Allocation and Apportionment of Overheads

Allocation is the charging of overheads directly to one cost center. Whereas spreading common overheads over different cost centers on a fair basis is called apportionment.

What are overheads?

All the indirect costs of the business are called overheads. Indirect costs are those costs that cannot be charged directly to a specific product. Some examples of overheads are:

  • Rent of the factory
  • Heat and light
  • Supervisor salary
  • Salaries of sales staff
  • Water rates
  • Depreciation

This is a very brief list but it gives you a basic idea that overheads are not directly linked with the manufacturing of products but without these expenses, the production process is impossible.

Why do we need to absorb overheads?

The business incurs expenditure on overheads (like those mentioned above) because it is crucial for the production to take place. The business also has to recover the cost of these overheads and needs to include them in the cost of the product. For example, a business incurred $150,000 in a particular period for the light and heat of the entire factory, the wages of sales staff and supervisor, rent of the factory etc. and produced 10,000 units. This is a huge amount that needs to be considered when costing the products and making pricing decisions, so that this expenditure can be recovered from the sales income. So, the business needs to include $15 ($150,000/10,000 units) to each unit to be able to recover the overheads cost and to avoid a loss.

How do we absorb the overheads?

Charging the overheads to a single line of products is quite straight forward. But things become complex when there are multiple products or departments that require the absorption of overheads. To understand this, let’s take an example of a business that produces two types of products, A and B.

Example

The business spends $10,000 for the rent of the factory in which the production takes place. The business has two departments, X and Y. Department X produces 10,000 units of product A and Department Y produces 90,000 units of product B in a particular period. Now, on what basis should the overheads be charged to each department? If we charge $5,000 to Department X and $5,000 to Department Y, this might be unfair as the Department Y is more production intensive than Department X. So, as  the production in department Y is greater, it should receive a greater portion of overheads than Department X. This is called fair allocation of overheads to each department and ultimately to each unit.

Absorption Costing

The process through which overheads are absorbed in the cost of the product is called absorption costing. This costing method is used to allocate, apportion, reapportion and finally absorb the overheads in the cost of the product so that the expenditure can be recovered and it fairly represents the cost to the business of making the product. There are four steps of Absorption Costing:

  1. Allocation
  2. Apportionment
  3. Reapportionment
  4. Absorption into the cost of product using Overhead Absorption Rate (OAR)

In this article, we are going to discuss Allocation and Apportionment. Reapportionment and OAR are explained separately.

Allocation of overheads

Allocation is the charging of overheads directly to one cost center i.e., a department, a production or service location. There are some overheads that can be specifically traced to a distinct cost center. For example, Department A incurred $3,000 for the salary of a supervisor that is specifically related to Department A. So, whole of $3,000 can be charged to Department A and there is no need to apportion this between other Departments. Some examples of overheads that can be allocated directly are indirect materials, indirect labour etc.

Apportionment of overheads

The second step of absorption costing is apportionment. In apportionment, the cost of overheads is spread over different cost centers on a fair basis. These fair bases are:

  • Floor area – For rent, rates and maintenance of building.
  • Number of employees – For workforce related costs like canteen costs etc.
  • Carrying amount of assets – For Depreciation, maintenance and insurance of plant and machinery
  • Kilowatt hours consumed – For electricity and power
  • Machine hours – For Machine’s running expenditure

Formula

The formula to apportion the total cost of overheads to a specific cost center is:

Apportionment to cost center = (Total overheads / Total number of bases) x Specific cost center’s base

Example – Allocation and Apportionment of Overheads

To understand the process of allocation and apportionment of overheads, let us take the example of High-five Limited, a manufacturing company. For the upcoming quarter, management has estimated the following overheads costs to be incurred:

Example - Allocation and Apportionment of Overheads

Solution

Example Solution - Allocation and Apportionment of Overheads