Chapter 4: Overhead Costing — Allocation, Apportionment, and Absorption
Overheads (indirect costs) are costs that cannot be directly traced to individual products. They include factory rent, supervisor salaries, depreciation, utilities, and administrative expenses. The challenge is fairly distributing these costs to products for accurate costing and pricing. This chapter covers the three-step process: allocation, apportionment, and absorption.
4.1 Classification of Overheads
| By Function | Examples | Treatment |
|---|---|---|
| Production/Factory | Factory rent, power, depreciation, indirect labor, indirect materials | Part of product cost (absorbed into products) |
| Administration | Office rent, office salaries, audit fees, legal fees | Period cost (not part of product cost usually) |
| Selling | Advertising, sales staff salary, showroom rent | Period cost |
| Distribution | Transport, warehousing, packing for delivery | Period cost |
4.2 The Three Steps of Overhead Costing
| Step | Process | When Used |
|---|---|---|
| 1. Allocation | Assign costs directly to the department that caused them | When cost is wholly identifiable with one department |
| 2. Apportionment | Share common costs among departments using appropriate bases | When cost benefits multiple departments |
| 3. Absorption | Charge department overheads to products using absorption rate | To include overheads in product cost |
Common Apportionment Bases
| Overhead Item | Basis of Apportionment | Rationale |
|---|---|---|
| Rent, rates, lighting, heating | Floor area (sq. ft.) | Space used determines benefit |
| Depreciation, insurance of machinery | Value of machinery | Higher value machines cost more |
| Supervision, canteen | Number of employees | More employees = more supervision needed |
| Power, electricity | Machine hours or HP of machines | Power consumption based on machine usage |
| Material handling | Weight or value of materials | Heavier materials need more handling |
4.3 Overhead Absorption Methods
| Method | Formula | Best For |
|---|---|---|
| Direct Labor Hour Rate | Total overheads / Total direct labor hours | Labor-intensive operations |
| Machine Hour Rate | Total overheads / Total machine hours | Machine-intensive operations |
| % of Direct Labor Cost | (Overheads / Direct labor cost) × 100 | When labor costs are significant |
| % of Direct Material Cost | (Overheads / Direct material cost) × 100 | When material costs dominate |
| % of Prime Cost | (Overheads / Prime cost) × 100 | General use |
| Unit Rate | Total overheads / Total units produced | Single product manufacturing |
Worked Example: Overhead Distribution
Data: Two production departments (A, B) and one service department (Maintenance)
| Item | Total | Basis | Dept A | Dept B | Maintenance |
|---|---|---|---|---|---|
| Rent | 60,000 | Floor area (3:2:1) | 30,000 | 20,000 | 10,000 |
| Power | 40,000 | Machine HP (4:3:1) | 20,000 | 15,000 | 5,000 |
| Direct allocation | 50,000 | Direct | 20,000 | 25,000 | 5,000 |
| Total before reapportion | 1,50,000 | 70,000 | 60,000 | 20,000 | |
| Reapportion Maintenance (3:2) | Service hours | 12,000 | 8,000 | (20,000) | |
| Total after reapportion | 1,50,000 | 82,000 | 68,000 | 0 |
If Dept A works 8,200 machine hours: Absorption rate = 82,000/8,200 = NPR 10/machine hour
4.4 Under/Over Absorption
| Situation | Condition | Treatment |
|---|---|---|
| Under-absorption | Actual overheads > Absorbed overheads | Debit to P&L (increases cost) |
| Over-absorption | Absorbed overheads > Actual overheads | Credit to P&L (reduces cost) |
4.5 Reciprocal Service Department Apportionment
When two or more service departments serve each other (reciprocal services), simple direct apportionment is insufficient. Two methods handle this:
Repeated Distribution Method
Data: After primary apportionment:
| Prod P1 | Prod P2 | Service S1 | Service S2 | |
|---|---|---|---|---|
| After primary | 80,000 | 60,000 | 30,000 | 20,000 |
| S1 serves: P1=40%, P2=30%, S2=30% | S2 serves: P1=50%, P2=40%, S1=10% | ||||
Round 1 — Apportion S1 (30,000):
P1: +12,000 | P2: +9,000 | S2: +9,000 | S1: 0
New S2 = 20,000 + 9,000 = 29,000
Round 2 — Apportion S2 (29,000):
P1: +14,500 | P2: +11,600 | S1: +2,900 | S2: 0
New S1 = 2,900
Round 3 — Apportion S1 (2,900):
P1: +1,160 | P2: +870 | S2: +870 | S1: 0
New S2 = 870
Round 4 — Apportion S2 (870):
P1: +435 | P2: +348 | S1: +87 | S2: 0
(Continue until amounts are negligible...)
Final totals (approximate):
P1 = 80,000+12,000+14,500+1,160+435+... ≈ 1,08,200
P2 = 60,000+9,000+11,600+870+348+... ≈ 81,800
Check: 1,08,200 + 81,800 = 1,90,000 = 80,000+60,000+30,000+20,000 ✓
Simultaneous Equation Method
Let S1* = total cost of S1, S2* = total cost of S2
S1* = 30,000 + 0.10 × S2* (S1 receives 10% of S2)
S2* = 20,000 + 0.30 × S1* (S2 receives 30% of S1)
Substituting: S1* = 30,000 + 0.10(20,000 + 0.30 × S1*)
S1* = 30,000 + 2,000 + 0.03 × S1*
0.97 × S1* = 32,000
S1* = 32,990
S2* = 20,000 + 0.30(32,990) = 20,000 + 9,897 = 29,897
Apportion S1* (32,990): P1=40%=13,196 | P2=30%=9,897 | S2=30%=9,897
Apportion S2* (29,897): P1=50%=14,949 | P2=40%=11,959 | S1=10%=2,990
Final: P1 = 80,000+13,196+14,949 = 1,08,145
P2 = 60,000+9,897+11,959 = 81,856
4.6 Machine Hour Rate — Detailed Calculation
Machine hour rate is used in capital-intensive industries where machine usage drives overhead costs.
Data for a CNC Machine:
| Item | Annual Cost (NPR) |
|---|---|
| Machine cost: NPR 20,00,000. Life: 10 years. Scrap: NPR 2,00,000 | |
| Depreciation: (20,00,000-2,00,000)/10 | 1,80,000 |
| Power: 10 HP × NPR 8/unit × 2,000 hrs | 1,60,000 |
| Repairs and maintenance | 40,000 |
| Insurance: 2% of machine cost | 40,000 |
| Operator wages (allocated) | 3,60,000 |
| Consumables (oil, tools) | 20,000 |
| Total annual cost | 8,00,000 |
Effective machine hours = 2,000 hrs (after deducting setup, maintenance downtime)
Machine Hour Rate = 8,00,000 / 2,000 = NPR 400/machine hour
If Job X uses this machine for 5 hours: OH charged = 5 × 400 = NPR 2,000
4.7 Activity-Based Costing (ABC) — Introduction
ABC assigns overheads based on activities that drive costs, rather than arbitrary volume-based rates. It provides more accurate product costs when overhead is significant and products differ in complexity.
| Step | Action | Example |
|---|---|---|
| 1 | Identify activities that consume resources | Machine setup, quality inspection, order processing, material handling |
| 2 | Assign costs to each activity (cost pool) | Setup costs = NPR 5,00,000; Inspection = NPR 3,00,000 |
| 3 | Identify cost driver for each activity | Setup: number of setups; Inspection: number of inspections |
| 4 | Calculate activity rate | Setup rate = 5,00,000/100 setups = NPR 5,000/setup |
| 5 | Assign costs to products based on activity usage | Product A uses 30 setups: 30 × 5,000 = NPR 1,50,000 |
Traditional vs ABC Comparison
| Aspect | Traditional Costing | Activity-Based Costing |
|---|---|---|
| Cost Assignment | Based on volume (labor hours, machine hours) | Based on activities that drive costs |
| Accuracy | May distort costs (cross-subsidization) | More accurate, especially for diverse products |
| Complexity | Simple to implement | Complex, requires detailed activity analysis |
| Best For | Single product, simple operations | Multiple products, high overhead, diverse complexity |
| Nepal Use | Most Nepali companies (simpler operations) | Banks (diverse services), MNCs in Nepal |
Practice Questions
Short Answer:
1. Distinguish between allocation and apportionment of overheads.
2. List the common bases for apportioning factory overheads.
3. What are the different methods of overhead absorption?
4. Explain under-absorption and over-absorption of overheads.
5. Why is machine hour rate preferred in capital-intensive industries?
Long Answer:
6. A factory has 3 production departments (P1, P2, P3) and 2 service departments (S1, S2). Apportion the following: Rent NPR 1,20,000 (area: 4:3:2:1:2), Power NPR 80,000 (HP: 5:3:2:1:1), Depreciation NPR 60,000 (machine value: 4:3:2:1:0). S1 serves P1:P2:P3 = 4:3:3. S2 serves P1:P2:P3 = 3:4:3. Calculate total overhead for each production department. (15 marks)
7. Discuss the different methods of overhead absorption. Which method would you recommend for: (a) a labor-intensive carpet factory, (b) an automated bottling plant? (15 marks)
8. Explain the three steps in overhead costing with a comprehensive example. (15 marks)
9. A department's budgeted overheads are NPR 5,00,000 for 10,000 machine hours. Actual overheads were NPR 5,20,000 for 9,800 hours. Calculate absorption rate, absorbed amount, and under/over absorption. (15 marks)
10. Discuss reciprocal service department apportionment methods (repeated distribution and simultaneous equation). (15 marks)
Exam Tips: ✓ Overhead distribution tables are almost always asked ✓ Know all apportionment bases ✓ Service department reapportionment is important ✓ Under/over absorption calculation frequently tested ✓ Show all workings in tabular format