200 : 1 800)	24 000	36 000
Depreciation (180 000 : 45 000)	36 000	9 000
Power (40 000 : 10 000)	24 000	6 000
Canteen (10 : 20)	6 000	12 000
Total	128 000	114 000

Check: 128 000 + 114 000 = £242 000.

Step 2: OARs. Machining is machine-intensive; Assembly is labour-intensive, with 30 000 budgeted direct labour hours.

• Machining: 128 000 ÷ 40 000 = £3.20 per machine hour
• Assembly: 114 000 ÷ 30 000 = £3.80 per direct labour hour

Step 3: full cost of one table. Each table uses £84.40 of materials, 5 direct labour hours at £12 (2 in Machining, 3 in Assembly), and 6 machine hours in Machining.

	£
Direct materials	84.40
Direct labour (5 × £12)	60.00
Machining overheads (6 × £3.20)	19.20
Assembly overheads (3 × £3.80)	11.40
Total cost	175.00

Under- and over-absorption

Because the OAR uses budgets, overheads absorbed rarely equal actual overheads.

Overheads absorbed = OAR × actual level of activity
Difference         = overheads absorbed − actual overheads
  positive → over-absorbed  (too much charged to products: add back to profit)
  negative → under-absorbed (too little charged: deduct from profit)

Brackenfield, actual results:

	Machining	Assembly
Actual activity	41 500 machine hours	28 800 labour hours
Absorbed	41 500 × 3.20 = £132 800	28 800 × 3.80 = £109 440
Actual overheads	£131 000	£113 200
Result	£1 800 over-absorbed	£3 760 under-absorbed

Overall, overheads are under-absorbed by 3 760 − 1 800 = £1 960. The costs charged to products were £1 960 too low, so £1 960 is deducted from profit in the statement of profit or loss.

Causes are a different actual level of activity from the budget, a different actual spend, or both. Assembly worked 1 200 fewer hours than budgeted, so it absorbed 1 200 × 3.80 = £4 560 too little; spending £800 below the £114 000 budget offsets part of this, leaving £3 760 under-absorbed.

2. Activity based costing (ABC)

A labour-hour rate assumes overheads are caused by labour time. Many are not: a product made in small batches needs more set-ups, inspections and orders, whatever its labour hours. ABC charges overheads according to the activities that cause them.

The terms

• Cost pool: a group of overhead costs caused by the same activity, such as all machine set-up costs.
• Cost driver: the factor that causes the cost of a pool to change, such as the number of set-ups.
• Attribution: charging the cost of each pool to products according to how much of the driver each product uses.

Method in steps

1. Allocate direct costs to each product.
2. Group overheads into cost pools and identify each pool’s cost driver.
3. Cost driver rate = cost of the pool ÷ total quantity of the driver.
4. Attribute: driver rate × driver quantity used by each product.
5. Divide each product’s attributed overheads by its units; add to direct costs.

Worked example 2: Tilby Audio

Tilby makes two speakers. Production overheads total £220 000.

	Standard	Premium
Units made	10 000	2 500
Direct materials per unit	£34	£80
Direct labour per unit (£12 an hour)	2 hours, £24	3 hours, £36
Machine hours per unit	1	4

Absorption costing, one rate per direct labour hour: labour hours = (10 000 × 2) + (2 500 × 3) = 27 500. OAR = 220 000 ÷ 27 500 = £8 per hour. Standard absorbs £16; Premium absorbs £24.

ABC. Tilby’s overheads fall into four cost pools:

Cost pool	£	Cost driver	Standard	Premium	Driver rate
Machine set-ups	60 000	Number of set-ups	10	30	£1 500
Quality inspections	50 000	Number of inspections	50	150	£250
Materials ordering	40 000	Number of orders	80	80	£250
Machine running	70 000	Machine hours	10 000	10 000	£3.50

Attribution:

	Standard £	Premium £
Set-ups	15 000	45 000
Inspections	12 500	37 500
Ordering	20 000	20 000
Machine running	35 000	35 000
Total	82 500	137 500
Per unit	82 500 ÷ 10 000 = £8.25	137 500 ÷ 2 500 = £55.00

Check: 82 500 + 137 500 = £220 000.

Cost per unit	Standard £	Premium £
Direct costs	58.00	116.00
Overheads: absorption	16.00	24.00
Total: absorption	74.00	140.00
Overheads: ABC	8.25	55.00
Total: ABC	66.25	171.00

Low-volume Premium uses most set-ups and inspections; the labour-hour rate loads those costs onto Standard.

3. Setting a selling price

Both methods give a total cost, so a price can be set by adding a profit:

Mark-up (% of cost):          price = total cost × (100 + mark-up) ÷ 100
Margin (% of selling price):  price = total cost ÷ (100 − margin) × 100

Brackenfield’s table (total cost £175): a 40% mark-up gives 175 × 1.4 = £245; a 30% margin gives 175 ÷ 0.7 = £250. Check the margin: (250 − 175) ÷ 250 = 30%.

Tilby, 20% mark-up:

	Standard	Premium
Absorption cost × 1.2	74.00 × 1.2 = £88.80	140.00 × 1.2 = £168.00
ABC cost × 1.2	66.25 × 1.2 = £79.50	171.00 × 1.2 = £205.20

Priced from absorption cost, Premium sells at £168, below its £171 ABC cost, losing money on each sale; Standard is over-priced by £9.30.

4. Comparing absorption, ABC and marginal costing

Inventory valuation and profit

• Marginal costing values inventory at variable production cost. All fixed production overheads are charged in full against the period’s profit.
• Absorption costing values inventory at full production cost, carrying some fixed production overheads forward.
• ABC also uses full production cost, but with different overhead per unit, so valuations differ.

When production equals sales, profit is the same under all three. When inventory rises, absorption and ABC profits are higher than marginal costing profit by the fixed overheads carried forward in the increase in inventory.

Worked example 3: Tilby’s profit three ways

In the year Tilby sold 9 000 Standard at £90 and 2 000 Premium at £200. There was no opening inventory. Closing inventory is 1 000 Standard and 500 Premium. Treat labour as variable and all production overheads (£220 000) as fixed, with actual overheads equal to the budget. Selling and administration costs are £60 000.

£	Marginal	Absorption	ABC
Revenue	1 210 000	1 210 000	1 210 000
Cost of production	870 000	1 090 000	1 090 000
Less closing inventory	(116 000)	(144 000)	(151 750)
Cost of sales	754 000	946 000	938 250
Contribution / gross profit	456 000	264 000	271 750
Fixed production overheads	(220 000)	–	–
Selling and administration	(60 000)	(60 000)	(60 000)
Profit for the year	176 000	204 000	211 750

Reconcile with marginal profit:

• Absorption: 1 000 × £16 + 500 × £24 = £28 000 of overheads carried forward; 176 000 + 28 000 = £204 000.
• ABC: 1 000 × £8.25 + 500 × £55 = £35 750; 176 000 + 35 750 = £211 750.

ABC profit is highest because unsold Premium units carry a large ABC overhead.

Benefits and limitations

Absorption costing

• Benefits: prices set from full cost aim to cover all production costs; fixed production costs are matched with the inventory they helped to make (accruals); simple to apply.
• Limitations: apportionment bases are arbitrary; one rate ignores what causes costs; profit can be raised by producing for inventory; budgeted rates cause under- or over-absorption; full cost misleads short-term decisions.

Activity based costing

• Benefits: more accurate product costs and prices; shows which products are really profitable; managers can cut costs by cutting the driver (fewer set-ups or orders).
• Limitations: costly to set up and maintain; choosing pools and drivers needs judgement; some overheads (such as rent) have no clear driver; little gain if products are similar.

Marginal costing

• Benefits: no apportionment; profit moves with sales, not production; contribution suits short-term decisions.
• Limitations: inventory excludes fixed production overheads; prices based on marginal cost may not cover fixed costs in the long run; semi-variable costs must be split by estimate.

Common errors

• Absorbing on budgeted activity when the question asks for overheads absorbed: absorbed always uses actual activity × the predetermined OAR.
• Mixing up the signs: absorbed more than actual is over-absorbed and adds to profit.
• Using a margin as a mark-up: a 30% margin on £175 is £250, not £227.50.
• Dividing an ABC pool by units made instead of by total driver quantity.
• Forgetting to divide attributed overheads by units to get a per-unit figure.
• Claiming absorption profit is always higher: only when inventory rises.

Next: the practice questions.

Official syllabus

AQA A-level Accounting (7127) specification, version 1.1, October 2026, for A-level exams June 2019 onwards (AQA). Section 3.12 Absorption and activity based costing.