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Business Processes & Accounting Systems · Week 10

Overhead Costing — Allocation, Apportionment, Re-apportionment & Absorption

What overheads are and how they're classified, cost centres, allocation vs apportionment and the bases used, re-apportioning service departments (direct, step-down, reciprocal), overhead absorption rates (actual vs predetermined, six methods, blanket vs departmental), and under/over absorption.

ITE36221 video · 30 min📄 Overhead costing session 10.pdf📄 Practice – Overhead costing.pdf

1What is overhead?

Definition

Overhead is the total of indirect materials, indirect labour and indirect expenses: costs incurred in making a product, providing a service or running a department that can't be traced directly and in full to the product 01:43.

The biscuit company 02:20
  • Direct: we can measure the flour and the labour hours per packet of biscuits.
  • Indirect (overhead): we can't say how much electricity, water, or the production manager's salary went into one packet.
Classification by element 03:42 Classification by function
Indirect materials (cleaning materials, lubricants) Production overhead: factory electricity
Indirect labour (supervisors, storekeepers) Selling and distribution overhead: showroom electricity
Indirect expenses (rent, insurance, depreciation) Administration overhead: HR building electricity

Overheads can't be traced to a unit directly, so they reach each unit through three stages:

  1. Allocation
  1. Apportionment (+ re-apportionment of service depts)
  1. Absorption into units

2Cost centres, allocation & apportionment

A cost centre is a responsibility centre whose manager is accountable for the expenses under their control. In simple terms, a department 06:05.

Cost centres can be production, service or process cost centres.

Allocation Apportionment
Meaning Whole cost items charged directly to one cost centre Sharing a common cost in proportions between two or more cost centres on a fair basis
Example Each department has its own electricity meter. Food colouring used only by Dept A (Rs 15,000) One electricity bill or the factory rent shared by floor area

Bases of apportionment

Overhead Basis
Rent, rates and taxes, lighting and heating, building insurance, depreciation and repairs, air conditioning Floor area occupied
Insurance and depreciation of plant and machinery Capital value (of machines)
Repairs and maintenance of plant and machinery Machine hours
Welfare, time-keeping, payroll office, canteen, recreation, supervision, medical Number of employees
Store-keeping expenses Value or weight of materials (or number of requisitions)
Transport service Truck mileage, tonnage, truck hours, number of packages
Electricity (power) Kilowatt usage (or floor area) 11:51
Video apportionment example 12:32
  • Electricity Rs 225,000 by kW usage 500 : 400 : 100 = 5 : 4 : 1 (A : B : maintenance): A = 225,000 ÷ 10 × 5 = 112,500, B = 90,000, maintenance = 22,500 15:01.
  • Rent Rs 150,000 by floor area 2,500 : 3,750 : 1,250 m² = 2 : 3 : 1: A = 150,000 ÷ 6 × 2 = 50,000, B = 75,000, maintenance = 25,000 16:01.
  • Machine insurance Rs 45,000 by machine value 300k : 500k : 100k = 3 : 5 : 1: A 15,000, B 25,000, maintenance 5,000 17:08.
  • Machine depreciation Rs 72,000, also 3 : 5 : 1: A 24,000, B 40,000, maintenance 8,000.

Adding the directly allocated items (A 15,000 · B 60,000 · maintenance 25,000), the primary totals are A 216,500 · B 290,000 · maintenance 85,500 17:35.

Re-apportionment: maintenance 85,500 by maintenance hours 3,000 : 2,000 (3 : 2) gives A +51,300 and B +34,200. Final: A 267,800 · B 324,200 19:28.

3Re-apportioning service department costs

  • Production departments carry out the central purpose of the organisation.
  • Service departments (stores, maintenance, canteen, personnel, accounting) support them and have no output of their own.
  • So their costs must be re-apportioned to production departments before absorption 18:14.
Service cost centre Re-apportionment basis
Stores Number (or value) of material requisitions
Maintenance Hours of maintenance work for each centre
Purchasing Number of purchase orders, or value of materials purchased
Inspection Inspection hours
Internal transport Weight and distance

Three methods:

Method When
1. Direct method Ignore services between service departments. Apportion each service department straight to production departments
2. Step-down method Some service departments serve others, but the services aren't reciprocated. Apportion one service department, including its share to the others, then the next
3. Reciprocal method Service departments serve each other. Use repeated distribution or simultaneous equations (let S = stores total, M = maintenance total…)
Lecture example: direct method
Prod A Prod B Stores Maintenance
Overheads 10,030 8,970 10,000 8,000
Material requisitions (Rs) 30,000 50,000 – –
Maintenance hours 8,000 1,000 – –
  • Stores (10,000) by requisitions 30 : 50: A = 10,000 × 3/8 = 3,750, B = 6,250
  • Maintenance (8,000) by hours 8,000 : 1,000: A = 8,000 × 8/9 = 7,111, B = 889
Prod A Prod B
Own overheads 10,030 8,970
From stores 3,750 6,250
From maintenance 7,111 889
Total 20,891 16,109

Check: 20,891 + 16,109 = 37,000, the total of all four departments.

4Overhead absorption

Definition

Absorption is the systematic process of charging the overheads of production departments to the units produced, using an overhead absorption rate (OAR) 21:44.

Actual OAR = Actual overheads ÷ Actual activity
Predetermined OAR = Budgeted overheads ÷ Budgeted activity ← normally used

Why predetermined? Actual figures are only known at the end of the period. Product costs are needed now, for pricing, planning and control 28:19.

Methods of absorption

Method OAR formula Best for
Production unit POH ÷ number of units Identical products (every biscuit packet is the same) 24:27
% of direct labour cost POH ÷ direct labour cost × 100
% of direct material cost POH ÷ direct material cost × 100
% of prime cost POH ÷ prime cost × 100
Direct labour hour rate POH ÷ labour hours Labour-intensive departments 23:52
Machine hour rate POH ÷ machine hours Machine-intensive departments
  • Blanket (single) rate: one rate for the whole factory. Simple, but inaccurate when departments differ.
  • Departmental rates: a separate OAR for each production department. More accurate.
Video absorption example 25:46
  • Dept A (labour-intensive): OH 267,800 ÷ 4,000 labour hours = Rs 66.95 per labour hour. A packet needing 2 labour hours absorbs Rs 133.90.
  • Dept B (machine-intensive): OH 324,200 ÷ 2,000 machine hours = Rs 162.10 per machine hour 26:55.

5Under- and over-absorption

Absorbed overhead = predetermined OAR × actual activity. Compare it with actual overhead:

Result Meaning Treatment
Over-absorption Absorbed > actual: costs were overstated 29:03 Credit to the P&L (adds to profit)
Under-absorption Absorbed < actual: costs were understated 29:24 Debit to the P&L (an extra expense)

Causes:

  • actual overheads differ from budget
  • actual activity differs from budget
  • both
🧪 Try it — Overhead costing workbench

Defaults reproduce the video's biscuit company (A 267,800 → Rs 66.95/hr; B 324,200 → Rs 162.10/hr). Edit any figure. A and B are production departments; S is the maintenance service department.

Exam focus

A typical question is a full overhead analysis sheet:

  1. Allocate direct items.
  2. Apportion shared costs with the right bases (state them).
  3. Re-apportion the service departments (direct, step-down or reciprocal).
  4. Compute departmental OARs (labour hour vs machine hour, and say why).
  5. Cost a unit or job.
  6. Work out the under/over absorption.

Also define allocation vs apportionment and explain why predetermined rates are used.

6Practice questions (course paper)

Q1: Primary apportionment and redistribution
Expense (basis) X Y A B Total
Depreciation (asset value 10:5:3:1) 100,000 50,000 30,000 10,000 190,000
Rent, rates, taxes (floor space 5:4:1:2) 15,000 12,000 3,000 6,000 36,000
Insurance (asset value) 8,000 4,000 2,400 800 15,200
Power (machine hours 10:5:4:1) 10,000 5,000 4,000 1,000 20,000
Canteen (workers 100:50:50:25) 4,800 2,400 2,400 1,200 10,800
Electricity (light points 50:30:20:20) 2,000 1,200 800 800 4,800
Primary total 139,800 74,600 42,600 19,800 276,800
A to X : Y = 3 : 2 25,560 17,040 (42,600)
B to X : Y = 9 : 1 17,820 1,980 (19,800)
Production overheads 183,180 93,620 — — 276,800
Q2 and Q6: damaged tables

The tables in Q2 are too jumbled in the PDF to read reliably, so there's no answer for Q2 here; use the method from Q1 and Q3. Q6 is reconstructed below; check its data against your own copy of the paper.

Q3: Reciprocal services (Departments 1, 2, 3; services A and B)

Overheads: 1 = 5,000 · 2 = 8,000 · 3 = 15,000 · A = 1,000 · B = 4,000 (total 33,000).

Simultaneous equations:

  • A = 1,000 + 0.2B
  • B = 4,000 + 0.1A
  • So A = 1,836.73 and B = 4,183.67
1 2 3
Own overheads 5,000 8,000 15,000
Share of A (30% / 50% / 10%) 551.02 918.37 183.67
Share of B (40% / 30% / 10%) 1,673.47 1,255.10 418.37
Total 7,224.49 10,173.47 15,602.04

Repeated distribution reaches the same totals: keep sharing A and B out until the amounts left are negligible.

The paper says "two production and three service departments", but its apportionment table treats 1, 2 and 3 as production and A and B as service.

Q4 and Q5: Same overhead, six absorption bases

Q4: direct material = 4.5 kg × Rs. 2 = 9, direct labour = 6 h × Rs. 1 = 6, prime cost 15 per unit. Overheads are 3,000 for 2,000 units.

Basis Rate Overhead per unit Cost per unit
Production units 3,000 / 2,000 = 1.50 per unit 1.50 16.50
% of direct wages 3,000 / 12,000 = 25% 1.50 16.50
% of direct material 3,000 / 18,000 = 16.67% 1.50 16.50
% of prime cost 3,000 / 30,000 = 10% 1.50 16.50
Direct labour hours 3,000 / 12,000 h = 0.25 per hour 1.50 16.50
Machine hours 3,000 / 4,000 h = 0.75 per hour 1.50 16.50

All six give the same answer, because there's only one product and every base is proportional to output.

Q5: direct material 10 × 5 = 50, direct labour 8 × 4 = 32 (prime 82). Overhead 10,000 / 1,000 units = 10 per unit on every basis (machine hour rate 2.50 × 4 hours). Cost = 92.

Q6: New Enterprises, cost of an article

Data read from the damaged table:

  • Floor space: 2,000 / 2,500 / 3,000 / 2,000 / 500
  • Light points: 10 / 15 / 20 / 10 / 5
  • Direct wages: 3,000 / 2,000 / 3,000 / 1,500 / 500
  • HP: 60 / 30 / 50 / 10 / 0
  • Machinery value: 60,000 / 80,000 / 100,000 / 5,000 / 5,000
  • Working hours: A 6,226, B 4,028, C 4,066
A B C D E
Primary totals 7,550 7,200 9,650 3,125 1,075

Simultaneous equations: D = 3,125 + 0.1E and E = 1,075 + 0.1D, so D = 3,265.15 and E = 1,401.52.

A B C
Final overheads 8,763.64 8,459.85 11,376.52
Rate per hour 1.408 2.100 2.798
Hours used by the article 4 5 3
Overhead 5.63 10.50 8.39

Total cost = 50 + 30 + 24.53 = Rs. 104.53

7Quick revision sheet

Concept Remember it as
Overhead Indirect material + indirect labour + indirect expenses
Function classes Production · selling & distribution · administration
Cost centre Department; production, service or process
Allocation Whole cost to one centre
Apportionment Share on a fair basis (floor area, capital value, employees, machine hours, kW)
Re-apportionment Service → production: direct · step-down · reciprocal (repeated distribution, equations)
Direct-method example A 20,891 · B 16,109 (total 37,000)
Absorption Charge to units with an OAR
OAR Budgeted OH ÷ budgeted activity (predetermined)
Methods Unit · % labour, material or prime cost · labour hour · machine hour
Blanket vs departmental One rate vs one per department (more accurate)
Video example 267,800 ÷ 4,000 = 66.95/hr; × 2 hrs = 133.90 per unit
Over-absorbed Absorbed > actual → credit P&L
Under-absorbed Absorbed < actual → debit P&L

?Self-check quiz

12 questions on this week. Answer them all, then press Check my answers. Your best and latest scores are saved and shown on the subject page.

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