Overhead Absorption is a crucial step in cost accounting that involves allocating indirect costs to various cost centers and ultimately to products or services. This process ensures that each product or service bears its fair share of overhead expenses, allowing for accurate pricing and profitability analysis. The absorption of overheads is carried out through Primary Distribution and Secondary Distribution.
Overhead Absorption is the process of assigning or apportioning overhead costs to cost units, which are typically products or services. It’s essential because overheads, unlike direct costs, cannot be directly traced to a specific product. Proper absorption ensures that all indirect costs are included in the total cost of production, leading to accurate pricing and financial decisions.
Primary Distribution of Overheads
Primary Distribution is the first step in overhead absorption. It involves allocating or apportioning overhead costs to various departments or cost centers within the organization. This step considers both production departments (which are directly involved in manufacturing) and service departments (which provide support functions).
- Allocation:
This refers to directly assigning whole overheads to a specific department or cost center. For example, if the rent of a factory building is entirely for the production area, it is allocated fully to the production department.
- Apportionment:
When an overhead cost relates to more than one department, it needs to be divided (apportioned) based on an appropriate basis. For example, the factory rent may be apportioned between different departments based on the area occupied or square footage.
Bases of Apportionment:
Overhead costs are apportioned using various bases depending on the nature of the cost:
- Rent and Rates: Apportioned based on the area occupied by each department.
- Power and Fuel: Apportioned based on machine hours or horsepower used.
- Depreciation: Apportioned based on the value of machinery or equipment in each department.
- Supervision and Salaries: Apportioned based on the number of employees in each department.
Example of Primary Distribution
Suppose a factory has three departments: Department A (Production), Department B (Production), and Department C (Service). The total overheads of $50,000 are allocated and apportioned as follows:
| Overhead Item | Total Cost ($) | Basis of Apportionment | Department A ($) | Department B ($) | Department C ($) |
| Rent | 10,000 | Area occupied | 4,000 | 3,000 | 3,000 |
| Power | 15,000 | Machine hours | 6,000 | 7,000 | 2,000 |
| Supervision Salaries | 25,000 | Number of employees | 10,000 | 10,000 | 5,000 |
| Total Overheads | 50,000 | 20,000 | 20,000 | 10,000 |
In this example, each department’s share of overheads is determined based on appropriate allocation and apportionment criteria.
Secondary Distribution of Overheads:
Once the primary distribution is completed, the next step is Secondary Distribution. This process reallocates the overheads of service departments (e.g., maintenance, HR, canteen) to production departments. The rationale behind this step is that service departments do not produce products directly, but their costs must be absorbed by production departments since they contribute indirectly to production.
Methods of Secondary Distribution
There are several methods to reallocate service department overheads to production departments:
-
Direct Reallocation Method:
Service department overheads are directly distributed to production departments without considering inter-service department exchanges. This method is simple but may lead to inaccurate cost allocation when service departments provide services to each other.
-
Step-Ladder (Sequential) Method:
Service department overheads are allocated sequentially, starting with the department that provides the most service to others. Each department’s overhead is fully reallocated before moving to the next. This method partially considers inter-service department exchanges.
-
Reciprocal Method:
This method fully accounts for the mutual services exchanged between service departments. It uses simultaneous equations or repeated distribution to accurately allocate overheads. While more accurate, this method is complex and time-consuming.
Example of Secondary Distribution
Using the same departments (A, B, and C) from the primary distribution example, suppose Department C’s $10,000 overhead is redistributed to Departments A and B based on labor hours:
| Department | Labor Hours | Proportion | Share of Department C’s Overheads ($) |
| Department A | 60 | 60% | 6,000 |
| Department B | 40 | 40% | 4,000 |
After secondary distribution, the final overheads absorbed by Departments A and B will be:
- Department A: $20,000 (from primary distribution) + $6,000 (from Department C) = $26,000
- Department B: $20,000 (from primary distribution) + $4,000 (from Department C) = $24,000
Absorption of Overheads to Cost Units:
After the primary and secondary distribution, the overheads in the production departments must be absorbed into the cost of products. This is done using an overhead absorption rate, calculated as:
Overhead Absorption Rate = Total Overheads / Base (e.g., labor hours, machine hours, units produced)
The appropriate base depends on the production process and the nature of the overheads.
Types of Overhead Absorption Rates:
-
Machine Hour Rate:
Suitable when machinery plays a significant role in production. Overheads are divided by total machine hours.
-
Labor Hour Rate:
Used when manual labor is more dominant. Overheads are divided by total labor hours.
-
Percentage of Direct Material or Direct Labor Cost:
Overheads are absorbed as a percentage of direct material or labor costs.
Importance of Overhead Absorption:
-
Accurate Product Costing:
Ensures that products are neither under-costed nor over-costed.
-
Pricing Decisions:
Enables organizations to set competitive and profitable prices.
-
Profit Analysis:
Provides a clear understanding of the profitability of each product or service.
-
Cost Control:
Helps in monitoring and controlling overhead expenses by linking them to production output.