Allocation, Apportionment and Absorption of Overheads

Allocation, apportionment, and absorption are three methods used in cost accounting to assign or allocate overhead costs to products, services, or departments. These methods help to ensure that overhead costs are accurately assigned to the specific cost objects that caused them, allowing businesses to make informed decisions about pricing, profitability, and cost control.

Allocation:

Allocation is the process of assigning direct costs to specific cost objects or products. In this method, overhead costs are assigned directly to a single cost object. For example, if a company has a single overhead cost related to the production of a specific product, this cost would be directly allocated to that product.

Basis of allocation of Overhead with formula

The basis of allocation of overhead refers to the method used to distribute indirect costs to cost centers or cost objects. The choice of basis of allocation will depend on the nature of the cost and the objective of the allocation.

Here are Some Common bases of allocation of overhead and their formulas:

Direct labor hours: Overhead costs can be allocated based on the number of direct labor hours required for each cost center or cost object. The formula for allocation based on direct labor hours is:

Overhead allocation = Overhead cost x (Direct labor hours for the cost center or cost object / Total direct labor hours)

Machine hours: Overhead costs can be allocated based on the number of machine hours required for each cost center or cost object. The formula for allocation based on machine hours is:

Overhead allocation = Overhead cost x (Machine hours for the cost center or cost object / Total machine hours)

Floor area: Overhead costs can be allocated based on the amount of floor space occupied by each cost center or cost object. The formula for allocation based on floor area is:

Overhead allocation = Overhead cost x (Floor area for the cost center or cost object / Total floor area)

Number of employees: Overhead costs can be allocated based on the number of employees in each cost center or cost object. The formula for allocation based on number of employees is:

Overhead allocation = Overhead cost x (Number of employees for the cost center or cost object / Total number of employees)

Sales revenue: Overhead costs can be allocated based on the sales revenue generated by each cost center or cost object. The formula for allocation based on sales revenue is:

Overhead allocation = Overhead cost x (Sales revenue for the cost center or cost object / Total sales revenue)

Material cost: Overhead costs can be allocated based on the cost of materials used by each cost center or cost object. The formula for allocation based on material cost is:

Overhead allocation = Overhead cost x (Material cost for the cost center or cost object / Total material cost)

Number of units produced: Overhead costs can be allocated based on the number of units produced by each cost center or cost object. The formula for allocation based on number of units produced is:

Overhead allocation = Overhead cost x (Number of units produced for the cost center or cost object / Total number of units produced)

Apportionment:

Apportionment is the process of dividing overhead costs among different cost objects or departments based on some basis of apportionment. This method is used when overhead costs cannot be directly traced to a single cost object. For example, if a company has overhead costs related to the maintenance of a factory building, these costs may be apportioned to different departments based on the amount of space each department occupies.

Basis of Apportionment of Overhead with formula

The basis of apportionment of overhead refers to the method used to allocate indirect costs to different cost objects or departments. The choice of basis of apportionment will depend on the nature of the cost and the objective of the allocation.

Here are some common bases of apportionment of overhead and their formulas:

Direct labor hours: Overhead costs can be allocated based on the number of direct labor hours required for each cost object or department. The formula for apportionment based on direct labor hours is:

Overhead apportionment = Overhead cost x (Direct labor hours for the cost object or department / Total direct labor hours)

Machine hours: Overhead costs can be allocated based on the number of machine hours required for each cost object or department. The formula for apportionment based on machine hours is:

Overhead apportionment = Overhead cost x (Machine hours for the cost object or department / Total machine hours)

Floor area: Overhead costs can be allocated based on the amount of floor space occupied by each cost object or department. The formula for apportionment based on floor area is:

Overhead apportionment = Overhead cost x (Floor area for the cost object or department / Total floor area)

Number of employees: Overhead costs can be allocated based on the number of employees in each cost object or department. The formula for apportionment based on number of employees is:

Overhead apportionment = Overhead cost x (Number of employees for the cost object or department / Total number of employees)

Sales revenue: Overhead costs can be allocated based on the sales revenue generated by each cost object or department. The formula for apportionment based on sales revenue is:

Overhead apportionment = Overhead cost x (Sales revenue for the cost object or department / Total sales revenue)

Material cost: Overhead costs can be allocated based on the cost of materials used by each cost object or department. The formula for apportionment based on material cost is:

Overhead apportionment = Overhead cost x (Material cost for the cost object or department / Total material cost)

Number of units produced: Overhead costs can be allocated based on the number of units produced by each cost object or department. The formula for apportionment based on number of units produced is:

Overhead apportionment = Overhead cost x (Number of units produced for the cost object or department / Total number of units produced)

Absorption:

Absorption is the process of including all overhead costs in the cost of a product or service. In this method, overhead costs are absorbed into the cost of each product or service based on a predetermined overhead absorption rate. The absorption rate is calculated by dividing total overhead costs by the total number of units produced. This method is useful in determining the true cost of a product or service, including all direct and indirect costs.

Basis of Absorption of Overhead with formula

Basis of absorption of overhead refers to the method used to allocate indirect costs to products or services. The choice of basis of absorption will depend on the nature of the cost and the objective of the allocation.

Here are Some Common bases of absorption of overhead:

Direct labor cost: Overhead costs can be absorbed based on the direct labor cost of each product or service. The formula for absorption rate based on direct labor cost is:

Overhead absorption rate = Total overhead costs / Total direct labor costs

Direct labor hours: Overhead costs can be absorbed based on the direct labor hours required for each product or service. The formula for absorption rate based on direct labor hours is:

Overhead absorption rate = Total overhead costs / Total direct labor hours

Machine hours: Overhead costs can be absorbed based on the number of machine hours required for each product or service. The formula for absorption rate based on machine hours is:

Overhead absorption rate = Total overhead costs / Total machine hours

Direct material cost: Overhead costs can be absorbed based on the direct material cost of each product or service. The formula for absorption rate based on direct material cost is:

Overhead absorption rate = Total overhead costs / Total direct material costs

Percentage of prime cost: Overhead costs can be absorbed as a percentage of prime cost, which is the sum of direct material cost and direct labor cost. The formula for absorption rate based on percentage of prime cost is:

Overhead absorption rate = Total overhead costs / Total prime cost x 100%

Importance of Overhead Allocation

Overhead allocation is important for several reasons:

• Accurate product costing: Overhead costs are indirect costs that are not directly traceable to a particular product or service. By allocating overhead costs to individual products or services, businesses can get a more accurate picture of the true cost of each product or service. This information is essential for setting prices and making informed decisions about resource allocation.
• Performance evaluation: Overhead allocation allows businesses to evaluate the performance of each cost center or department. By allocating overhead costs to each department, managers can see the true cost of running that department and make informed decisions about resource allocation and process improvement.
• Resource allocation: Overhead allocation helps businesses to allocate resources effectively. By identifying the true cost of each department or product, businesses can make informed decisions about how to allocate resources such as labor, materials, and equipment.
• Budgeting and forecasting: Overhead allocation helps businesses to develop accurate budgets and forecasts. By understanding the true cost of each department or product, businesses can forecast future costs more accurately and plan their budgets accordingly.

Procedure for Accounting & Control of Overhead

The procedure for accounting and control of overhead involves the following steps:

• Identification of Overhead: The first step in accounting and control of overhead is to identify all the overhead costs. Overhead costs include all indirect costs that cannot be directly traced to a product or service. Examples of overhead costs include rent, utilities, depreciation, insurance, salaries of support staff, and other administrative expenses.
• Classification of Overhead: The next step is to classify the overhead costs into different categories such as production overhead, administrative overhead, and selling and distribution overhead.
• Allocation of Overhead: Once the overhead costs have been identified and classified, the next step is to allocate them to different cost centers or departments. This is done using different methods such as the direct method, step-down method, and reciprocal method. The choice of method depends on the nature and complexity of the business operations.
• Apportionment of Overhead: After allocating the overhead costs to different departments, the next step is to apportion them to the products or services produced by each department. This is done using a suitable basis of apportionment such as direct labor hours, machine hours, or square footage.
• Absorption of Overhead: The final step is to absorb the overhead costs into the cost of the product or service. This is done by adding the allocated and apportioned overhead costs to the direct materials and direct labor costs of the product or service. The total cost of the product or service is then divided by the number of units produced to arrive at the unit cost.
• Control of Overhead: Once the overhead costs have been allocated, apportioned, and absorbed into the cost of the product or service, the next step is to control them. This is done by analyzing the overhead costs and identifying areas where costs can be reduced or eliminated. This may involve cost-cutting measures such as reducing energy consumption, renegotiating contracts, or outsourcing non-core activities.
• Reporting and Analysis: The final step is to report the overhead costs and analyze them to identify trends and areas for improvement. This may involve preparing financial statements such as the income statement and balance sheet, as well as analyzing the overhead costs to identify areas where costs can be reduced or eliminated.

Re – Appointment of Service Department Overheads concept and formula

Re-apportionment of service department overheads is the process of re-distributing the overhead costs of the service departments to the production departments that use their services. The main aim of re-apportionment is to ensure that the overhead costs of the service departments are fairly allocated to the production departments.

The formula for re-apportionment of service department overheads is as follows:

Total overheads of service department / Total units of service provided = Overhead rate per unit of service

Once the overhead rate per unit of service has been calculated, it is multiplied by the number of units of service used by each production department to calculate the overhead cost that should be allocated to each production department.

For example, let’s say a company has two service departments, A and B, and two production departments, X and Y. The overhead costs of service department A are $20,000 and it provides 5,000 units of service. The overhead costs of service department B are $30,000 and it provides 10,000 units of service. Production department X uses 2,000 units of service from department A and 5,000 units of service from department B, while production department Y uses 3,000 units of service from department A and 4,000 units of service from department B.

To calculate the overhead cost that should be allocated to production department X from department A, the overhead rate per unit of service is calculated as follows:

Overhead rate per unit of service for department A = $20,000 / 5,000 units of service = $4 per unit of service

The overhead cost that should be allocated to production department X from department A is therefore:

Overhead cost from department A to production department X = 2,000 units of service x $4 per unit of service = $8,000

Similarly, to calculate the overhead cost that should be allocated to production department X from department B, the overhead rate per unit of service is calculated as follows:

Overhead rate per unit of service for department B = $30,000 / 10,000 units of service = $3 per unit of service

The overhead cost that should be allocated to production department X from department B is therefore:

Overhead cost from department B to production department X = 5,000 units of service x $3 per unit of service = $15,000

The same process is repeated for production department Y, and the total overhead cost that should be allocated to each production department is calculated by adding the overhead costs from each service department.

Methods of Re-Apportionment of Overheads

There are several methods of re-apportioning overhead costs from service departments to production departments. The choice of method will depend on the nature of the overheads, the structure of the business, and the objectives of the management. The following are the most commonly used methods:

• Direct method: The direct method allocates the overhead costs of each service department directly to the production departments based on their usage of the services. This method is easy to understand and implement, but it does not take into account the reciprocal services provided by the service departments to each other.
• Step-down method: The step-down method, also known as the sequential method, first allocates the overhead costs of the service department that provides the most services to other departments. Then, the overhead costs of the next service department are allocated, taking into account the overhead costs already allocated from the previous department. This process continues until all service department overheads have been allocated. This method recognizes the mutual services provided by the service departments and is more accurate than the direct method.
• Reciprocal method: The reciprocal method is the most complex method of re-apportioning overhead costs. It takes into account the mutual services provided by the service departments to each other. Under this method, the overhead costs of each service department are first allocated to other service departments based on their usage of the services. Then, the overhead costs of the service departments are allocated to the production departments based on their usage of the services. This method provides the most accurate allocation of overhead costs but is also the most time-consuming and costly.

Absorption of Factory Overheads concept

Absorption of factory overheads refers to the process of including overhead costs in the total cost of production. This is done to determine the total cost of producing a product, which includes not only direct materials and labor costs but also indirect costs such as factory rent, utilities, and maintenance.

The formula for absorption of factory overheads is:

Total cost of production = Direct materials cost + Direct labor cost + Factory overhead cost

The factory overhead cost is absorbed into the total cost of production based on a predetermined overhead absorption rate. This rate is calculated by dividing the total factory overhead cost by a base, which is typically the direct labor cost or machine hours.

For example, if the total factory overhead cost is $50,000 and the total direct labor cost is $100,000, the overhead absorption rate would be:

Overhead absorption rate = Total factory overhead cost / Direct labor cost

= $50,000 / $100,000

= 0.5 or 50%

This means that for every dollar of direct labor cost, 50 cents of factory overhead cost will be absorbed into the total cost of production.

To illustrate the absorption of factory overhead, let’s assume a company produces 1,000 units of a product and the total cost of production is $100,000. The direct materials cost is $30,000, and the direct labor cost is $20,000. The overhead absorption rate is 50%.

Using the formula, the total factory overhead cost absorbed into the total cost of production would be:

Total factory overhead cost = Overhead absorption rate x Direct labor cost

= 0.5 x $20,000

= $10,000

Thus, the total cost of production would be:

Total cost of production = Direct materials cost + Direct labor cost + Factory overhead cost

= $30,000 + $20,000 + $10,000

= $60,000

Therefore, the cost per unit would be:

Cost per unit = Total cost of production / Number of units produced

= $60,000 / 1,000

= $60 per unit.

Overhead Recovery Rates

Overhead recovery rates refer to the rate at which a company recovers overhead costs by allocating them to its products or services. These rates are used to determine the cost of each unit of output and help in pricing decisions.

There are several methods for calculating overhead recovery rates:

Percentage of Direct Labor Cost: In this method, the overhead cost is allocated as a percentage of the direct labor cost. For example, if the overhead cost is $100,000 and the direct labor cost is $500,000, the overhead recovery rate would be 20% ($100,000/$500,000).

Percentage of Direct Material Cost: In this method, the overhead cost is allocated as a percentage of the direct material cost. For example, if the overhead cost is $100,000 and the direct material cost is $300,000, the overhead recovery rate would be 33.33% ($100,000/$300,000).

• Machine Hour Rate: In this method, the overhead cost is allocated based on the number of machine hours used. For example, if the overhead cost is $100,000 and the total machine hours used are 10,000, the overhead recovery rate would be $10 per machine hour ($100,000/10,000).
• Direct Labor Hour Rate: In this method, the overhead cost is allocated based on the number of direct labor hours used. For example, if the overhead cost is $100,000 and the total direct labor hours used are 5,000, the overhead recovery rate would be $20 per direct labor hour ($100,000/5,000).
• Activity-Based Costing Rate: In this method, the overhead cost is allocated based on the activities that contribute to the cost. For example, if the overhead cost is $100,000 and there are three activities that contribute to the cost, the overhead recovery rate for each activity would be calculated based on the cost drivers of each activity.

Once the overhead recovery rate is determined, it is used to allocate overhead costs to products or services based on the amount of the cost driver used. For example, if the overhead recovery rate is $10 per machine hour and a product uses 5 machine hours, the overhead cost allocated to that product would be $50 ($10 x 5).