OVERHEAD COST ALLOCATION

COST AND MANAGEMENT ACCOUNTING I

ACC 211
OVERHEADS

• Are indirect expenses which cannot be trace directly to a

product, service or department. For example, rent, rates,
insurance, depreciation, electricity, water, maintenance of plant
and machinery. They are also classified as overheads which
consist of the total of all indirect cost
PRODUCTION AND NON-PRODUCTION
OVERHEADS
• Production / Manufacturing overheads are indirect costs that
are related to the production of the products of the business.
They make up part of the production cost.
• Non-production / Non-manufacturing overheads are expenses
that are not directly or indirectly, related to the production.
They are classified as Selling overheads, Distribution
overheads, Administration overheads and Finance overheads
Overhead is actually the total of the
following
➢Indirect materials
➢Indirect expenses
➢Indirect labor
The total of these indirect costs is usually split
into the following categories.
➢Production
➢Selling and distribution
➢Administration
ACCOUNTING TREATMENT - PRODUCT AND
PERIOD COST
• Product cost is taken into profit and loss account only to the
extent of number of units sold and cost of unsold units is taken
into to the balance sheet as a closing stock.
• Whereas period cost in total is charged to profit and loss
account. Product cost is used for stock valuation purpose but
period cost is least concern with stock valuation.
• Under Absorption costing system there are four steps of
charging overhead costs to cost centers and cost units.
1.Allocation.
2. Apportionment.
3.Re-apportionment.
4.Absorption
COST ALLOCATION

• Is the process by which whole cost items are charged direct to

a cost unit or cost Center
• Allocation is the charging or distributing of cost directly to the
cost centers or cost units. Costs that relate to a single cost
center are allocated to that cost center. Normally indirect
materials and indirect labor costs are allocated
COST CENTER

• The department or sub-part of a division, to which costs can be

identified
COST CENTERS

Cost centers may be one of the following types.

• A production department, to which production overheads are charged

• A production area service department, to which production overheads are charged
• An administrative department, to which administration overheads are charged
• A selling or a distribution department, to which sales and distribution overheads are
charged
• An overhead cost center, to which items of expense which are shared by a number of
departments, such as rent and rates, heat and light and the canteen, are charged
ALLOCATION TO COST CENTERS

➢Direct labor will be charged to a production cost center.

➢The cost of a warehouse security guard will be charged to the
warehouse cost center.
➢Paper (recording computer output) will be charged to the
computer department.
➢Costs such as the canteen are charged direct to various overhead
cost centers.
EXAMPLE: OVERHEAD ALLOCATION

• Consider the following costs of a company.

• Wages of the foreman of department A TZS200,000
• Wages of the foreman of department B TZS150,000

• Indirect materials consumed in department A TZS50,000

• Rent of the premises shared by departments A and B TZS300,000
• The cost accounting system might include three overhead cost centers.
Cost Centre:
101 Department A
102 Department B

201 Rent
SOLUTION

• Overhead costs would be allocated directly to each cost center,

ie TZS200,000 + TZS50,000 to cost Centre 101,
• TZS150,000 to cost center 102 and
• TZS300,000 to cost center 201.
• The rent of the factory will subsequently be shared between
the two production departments but, for the purpose of day to
day cost recording, the rent will first of all be charged in full to
a separate cost center
OVERHEAD APPORTIONMENT

• Apportionment is a procedure whereby indirect costs are spread

fairly between cost centers. Service cost center costs may be
apportioned to production cost centers by using the reciprocal
method.
• Apportionment is where an overhead is common, combined or
joint to more than one cost center and therefore it needs to be
shared out amongst the relevant cost centers based on benefit
received by each cost center
ILLUSTRATION QN.

• Malenda Inc has two production departments (A and B) and

two service departments (maintenance and stores). Details of
next year's budgeted overheads are shown below.
Total (TZS) Total (TZS)
Heat and light 19,200 Rent and rates 38,400
Repair costs 9,600 Canteen 9,000
Machinery 54,000 Machinery insurance 25,000
depreciation
 • Details of each department are as follows
A B Maintenance Store Total
Floor area (m2) 6,000 4,000 3,000 2,000 15,000
Machinery book value 48,000 20,000 8,000 4,000 80,000
Number of employees 50 40 20 10 120
Allocated overheads 15,000 20,000 12,000 5,000 50,000
 • Service departments' services were used as follows.
A B Maintenance Store Total
Maintenance hours worked 5,000 4,000 - 1,000 10,000
Number of stores requestion 3,000 1,000 1,000 - 4,000
APPORTIONMENT OF OVERHEAD

• Stage 1:
• The first stage of overhead apportionment is to identify all overhead
costs as production department, production service department,
administration or selling and distribution overhead
• Bases of apportionment
• It is considered important that overhead costs should be shared out
on a fair basis
 OVERHEAD TO WHICH THE BASIS APPLIES

Overhead Basis
Rent, rates, heating and light, repairs Floor area occupied by each cost
and depreciation of buildings centre
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, Number of employees, or labor hours
wages and cost offices, first aid worked in each cost center (Wage
cost)
Power Kilowatt hour / capacity of machines
(horse power)
Item cost Basis of apportionment A B Maintenance Store Total
 SOLUTION

Item cost Basis of A B Maintenance Store Total

apportionment
Heat and Light Floor Area 7,680 5,120 3,840 2,560 19,200
Repair Cost Floor Area 3,840 2,560 1,920 1,280
9,600
Machine depreciation Machine Value 32,400 13,500 5,400 2,700 54,000

Rent and rates Floor Area 15,360 10,240 7,680 5,120 38,400

Canteen No of employee 3,750 3,000 1,500 750 9,000

Machine insurance Value of Machine 15,000 6,250 2,500 1,250 25,000

Total 78,030 40,670 22,840 13,660
REAPPORTION SERVICE DEPARTMENT COSTS

• Service departments are cost centers, which exist to provide

services to other departments. The canteen is a common
example, having allocated and apportioned the costs to the
production and service departments, the totals of service cost
centers, the latter need to be reapportioned to the production
cost centres.
 SERVICE DEPARTMENT ALLOCATION BASIS

Service Cost center Basis of Reapportionment

Store Number of material requisitions
Maintenance Number of maintenance hours or number of
maintenance calls
Canteen Number of employees
Production Planning Direct labor hours worked in each production cost
center
METHODS AVAILABLE FOR REAPPORTIONMENT

• Direct method is used when service centers do not exchange

services with each other, means they only provide services to
production centers.
• Indirect method is used when service centers exchange
services with each other. Means service centers provide
services to production centers and to each other’s as well.
INDIRECT METHOD

• Indirect method further sub divided into 2 methods:

a. Step Down method (one-way method) : One service department provides
services to other service departments but others do not. Service department
which provides service to other service center is reapportioned first. This is the
only method in which sequence of re-apportionment matters.
b. Reciprocal method (two-way method) : Service departments provide
services to each other. It may be solved algebraically by simultaneous equation
or through repeated distribution. For example, the maintenance department
will use the canteen, while the canteen may rely on the maintenance
department to ensure its equipment is functioning properly or to replace bulbs,
plugs, and so on).
DIRECT METHOD OF
REAPPORTIONMENT
• Direct method of reapportionment
• The direct method of reapportionment involves apportioning the
costs of each service cost center to production cost centers only
Example: Malenda qn, direct method (ignores inter-service department work)
A B Maintenance Store
Allocated costs 78,030 40,670 22,840 13,660
General costs 15,000 20,000 12,000 5,000
Total
93,030 60,670 34,840 18,660
 • Service departments' services were used as follows.
A B Maintenance Store Total
Maintenance hours worked 5,000 4,000 - 1,000 10,000
Number of stores requestion 3,000 1,000 1,000 - 4,000

Required
Calculate the total production overhead costs of Departments A and B using
the direct method of reapportionment
• Stage 1: Apportioning general overheads
• Overhead apportionment follows on from overhead allocation.
The first stage of overhead apportionment is to identify all
overhead costs as production department, production service
department, administration or selling and distribution
overhead
BASES OF APPORTIONMENT

• It is considered important that overhead costs should be

shared out on a fair basis.
 BASIS OF APPORTIONMENT
Overhead Basis
Rent, rates, heating and light, repairs Floor area occupied by each cost
and depreciation of buildings centre
Depreciation, insurance of Cost or book value of equipment
equipment
Personnel office, canteen, welfare, Number of employees, or labor
wages and cost offices, first aid hours worked in each cost centr
(Wage cost)
Power Kilowatt hour / capacity of machines
(horse power)
• Using the Malenda question above, show how overheads
should be apportioned between the four department.
 SOLUTION

Item cost Basis of A B Maintenance Store Total

apportionment
Heat and Light Floor Area 7,680 5,120 3,840 2,560 19,200
Repair Cost Floor Area 3,840 2,560 1,920 1,280
9,600
Machine depreciation Machine Value 32,400 13,500 5,400 2,700 54,000

Rent and rates Floor Area 15,360 10,240 7,680 5,120 38,400

Canteen No of employee 3,750 3,000 1,500 750 9,000

Machine insurance Value of Machine 15,000 6,250 2,500 1,250 25,000

Total 78,030 40,670 22,840 13,660
REAPPORTION SERVICE DEPARTMENT COSTS

• Service departments are cost centers, which exist to provide

services to other departments. The canteen is a common
example, having allocated and apportioned the costs to the
production and service departments, the totals of service cost
centers, the latter need to be reapportioned to the production
cost centers.
 BASIS OF REAPPORTIONMENT

Service Cost center Basis of Reapportionment

Store Number of material requisitions
Maintenance Number of maintenance hours or
number of maintenance calls
Canteen Number of employees
Production Direct labor hours worked in each
Planning production cost center
METHODS ARE AVAILABLE FOR
REAPPORTIONMENT
• Direct method
• Indirect method

• Step Down method (one-way method)

• Reciprocal method (two-way method)
DIRECT METHOD OF REAPPORTIONMENT

• The direct method of reapportionment involves apportioning

the costs of each service cost center to production cost centers
only
• It is used when service centers do not exchange services with
each other, means they only provide services to production
centers
 EXAMPLE: MALENDA QNS

A B Maintenan Store
ce
Allocated 78,030 40,670 22,840 13,660
costs
General costs 15,000 20,000 12,000 5,000
Total 93,030 60,670 34,840 18,660
 • Service departments' services were used as follows
A B Maintenan Store Total
ce
Maintenance hours 5,000 4,000 - 1,000 10,000
worked
Number of stores 3,000 1,000 1,000 - 4,000
requestion
• Calculate the total production overhead costs of Departments A and B
using the direct method of reapportionment
Service Basis of apportionment Total cost Dept A Dept B
department
Maintenance maintenance Hrs 34,840 19,356 15484
Store No of Store requisition 18,660 13,995 4,665
53,500 33,351 20,149
Previous Allotd 153,700
cost 93,030 60,670
Total Overhead 207,200 126,381 80,819
STEP DOWN METHOD OF REAPPORTIONMENT

• Step 1
• Reapportion one of the service cost center’s overheads to all the other
centers which make use of its services (production and service).
• Step 2
• Reapportion the overheads of the remaining service cost center to the
production departments only. The other service cost center is ignored.
 SOLUTION

A B Maintenance Store
General
allocated 93,030 60,670 34,840 18,660
Apportion Store 11,196 3,732 3,732 (18,660)
38,572
Apportion
maintenance 21,429 17,143 (38,572) -
125,655 81,545 - -
 IF THE FIRST APPORTIONMENT HAD BEEN THE
MAINTENANCE DEPARTMENT

A B Maintenance Store
General allocated 93,030 60,670 34,840 18,660
Apportion
maintenance 17,420 13,936 (34,840) 3,484
22,144
Apportion Store 16,608 5,536 - (22,144)
127,058 80,142 - -
OVERHEAD ABSORPTION

• Overhead absorption is the process whereby overhead costs

allocated and apportioned to production cost centers are
added to unit, job or batch costs. Overhead absorption is
sometimes called overhead recovery
ABSORPTION RATE

• Overheads are usually added to cost units using a

predetermined overhead absorption rate, which is calculated
using figures from the budget.
• Absorption rate is a method of including a fair proportion of
the total overheads costs as part of the cost of each cost unit.
 Budgeted Production Overhead
• 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝 𝐀𝐛𝐬𝐨𝐫𝐩𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝐿𝑒𝑣𝑒𝑙
CALCULATION OF OVERHEAD ABSORPTION RATES

• Step 1: Estimate the overhead likely to be incurred during the coming period
• Step 2: Estimate the activity level for the period. This could be total hours,
units, or direct costs or whatever it is on which the overhead absorption rates
are to be based.
• Step 3: Divide the estimated overhead by the budgeted activity level. This
produces the overhead absorption rate.
• Step 4: Absorb the overhead into the cost unit by applying the calculated
absorption rate.
• ABC cooperation has the fallowing budgeted hours for the year 2012
• Estimated overhead Tsh.800,000
• Estimated direct labor hour Tsh. 10,000
• Required
• Calculate overhead applied per direct labor hour
• Calculate the overhead applied if 9,500 actual direct labor hour are used during 2012
• Calculate under and over applied overhead if the actual overhead is TZS752,000
BLANKET RATE AND DEPARTMENTAL RATE

• Blanket rate refers to a situation where single OAR is used for

the whole factory or organization. It is appropriate
➢Fewer departments
➢Fewer products
➢Similar processes and activities
DEPARTMENTAL RATE

• Departmental rate is also known as separate absorption rate. It

uses a separate OAR for each department or cost Centre. It is
appropriate,
➢Multiple departments
➢Wide range of products
➢Different processes and activities
COMPARISON BLANKET AND
DEPARTMENTAL RATE
➢ If blanket overhead absorption rate is used for the whole factory then
some products will receive a higher overhead proportion and some will
be under charged. Using a separate absorption rate is more appropriate
where product spent different amount of time in each department.

➢ The use of blanket rate saves time and thus cost, but less accurate than
departmental rates.

➢ Therefore, a careful selection of which type of rate to use is essential,

taking into account the cost-benefit analysis.
ILLUSTRATION

The Old Grammar School has two production departments, for which the following
budgeted information is available.
Department A Department B Total
Budgeted overheads 360,000 200,000 560,000
Budgeted direct labor 200,000 40,000 240,000
hours
If a single factory overhead absorption rate is applied, the rate of overhead recovery
would be:
 560000
• =2.33 per direct labor hours
240000 ℎ𝑟𝑠
• If separate departmental rates are applied, these would be
Department A = 360,000
200,000
= 1.8 per Direct Labor hour

200,000
Department B = = 5 per Direct labor hour
40,000
Department B has a higher overhead rate of cost per hour worked than
department A.
Job X has a prime cost of $100, takes 30 hours in department B and
does not involve any work in department A.
Job Y has a prime cost of $100, takes 28 hours in department A and
2 hours in department B. What would be the factory cost of each job,
using the following rates of overhead recovery?
a) A single factory rate of overhead recovery
b) Separate departmental rates of overhead recovery
 SOLUTION

Job X Job Y
(a) Single factory rate $ $
Prime cost 100 100
Factory overhead (30 x$2.33) 70 70
Factory cost 170 170
Separate departmental rates $ $
Prime cost 100 100.00
Factory overhead: department A 0 (28 x $1.80) 50.40
department B (30 x $5) 150 (2 x $5) 10.00
Factory cost 250 160.40
OVER/ UNDER ABSORPTION OF OVERHEADS

• Predetermined absorption rate or Overhead absorption rate (OAR) is

based on budgeted overheads and budgeted activity levels. The absorbed
overheads will differ from actual overheads incurred.

• Absorbed OH < Actual OH = UNDER absorption

• Absorbed OH > Actual OH = OVER absorption
• Under or over absorption of overheads will occur if:
• Actual overheads are different from the budgeted overheads
• Actual activity level different from the budgeted activity level
• Or both situations arise
• Pembele has a budgeted production overhead of $50,000 and a budgeted
activity of 25,000 direct labour hours and therefore a recovery rate of $2
per direct labour hour.
• Calculate the under-/over-absorbed overhead, and the reasons for the
under/over absorption, in the following circumstances.
• Actual overheads cost $47,000 and 25,000 direct labour hours are worked.
• Actual overheads cost $50,000 and 21,500 direct labour hours are worked.
• Actual overheads cost $47,000 and 21,500 direct labour hours are worked
• Case I
Actual overhead 47,000
Absorbed overhead (25,000 x $2) 50,000
Over-absorbed overhead 3,000
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