COST ALLOCATION

Session Objectives
 What is overhead?

 Basis of classifying overheads

 Various types of overheads

 Steps in overhead accounting

 Basis of Apportionment of Overheads

 Principles of Apportionment

 Methods of Reapportionment

 Absorption of overheads

 Methods of absorption

 Under absorption & Over absorption

Concept of Allocation

Cost allocation is the process of assigning costs in a situation wherein a direct measure does not exist for
the quantity of resources consumed by a particular cost object. Cost allocations involve the use of
surrogate rather than direct measures. The basis that is used to allocate costs to cost objects is called an
allocation base or cost driver.
Definition of Overheads

Overheads are the indirect costs that cannot be allocated to any specific job or process as they are not
capable of being identified with any specific job or process. It includes cost of indirect material, indirect
labor and indirect expenses that cannot be conveniently charged to any job or process. The CIMA defines
overhead cost as “the total cost of indirect materials, indirect labor and indirect expenses. In short, it is
the cost of materials, labor and expenses that cannot be economically identified with specific saleable cost
unit.
Classification of Overheads
The basic principles to be considered while treating an item as OH are as follows.

 The aggregate of indirect material costs, indirect wages and indirect expenses is OH. Thus, it comprises of all indirect
costs. Therefore, the relationship of the items of costs to products, jobs etc. must be traced.

 Direct costs are also treated as OH in cases where efforts involved in identifying and accounting are
disproportionately large. Costs incurred for items like nuts, bolts etc., if very small, can be apportioned as OH over the
jobs or products.

 The OH can be apportioned to a cost centre in accordance with the principles of benefit and/or responsibilities. The
benefit principle implies that if cost centre occupies a certain proportion of a large unit of space for which standing
charges are accurately ascertained, it should be charged with a corresponding proportion of such costs. The
responsibility principle implies that as the departmental head has no control over the amount of rent and rates paid,
his department should not bear any brunt of allocation of such costs.

 Capital expenditure should be excluded from costs and should not be treated as OH.
 Expenditure that doesn’t relate to costs shall not be treated as OH. Payment like donations, subscriptions etc. cannot
be treated as OH.
Classification of Overhead Costs
Steps on Overhead Accounting
The various steps in an overhead accounting are:

 Collection of overhead details

 Distribution of overhead to cost centres

 Reapportionment of service department costs to production departments

Overhead Allocation
• Allocation is the process by which whole cost items are charged direct to a cost unit or cost
centre
• For example, the following cost will be charged to the following cost centres via the
process of allocation:-
 Direct labour will be charged to the production cost centre
 The cost of warehouse security will be charged to the warehouse cost centre
 Costs such as canteen are charged direct to the various overhead cost centres.
Apportionment of overhead
• Apportionment of overhead is distribution of overheads to more than one cost centre on some
equitable basis.
• When the indirect costs are common to different cost centres, these are to be apportioned to the cost
centres on an equitable basis. For example, the expenditure on general repair and maintenance
pertaining to a department can be allocated to that department but has to be apportioned to various
machines (Cost Centres) in the department. If the department is involved in the production of a single
product, the whole repair & maintenance of the department may be allocated to the product.
Overhead apportionment basis:-
Overhead to which basis apply Basis of apportionment

Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of building

Deprecation and insurance of equipment Cost or book value of equipment

Personnel, office, canteen, welfare, wages Number of employees, or labour hours worked in each cost
and costs of offices, first aid centre
Reapportionment of overhead
The third step is the reapportionment of service department costs to production departments. The
reapportionment of service department costs to the production departments or cost centres is known as
secondary distribution. The methods of redistribution of service department costs to production
departments are direct redistribution method, step method and reciprocal service method.
Basis of apportionment of service cost centres
Service cost centre Possible basis of apportionment

Stores Number of cost value of material requisitions

Maintenance Hours of maintenance work done for each cost centre

Production planning Direct labour hours worked in each production cost centre
Reapportionment of overhead – cont:
Under the direct redistribution method, the costs of service departments are directly apportioned to production
departments without taking into account any service rendered by one service department to another service
department. Thus, proper apportionment cannot be made and the production department may either be overcharged
or under charged. As budgeted OH for each department cannot be prepared thoroughly, the department OH rates
cannot be ascertained correctly.

As per the step method, the cost of most serviceable departments is first apportioned to other service departments
and production departments. The next service department is taken up and its cost is apportioned. This process goes on
till the cost of the last service department is apportioned. Thus, the cost of the last service department is apportioned
only to the production departments.

The reciprocal service method considers the fact that every department should be charged for the services rendered to
it. If two service departments provide service to each other, each department should be charged for the cost of service
rendered by the other.
Reapportionment of overhead – cont:
Illustration: Direct Redistribution

The particulars of cost incurred in the production departments and service departments of a manufacturing concern are
as follows. Cost of service department D is to be apportioned in the ratio of 5:4:4 and E in the ratio of 4:3:2.
Production departments Service Departments

A B C D E

1,00,000 1,50,000 1,25,000 75,000 60,000

Calculate the costs allocated to each production department.

Reapportionment of overhead – cont:
Illustration: Reciprocal Service Method

A company has three production departments and two service departments. The overhead analysis sheet provides the
following totals of the overheads analyzed to production and service departments.
(Rs.)
Production department A 24,000
B 21,000
C 15,000
Service Department X 7,020
Y 9,000
The expenses of the service departments are follows.

Production Dept: Service Dept:

A B C X Y

Service Dept: X 20% 40% 30% - 10%

Y 40% 20% 20% 20% -
Illustration
Absorption of overheads

“Process of allocating the overhead expenses to the cost centres/cost units is known as overhead
absorption”
Cost allocation and cost absorption is the portioning of a cost among a set of cost objectives. For this
purpose, the cost object could be production units, machines, groups of machines, individual products or
groups of products.
TOTAL OVERHEADS OF COST CENTRE
Overhead absorption Rate =
TOTAL QUANTUM OF BASE

The base ( denominator) is selected on the basis of type of the cost centre and its contribution to the
products or services, for example, machine hours, labour hours, quantity produced etc.
Absorption Rates
Actual rate
Actual rate
The actual rate is computed by dividing the Actual OH expenses
incurred during a period of time by the actual quantum (quantity of
Predetermined rate
value) of the base selected for that period.
Moving average rate

Blanket and multiple rates

Absorption Rates
Predetermined rate
Actual rate
In practice, actual OH costs are not always readily available for
Predetermined rate application since the total figure of OH cost incurred during the
period will be ascertained only at the end of the accounting
Moving average rate period and application of actual OH absorption is not possible.
To overcome the difficulty, a predetermined OH absorption rate
Blanket and multiple rates is calculated at the beginning of the accounting period and is
applied to the completed units during the period. The major
objective of using predetermined absorption rates is to recover
the OH as soon as the product has been completed, to arrive at
the product cost. It is calculated with the budgeted figures of
the forthcoming accounting period based on the expected level
of activity.
Absorption Rates
Moving Average rate
Actual rate
These rates are a compromise between the actual rate and
Predetermined rate predetermined rate. It is computed by dividing the average of
the past twelve months or six months actual OH cost by the
Moving average rate estimated base for the months.

Blanket and multiple rates

Absorption Rates
Blanket and Multiple rates
Actual rate
A common absorption rate used throughout a factory and for
Predetermined rate all jobs and units of output irrespective of the department in
which they were produced is called blanket absorption rate.
Moving average rate Such rate is not appropriate where there are number of
departments in the factory and jobs do not spend an equal
Blanket and multiple rates amount of time in each department. In some cases, all the jobs
or units may not pass through all the departments, in the
factory. In such circumstances departmental OH rate of
respective departments is applied to the jobs or units
depending on time spent in each department, to ensure that
all jobs are charged with their fair share
Methods of Absorption
Under absorption/overabsorption
The overhead absorption rate is predetermined from budget estimates of overhead cost and the
expected volume of activity.

Over or under recovery of overhead will occur in the following circumstances:-

• Actual overhead costs are different from budgeted overhead
• The actual activity level is different from the budgeted activity level
• Actual overhead costs and actual activity level differ from the budgeted costs and levels
Under absorption/overabsorption
The overhead absorption rate is predetermined from budget estimates of overhead cost and the
expected volume of activity.

Over or under recovery of overhead will occur in the following circumstances:-

• Actual overhead costs are different from budgeted overhead
• The actual activity level is different from the budgeted activity level
• Actual overhead costs and actual activity level differ from the budgeted costs and levels
Under absorption/overabsorption
The following data is given for a production department:-
Budgeted overhead Rs 80,000
Budgeted direct labour hours 40,000
Actual overhead Rs 84,000
Actual direct labour hours 45,000
Calculate the under/over absorbed overheads
Under absorption/overabsorption
The accountant of a newly formed company was asked to establish a predetermined rate for applying overheads to the job moving
through a single manufacturing shop and to check results periodically. He has extracted the following information pertaining to
factory overhead costs for the year 2006-07:
The estimated and actual direct labour hours for the period were 1,44,000 and 1,21,500 respectively. Compute the under or over
absorption of overhead costs for the period.

Estimated costs Actual costs

Particulars
(Rs.) (Rs.)
Factory supervision 50,000 51,000
Indirect labour 1,15,000 99,000
Inspection 70,000 73,000
Maintenance 35,000 39,000
Indirect material 25,000 20,000
Heat, light and power 20,000 18,000
Depreciation 35,000 35,000
Miscellaneous expenses 10,000 3,000