In cost accounting, the allocation and apportionment of overheads are crucial for accurately determining the cost of products. Overheads are indirect costs that cannot be directly attributed to specific cost objects, like products or services.
Allocation of Overhead
Allocation refers to the process of assigning entire overhead costs directly to a specific cost center or department that exclusively incurs the overhead. This process is straightforward when there is a direct relationship between the overhead and the cost center. For example, the salary of a department manager can be entirely allocated to their respective department.
Apportionment of Overhead
Apportionment is used when overhead costs relate to more than one cost center and need to be divided in a rational and equitable manner. This distribution is based on estimates and may use various bases for apportionment, such as floor area (for rent and utilities), machine hours (for machine-related expenses), labor hours, or units produced, among others.
Steps in Apportionment of Overhead:
1. Collection and Classification of Overhead Costs
The first step is to identify and collect all indirect costs (overheads) from various source documents – invoices, wage sheets, utility bills, and department expense reports. These are then classified into three categories: Factory/Production Overheads (rent, depreciation), Administration Overheads (office salaries, printing), and Selling & Distribution Overheads (advertising, carriage outwards). Proper classification ensures that costs are allocated to the correct functional area. This step establishes the complete pool of expenses that need to be distributed across departments and cost centers – forming the foundation for subsequent apportionment.
2. Allocation of Direct Overheads
Direct overheads are those that can be specifically traced to a particular department or cost center without any ambiguity. For example, salary of a foreman working exclusively in Department A, or electricity charges for a dedicated machine in Department B, are directly charged (allocated) to that department. This step involves charging the cost in full to the identifiable cost center, rather than sharing it. It is simple and accurate. After this step, only those overheads remain which are common to multiple departments and need further apportionment.
3. Identification of Service Departments
This step involves identifying those departments that do not produce goods directly but render services to production departments – such as Maintenance, Stores, Power House, Canteen, and Administration. They are called Service/Indirect Departments. Their costs are incurred for the benefit of other departments. Recognizing them is critical because their overheads must ultimately be absorbed into production costs. Production departments (like Machining, Assembly) are the final absorbers. This distinction determines the direction of cost flow in the subsequent apportionment and re-apportionment stages.
4. Primary Apportionment (Distribution to All Departments)
Here, common overhead costs (like rent, lighting, insurance, and general supervision) are distributed among all departments – both production and service – using suitable bases:
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Rent/Insurance – Floor area
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Lighting – Light points or area
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Canteen – Number of employees
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Stores overhead – Value of materials consumed
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Power – Horsepower or machine hours.
This is the first stage of apportionment. Every common cost is split proportionately across all cost centers using a logical, equitable basis. The total overhead cost of the organization gets fully distributed at this stage.
5. Secondary Apportionment (Re-apportionment of Service Department Costs)
Now, the total costs accumulated by service departments are transferred to production departments – because service departments exist only to assist production. This is done using a suitable basis (e.g., Maintenance cost based on machine hours worked in each department). Methods include:
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Direct Redistribution – service cost directly to production
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Step Method – sequential, starting with the largest service department
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Reciprocal/Simultaneous Equation Method – when services are interchanged between service departments.
This step ensures that all overhead costs finally reside only in production departments.
6. Absorption (Final Charging to Production)
This is the final step where the total overhead cost of each production department is charged to individual cost units (products) passing through it. This is done using a predetermined absorption rate, such as:
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Direct Labour Hour Rate
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Machine Hour Rate
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Direct Material Cost Percentage.
The formula is: Budgeted Overheads ÷ Budgeted Activity Level. This rate is applied to each unit produced to determine overhead cost per unit. Absorption completes the journey from common incurred cost to product-specific cost, enabling accurate product pricing and profitability analysis.
What would you like next?
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Methods of Absorption (Direct Material %, Direct Labour %, Machine Hour Rate, etc.)?
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Differences between Allocation, Apportionment, and Absorption?
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Treatment of Under/Over-Absorption of Overheads?
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Problems – a fully solved numerical on Primary + Secondary Apportionment?
Incorporating Machine Hour Rate
The machine hour rate is particularly relevant for allocating and apportioning overheads related to machinery and equipment. This rate is used as a base for apportioning the costs directly associated with machine usage.
Steps to Calculate Machine Hour Rate:
1. Determine the Cost Centre
The first step is to identify the machine or department for which the machine hour rate is to be calculated. All expenses related to that specific machine are collected separately. This ensures that only relevant costs are included in the calculation, resulting in an accurate machine hour rate.
2. Calculate Standing Charges
Standing charges are fixed costs that do not change with machine usage. These include factory rent, insurance, supervisor’s salary, and depreciation. All such fixed expenses relating to the machine are identified and totaled. These costs form an important part of the total machine overhead.
3. Calculate Machine Running Expenses
Machine running expenses are costs incurred only when the machine operates. These include power, fuel, lubricants, repairs, maintenance, and consumable stores. These variable expenses are collected and added to the total machine overhead because they directly depend on machine operation.
4. Calculate Total Machine Overheads
After identifying both standing charges and running expenses, they are added together to determine the total machine overhead. This total represents all indirect costs associated with operating the machine during the accounting period and forms the numerator in the machine hour rate calculation.
5. Determine Effective Machine Hours
Calculate the actual hours for which the machine is available for productive work. Deduct idle time caused by maintenance, breakdowns, holidays, and other unavoidable interruptions from the total available hours. These effective machine hours are used as the basis for calculating the machine hour rate.
6. Apply the Machine Hour Rate Formula
Substitute the total machine overheads and effective machine hours into the formula to calculate the machine hour rate.
Machine Hour Rate = Total Machine Overheads ÷ Effective Machine Hours
The result gives the overhead cost chargeable for each hour the machine is operated.
7. Charge Overheads to Production
Multiply the machine hour rate by the number of hours each job or product uses the machine. This allocates overhead costs fairly to production, helping determine accurate product costs, prepare cost sheets, fix selling prices, and improve cost control.
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