Overhead Cost Allocation

Costs incurred by cost centers are classified into two types

a) Direct Costs
b) Indirect Costs

Costs which can be traced to the finished products manufactured are called ‘direct costs’. In other words a relationship between costs and finished products manufactured can be established.

Costs which cannot be traced to the finished products manufactured are called ‘indirect costs’. They are also known as ‘Overheads’. This implies overheads can only be apportioned to the finished products.

Example: A unit manufactures two products – Leather shoes & Leather wallets
Material (Leather) used for both the products is traceable to them individually. However, expenditure of a common machine used in making both the products cannot be traceable to them.

Therefore in the above case ‘Material’ would be a direct cost and ‘Machine expenses’ would be indirect cost.
Importance of overhead allocation

Total cost of product constitutes Direct Material, Direct Labor & Overheads. Direct Material and Direct Labor are directly traceable to the products manufactured. Accuracy of product cost computation depends on accurate distribution of overheads to products. Inaccuracies would lead to incorrect decisions – especially the pricing decisions.

However, the method of overhead distribution should be chosen by considering time and cost factors in addition to accuracy.

Traditional Distribution

Traditionally overhead apportionment to products was made in the following three step approach

I) Primary Distribution (Allocation & Apportionment)
II) Secondary Distribution (Re-apportionment)
III) Absorption

overhead_1

Allocation & Apportionment (Primary Distribution)
Primary distribution of overheads which is also called as ‘Departmentalization’ of overheads involves allocation & apportionment. Allocation of overheads is made when they are traceable to cost centers. Overheads are apportioned when they are not traceable to cost centers. Apportionment is made using the most suitable bases.

Re-apportionment (Secondary Distribution)
Cost centers are two types:

a) Production Cost Centers: They are cost centers where finished products are manufactured

b) Service Cost Centers: They are cost centers that support the production cost centers in manufacture of a product
Ex: Stores, Engineering, Purchase etc.

Re-apportionment is a process where service centers costs are transferred to production centers.

Methods of re-apportionment

The following are the methods used to re-apportion service department costs to production departments.

Scenario Method for re-apportionment
No service between service cost centers Direct re-distribution method
Non reciprocal service between service cost centers Step ladder method
Reciprocal service between service cost centers 1) Repeated distribution method
2) Trial & Error method
3) Simultaneous Equation method

Absorption

The process of recovering overheads to cost of products is called ‘absorption’. In other words all the overheads allocated & apportioned to a department are finally absorbed by the units produced.

Absorption of overheads can be made based on some suitable basis. The following are some of widely used methods of absorption:

a) On the basis of ‘Production units’
b) As a % of ‘Direct Labour Cost’
c) As a % of ‘Direct Material Cost’
d) As a % of ‘Prime Cost’
e) On the basis of ‘Direct Labour Hours’ i.e. Labour Hour Rate
f) On the basis of ‘Machine Hours’ i.e. Machine Hour Rate

Overhead absorption rates are determined based on any one of the above methods. This rate is applied to individual cost units (products, services etc) to derive the total overhead absorbed.

When actual overhead rate is applied on actual cost units, the actual and absorbed overheads would be equal. However if a pre-determined rate is applied on the actual base, it would result in a difference between actual and absorbed overheads. This would happen either because the actual base deviated from the budgeted base or the actual expenses deviated from the budget.

If the absorbed overhead is more than the actual, it is called ‘over absorption’. On the other hand if the actual overhead is more than the absorbed overhead then it is called ‘under absorption’.

Example:

Budgeted Overhead – $ 50,000
Budgeted Volume (units) – 25,000
Actual Overhead – $ 48,000
Actual Volume (units) – 26,000
Absorbed overheads = 26,000 X 50,000 / 25,000 = 52,000
Absorbed overheads – Actual overheads = 52,000 – 48,000 = 4000
Therefore Over Absorption = $ 4000

Activity Based Costing

Traditionally cost accountants had arbitrarily added a percentage of expenses into the direct costs to include overheads. This method is quite satisfactory when the overhead costs are a small percentage compared to direct labor component in actual making of products. However as the percentages of overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products.

For example, one product might take more time in one machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad ‘on-cost’ percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another

Therefore, using an arbitrary percentage leads to distortion of costs resulting in the following problems:

a) Fixation of wrong selling prices (By pricing low profitable opportunities may be missed or by pricing high customers may be lost)
b) Taking wrong decisions (product sales mix decisions etc)

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity.

Cost drivers are used to measure the use of activities by different products / services.
For example the cost of the activity ‘purchasing’ is measured by the number of purchase orders placed.

Overhead Allocation – Traditional vs Activity Based Costing

 

Traditional Vs Activity Based Costing

Steps involved in ABC model

a) Pick resource wise cost data financial accounting records
b) Identify activities
c) Map resource costs to activities
d) Identify activity cost drivers
e) Compute overhead costs of the products / services

Example
Map resource costs to activities

Financial Accounting Data
Expense Amount
Power 210,000
Fuel 54,000
Salaries 350,000
Depreciation 320,000
Rent 125,000
Total 1,059,000
Activities
Expense Machining Purchase Quality Material Handling Total
Power 160,000 15,000 20,000 15,000 210,000
Fuel 50,000 - 4,000 - 54,000
Salaries 120,000 80,000 100,000 50,000 350,000
Deprecation 260,000 20,000 5,000 35,000 320,000
Rent 90,000 10,000 2,000 23,000 125,000
Total 680,000 125,000 131,000 123,000 1,059,000

Identify cost drivers & compute cost driver rates

Activity Cost Driver Rate
Machining # of production runs $ 100 per production run
Purchase # of purchase orders $ 50 per purchase order
Quality # of inspections $ 282 per inspection
Material Handling # of components $ 6150 per component

 

Selling and Distribution Overhead

Selling is a common function in both manufacturing companies as well as trading companies. Thus selling and distribution costs are incurred both manufacturing and trading companies. Most of the selling and distribution costs are not identifiable to products; therefore they are in the nature of indirect costs.

Selling overhead and distribution overhead are two different terms. Selling overhead represents indirect costs incurred for: i) Creation and simulation of demand ii) Securing orders.

Distribution overhead is incurred after the completion of the manufacture process. They are incurred to move the product the customer (or customer’s place).

It is difficult to lay down an exhaustive list of groups under which selling and distribution overheads may be classified. Below is an illustrative classification.

selling and distribution overheads

Process of absorption

The process of collection and distribution of selling & distribution overheads has three stages of analysis as below

selling and distribution overheads

Bases for analysis by function / cost center

Some of the commonly used bases for apportionment of selling & distribution overheads to functions / cost centers are

Type of overhead Base
Advertisement Sales value or sales units
Depreciation Value of assets used
Credit monitoring # of sales orders
Warehouse rent Floor area
Transportation Weight and distance carried
Insurance of stock Value of stock

 

Bases for analysis by products or group of products

Functional costs that cannot be directly allocable to the products are apportioned using one or more of the following bases -

1) Overhead rate per unit of the product: This method is used for allocation of Advertisement costs, warehouse costs etc.

2) As per the number of orders delivered: This method is often used to distribute Transportation costs.

3) As a percentage of sales value: This method is used to allocate Sales Commission, Salesman travel costs etc.

4) As a percentage of cash collected: This method is used to allocate bad debts, collection expenses etc.

Updated: 18-June-2012

Comments

  1. Shirisha Nakkaraboina says:

    hello

    Thanks a lot for providing such a good material but i wanted to bring to your notice that if you could provide the links to the hilighted things in different colours so that it gives the brief description about what it is or definitions kind of thing would be more appropriate.

  2. jagadish.p says:

    sir thanks for providing such a great material, but if you provide problems that might help to students and that which makes your publicity,and also please provide the links to this

    • Hi Jagadish,

      Thanks for your feedback. We will surely include examples / problems with detailed notes. Keep visiting the blog for more notes.

      Thanks,
      VK

  3. Thanx for exposing me in this beautiful knowledge.i like it vry much.Drop again more better materials.

  4. Imraan Desai says:

    thanx a million for helping me wit my hmewrk!!

  5. Hi Vijay,

    The material is very good,thanks for writing such a excellent material which is easy to understand.A graph or tree diagram of Methods of re-apportionment could help us understand it better,because people remember and understand pictures very well.

    Thanks

    Satish

    • @ Satish – Thanks for your suggestion. To certain extent, we tried giving a pictoral view of a concept for easy understanding. We would try doing more of that.

  6. this is very good….

  7. Thank you so much for the guideline.

  8. Infinity thanks
    a very good web to visit again

  9. Megh Bahdur Thapa says:

    Hi,

    I am verry glade for this page.I can take a good knowledge fom this page.Thanks all.

  10. Sir,
    Am seing a set of simulteneous equations if we have cost drivers for different products having diferent rates.Does it arrive to such situations always?

    • Hi,

      When there is interdependancy amongst the service cost centers, we tend to use ‘simultaneous equation method’ to distribute the overhead cost.

      It is not necessary to use the said method in all scenarios with multiple cost drives and products.

      Perhaps I could give better input, if you can share more details of the scenario that you are looking at.

      Thanks
      VK

  11. Hi there.
    Thanks for the simple explaination,
    Just two queriesl

    how the the total overhead is apportioned across to all the activities centres?
    how did you arrive at the activity rate for each of the activities?

    thanks
    Cheers
    Das

    • Hi Das,

      Here are my thoughts

      1) Activity cost pools are used to allocate / apportion overheads to various activities.

      A cost pool is a grouping of individual costs, typically by department or cost center. For example, the cost of machining department is accumulated in a cost pool and then allocated to the products that are using its services with the help of cost drivers.

      2) Once the cost drivers have been identified for the activity, the activity pool is divided with the cost driver units to arrive at the activity rate / cost driver rate. For example: Assuming 6,800 production runs (the example cited above does not provide all the info required to arrive at the cost driver rate) Cost per production run = 680,000 / 6,800 = 100 $

      Hope this clarifies.

      Thanks
      VK

  12. shankaranarayanan.g says:

    i wud like to thank for such lucidly elucidated material :)

  13. hi dear sir,
    thansk alot for providing us such information which is really helpfull.
    but kindly as sample and easy u can with more and more examples porvide as both absorption costing vs marginal costing their differents with alot examples.
    i will be thankfull as soon as u provide as
    best regards,

  14. Thank you for this great and simple article, it’s really helped!

  15. Richmond Kudjordji says:

    Thanks for this wonderful information its really helpful.
    But please we need more examples.
    Thanks.
    $RICHIE$

  16. EID SHADAD says:

    Thanks to the previous illustration,
    We would like to discuss the accounting treatment for loading differences
    Best Regards
    Eid Shadad

  17. Hi

    I’m currently working in a bank, and they have been applying ABC costing for the past 8 years.
    However we are having some trouble allocating overhead marketing cost for the brand to products, do you have any suggestions?

  18. HI
    I would like to know apart from factory over head how the office over head , sales and distribution over heads are applied where the in factory which manufacture multiple products .
    Thanks
    Albert

    • Hello Albert,

      We have updated the post with additional material on sales & distribution overheads. Please let us know if you need more info on this.

      Thanks,
      VK

  19. I had been struggling with the apportionment issue for some days now but from your simplified explanation, am sorted out with my assignment. Thanks and keep up the good work

  20. excellant, provide furthure explanation on the activity base costing

  21. iven mudenda says:

    hanks a lot for this information i really appreciate

  22. ALICE MASIBA says:

    Thanks for the information. may you display more examples

  23. zawedde sarah says:

    Thank you for your work.
    Add some calculation numbers as exampels

  24. Hi Mr Vijay,
    Thank you for providing such a symplified illustration of ABC. The three tabular format to divide cost to appropriate centres was indeedowesome.
    One typographical error was there under the ‘identify activities’ total cost under Quality to be 131,000, whereas it is 141,000:

  25. Amit Chirania says:

    The stuff is very helpful and self explanatory…thanks!

  26. B.MADHU SUDHAN says:

    Hai, i would like to know electircity distribution company Overhead cost, administration and Repairs & maintanance cost allocatocaton for audit pourpose

  27. alex muzira says:

    thanx alot for providing to us such info. bless you.

  28. alex muzira says:

    THE data is really helpful

  29. thanx…………………….

  30. fred KAWAGE says:

    THANX

  31. Thanks for valuable info.

  32. vivek agarwal says:

    thanx for such good material….but it could be even more better..the only thing is that u have to improve the quality of material by providing more examples, especially concept needed.

    thanx

  33. Shantaram Botre says:

    Sir,

    I thought it very useful understinding .Thanks

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