OVERHEADS
Allocation, Apportionment
& Absorption
Objective
Relationship with cost object
• Direct
• Indirect
Factors influencing classification
Objectives of Allocation*
 To obtain a mutually agreeable price
 To compute product-line profitability
 To predict the economic effects of planning
and control
 To value inventory
 To motivate managers
*As identified by the IMA
Overheads/Burden
Indirect Material + Indirect Labour + Indirect
other expenses= OHs
Cannot be conveniently charged to any job,
process or cost unit
Types of Departments
Producing departments are directly
responsible for creating the products or
services sold to customers.
Types of Departments
Supporting departments provide essential
support services for producing departments.
Maintenance, engineering, personnel, storage
Departmentalisation
For collection, allocation and apportionment of
overheads
Allocation: charging identifiable cost items to cost
centers or cost units
Examples:
Depreciation of a machine in machining
department - machining department
Salary of stores clerk - stores department
Examples of Departmentalisation for a
Manufacturing Firm
Production Departments
Assembly:
Supervisors’ salaries
Small tools
Indirect materials
Depreciation on machinery
Finishing:
Sandpaper
Depreciation on sanders
Support Departments
Materials Storeroom:
Clerk’s salary
Depreciation on forklift
Cafeteria:
Food
Cooks’ salaries
Depreciation on stores
Maintenance:
Janitors’ salaries
Cleaning supplies
Machine oil and lubricants
Apportionment
Common costs (non-allocable) allotted to two or
more cost centers or cost units on some rational
basis (a matter of judgment)
Sample apportionment
OH Item:
Rent, rates, heating, repairs,
depreciation of building
Lighting
Power
Depreciation, repair, insurance
and maintenance of plant
Personnel, staff welfare, canteen
Carriage inwards
Marketing and distribution
Delivery expenses
Remuneration of works director
Basis:
Floor Area
Floor Area / number of light
points
HP of machines
Book value or original cost
Number of employees
Value of material
Sales value
Weight, volume, miles
DLHs/Wages/Number of
employees
Criteria for allocation and
apportionment
• Neutrality: should not distort decision making
• Ability to bear: sales value, gross profit, asset
value, total costs
• Cause and effect relationship: maintenance cost
on the basis of hours spent for different cost
objects
• Benefits received: cost of power plant on the
basis of power used by diff. cost objects
• Equity/fairness
Apportionment of service center costs
• OH allocated or apportioned to production and
service departments: primary distribution
• Service department costs apportioned to
production departments: secondary distribution
Secondary distribution
• Direct method
• Step-down (sequential)
• Reciprocal
Direct Method of Allocation
Power
Support Departments
Grinding
Assembly
Producing Departments
Maintenance
Direct Method of Allocation
Power
Support Departments
Grinding
Assembly
Producing Departments
Maintenance
Step-down Method of Allocation
STEP 1: Rank service
departments
2
1
Maintenance
Grinding
3
Assembly
Step-down Method of Allocation
STEP 2
Power
Maintenance
Grinding
Assembly
Sequential Method of Allocation
STEP 2
Maintenance
Grinding
Assembly
The reciprocal method
of allocation
recognizes all
interactions among
support departments.
Absorption
Allocated or apportioned overhead absorbed by
cost units
Methods:
Production unit method: Budgeted/Actual OH
Budgeted/Actual units
% of DM cost
Budgeted/Actual OH
Budgeted/Actual DM cost
% of DL cost
% of Prime cost
DLH rate
MH rate
Praxis
Manless Limited does job order processing which involves manual and
machine operations.The budgeted P&L Account is as under:
Sales
75 lacs
Cost: DM
10
DL
5
Prime cost
15
Production overhead
30
Production cost
45
Admin, S&D cost
15
60
Profit
15
Other budgeted data: LHs: 2500, MHs:1500, Number of jobs: 300
A job enquiry has come and the prime cost estimation is as under:
DM:Rs.2,500; DL:Rs.2,000; DLHs: 8, MHs:5
Use different methods of OH absorption and recommend to the company.
Blanket rate v Departmental rate
• A plant wide rate for every job irrespective of the
department in which it is processed
• Not correct in case all jobs don’t pass through all
departments/ different jobs spend unequal time
in different departments
• Then departmental rates are required
Praxis
Refer to excel Sheet - 2
Predetermined OH rate
• Actual OH will be known after the time period is
over
• So absorbed on estimated basis taking expected
level of activity
Under/Over absorption
• Predetermined rate X actual production =
absorbed amount
• May be less than or more than the actual OH
Treatment:
Application of supplementary rate
Transfer to costing P&L Account
Carry forward to the next period
Support department cost allocation to
operating departments
Support department Cost pool
Cost object (operating
department)
•
Single rate (no distinction between variable and fixed
cost)
•
Dual rate (variable cost pool + fixed cost pool)
Under both the rate methods, allocation can happen by
using
i) Budgeted rate and budgeted hours to be used by
operating division
ii) Budgeted rate and actual hours used by operating
divisions
iii) Actual rate and actual hours used by operating
divisions
Data for both the methods
Sand Hill Company’s Central Computer Department renders
service to Microcomputer division and Peripheral equipment
division
Budgeted Fixed cost for 2009 for operating central computer
dept.: Rs.30,00,000 and variable cost per hour:Rs.200
(relevant range: 6000 to 18750 hours)
Practical capacity: 18750 hours
Budgeted usage in hours:
Microcomputer division:
8,000
Peripheral equipment division: 4,000
Actual usage in 2009:
Microcomputer division:
9,000
Peripheral equipment division: 3,000
Single rate
Sand Hill uses budgeted rate and actual usage
Total budgeted cost = Rs.30,00,000 + 12000 X Rs.200 =
Rs.54,00,000
Budgeted hours= 12,000
Rate per hour = Rs.450
Allocation:
Microcomputer:
9,000 X Rs.450 = Rs.40,50,000
Peripheral equipment: 3,000 X Rs.450 = Rs.13,50,000
Single rate sends a signal that Rs.450 is VCU. What if an
outside vendor offers the same service @Rs.340?
Dual rate
Sand Hill uses actual hours for VC and budgeted hours
for FC
Allocation:
Microcomputer: 8,000 X Rs.250 + 9,000 X Rs.200 = Rs.
38,00,000
Peripheral:
4,000 X Rs.250 + 3,000 X Rs.200 = Rs.16,00,000
Allocation based on supply of capacity
Budgeted FC per hours (18750 hrs): Rs.160/hr
Budgeted VC per hr.: Rs.200/hr
Single rate method:
Microcomputer:
9,000 X Rs.360 = Rs.32,40,000
Peripheral equipment: 3,000 X Rs.360 = Rs.10,80,000
Fixed cost of unused capacity: 6750 X Rs.160
=Rs.10,80,000
Cont..
Dual Rate Method:
Microcomputer:
Fixed cost: 8,000 X Rs.160 = Rs.12,80,000
VC:
9,000 X Rs.200 = Rs.18,00,000
Rs. 30,80,000
Peripheral equipment:
Fixed cost: 4,000 X Rs.160 = Rs. 6,40,000
VC:
3,000 X Rs.200 = Rs. 6,00,000
Rs.12,40,000
Fixed cost of unused capacity: 6750
=Rs.10,80,000
X
Rs.160
Cont…
• Using practical capacity highlights the unused
capacity cost and its management
• It also reduces the burden on the users
• But if FC is allocated on budgeted or actual use,
total FC is passed on to users!
• In case unused capacity arises only because of
one division, it makes sense for allocating the
unused capacity cost to that department
Budgeted v. Actual rate
• Affects the uncertainty faced by user
departments
• Budgeted rate:
users know the rate in advance and decide
whether to use internal service or external
service
cost variance or inefficiency to be borne by
supplier of service
Budgeted and Actual usage, Practical
Capacity level allocation
See excel Sheet 3
Common cost allocation
A cost of a common facility, activity or cost of
cost object shared by more than one user
Stand-alone cost-allocation method
Incremental cost allocation: primary user,
incremental users (everybody claims to be
incremental user)
Cost plus contracts: fertile ground for litigation
(bring clarity)
Revenue allocation & Bundled Products
When department managers have revenue or profit
responsibilities, allocation is called for
Shaving gel + shaving brush + razor
Stand-alone price
30
25
15
Bundled price: gel + brush Rs.50
gel + razor Rs.38
gel + brush + razor: Rs.64
Stand-alone allocation methods
• Selling price: considers customers’ willingness to
pay
• Unit cost
• Physical units: used when selling prices are
unstable and unit costs are difficult to calculate
Incremental allocation method
Products to be ranked by:
Product in the bundle with most sales can be
ranked first
Customer survey can reveal importance of the
products
Stand-alone performance of individual products
Top managers knowledge or intuition