Cost Allocation

 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
 Definition of Overheads
 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 Overhead Costs
Element wise Classification
Steps on Overhead Accounting

The various steps in an overhead

accounting are:
 Collection of overhead details
 Distribution of overhead to cost centers
 Reapportionment of service department
costs to production departments
 Primary Distribution of Overheads and
Reapportionment of Overheads

Refer to the Word file Attached

 Basis of apportionment of
overheads
 Direct Allocation

 Direct Labor Hours

 Direct Wages

 Number of workers
Methods of Reapportionment
 Direct Redistribution
• Chances of overcharge or under charge
• Non accuracy in department overhead rates
 Step Method
• Apportioning service department costs
 Reciprocal Service Method
• Simultaneous equation method
• Repeated distribution method
• Trial and error method
 Illustrations…

Refer to the Word file Attached

 Absorption of Overheads

“Process of allocating the overhead

expenses to the cost centers/cost units is
known as overhead absorption”
 Absorption rates
 Actual rate

 Predetermined rate

 Moving average rate

 Blanket and multiple rates

 Rate per unit of production

 OH rate = Budgeted overhead expenses

Budgeted production
 Features:
• Simple /easy to use
• Suitable for extractive industries
 Direct Wages Method
 OH rate = Budgeted overhead expenses
Direct wages
 Advantages:
• Consideration of time factor
• Stability of labor rates
• Proportional charge to production
• Easy availability of data
• Most appropriate in certain situations
 Limitations:
• Not related to efficiency of workers
• Consideration of time factor (piece rate basis)
• Ignores contribution by other factors of production
• No distinction between fixed and variable expenses
 Production hour method
 OH rate = Budgeted overhead expenses
Total productive hours of direct labor
 Advantages:
• When job is labor-oriented
• Uniform time for various jobs
• No impact on rate by the method of wage payment/grade/rate of
workers
 Limitations:
• Faulty distribution of overhead
• Not suitable where piece rate system is used
• Expenses not related to labor hours are ignored
• No clear distinction between types of labor/costs/workers
 Machine hour rate method
 OH rate = Total running expenses
Number of working hours for the machine
 Advantages:
• Scientific/practical/accurate
• Comparison of relative efficiencies
• Decision making by the management
• Detection of idle time
 Limitations:
• Higher cost
• Not useful when blanket rate is used
• Inaccurate results if use of labor is equally important
• Doesn’t consider expenses that are not proportionate to working
hours
 Direct material cost method
 OH rate = Budgeted overhead expense
Expected direct material cost
 Advantages:
• Simple /easy to use
• Suitable when
 Output is uniform

Stable material cost
 Proportion of OH to total cost is significant
 Limitations:
• Unstable and inaccurate
• No consideration for time factor
• No distinction between fixed and variable costs
• No distinction between production of workers and machines
 Prime cost method
 OH rate = Budgeted overhead expense
Prime cost
 Advantages:
 Simple /easy to use
 Suitable when there is no wide fluctuations in
processing
 Limitations:
 No consideration for time factor
 No distinction between fixed and variable costs
 Sale price method
 OH rate = Budgeted overhead expenses
Sale price of units of production
 Suitable for the absorption of :
• Administration
• Selling and distribution
• Research and development
• Design costs
Factors to be considered for determining
the basis of apportionment
 Adequacy: The OH rate should be in such a way that
equitable apportionment can be made to the cost centers
or cost units.
 Convenience: The OH rate should be simple and easy
to understand and also convenient in application.
 Time factor: The OH rate should have some relation to
the time taken by various jobs for completion.
 Manual or machine work: There can be different OH
rates for manual and machine work.
 Differential OH rates: If the nature of work done by the
various departments is not same, different OH rates can
be ascertained.
 Information: The availability of information affects the
selection of the OH rates.
 Under absorption/Over absorption
 The OH costs are fully recovered from
production, if actual rate method of
absorption is adopted. If the OH rate
absorbed is less than the overheads
incurred, it is called as under absorption of
overheads.
 If the OH rate absorbed is more than the
actual overheads incurred, it is known as
over absorption of overheads.
Accounting of Under absorption
and Over absorption
 Use of supplementary rates
To carry out adjustment for the difference between
overhead absorbed and overhead incurred
Under or over absorbed overheads/actual base
 Writing off to costing P/L account
Under/Over absorption due to abnormal situations
Distortion in the value of stock
Absorption in the accounts of subsequent years
 Deferred charge
Suitable when the business period is more than one
year
 Summary
 How we can define overhead?
 Classification and types of overheads
 Major steps involved in overhead accounting
 What are the basis for apportioning the
overheads?
 What are the principles of apportionment?
 Trace the common methods of reapportionment.
 What do you mean by absorption of overheads?
 Methods of absorption
 Under absorption and over absorption.