Cost Allocation, Apportionment and Absorption of Overheads

1 Cost Allocation, Apportionment and Absorption of Overheads1 Learning Objectives To understand and apply the cost concepts Cost Allocation Apportionment of Overheads Absorption of Overheads2 IntroductionThe objective of Cost Accounting is classifying costs and recording an appropriate allocation of expenditure for the determination of the costs of products or services, and for the presentation of suitably arranged data for the purpose of control and guidance of management 3 Cost Allocation 4 Itisthechargingofdiscrete,identifiableit emsofcosttocostcentresorcostunits. Itiscompletedistributionofanitemofoverhe adtothedepartmentsorproductsonlogicalore quitablebasisiscalledallocation. Whereacostcanbeclearlyidentifiedwithacos tcentreorcostunit,thenitcanbeallocatedto thatparticularcostcentreorunit. Allocationistheprocessbywhichcostitemsar echargeddirectlytoacostunitorcostcentre. Costallocationcallsfortwobasicfactors Concerneddepartment/productshouldhavecau sedthecosttobeincurred Allocation-Examples5 Electricitychargescanbeallocatedtovariou sdepartmentsifseparatemetersareinstalled Depreciationofmachinerycanbeallocatedtov ariousdepartmentsasthemachinescanbeident ified Salaryofstoresclerkcanbeallocatedtostore sdepartment Costofcoalusedinboilercanbedirectlyalloc atedtoboilerhousedivision.

2 Wagespaidtoworkersofservicedepartmentcan beallocatedtotheparticulardepartment. allocation is a direct process of identifying Overheads to cost units or cost centres. So the term allocation means allotment of whole item of cost to a particular cost centre or cost object without any Apportionment 6 CostApportionmentistheallotmentofproport ionsofitemstocostcenters. Whenitemsofcostcannotdirectlychargetoora ccuratelyidentifiablewithanycostcentres, Whereverpossible, ,ifitisnotpossibletochargetheoverheadsto aparticularcostcentreorcostunit, Apportionment ofoverheads. Itemsofindirectcostsresidualtotheprocess ofcostallocationarecoveredbycostapportio nment. Thepredeterminationofsuitablebasisofappo rtionmentisveryimportantandusuallyfollow ingprinciplesareadopted-(i)Serviceoruse( ii)Surveymethod(iii) Apportionment7 Thebasisforapportionmentisnormallypredet erminedandisdecidedafteracarefulstudyofr elationshipsbetweenthebaseandtheothervar iableswithintheorganisation.

3 Alotofquantitativeinformationhastobecoll ectedandconstantlyupdatedorperiodicallyr eviewedtoimproveupontheaccuracyofapporti onment. Insimplewords, of overhead costs Apportionmentofoverheadcostsmeanstodivid etotalcostofoverheadamongdifferentdepart mentsorbranchesorcostcentersofacompany. Weneedthestepsofapportionmentofoverheadc ostswhentherearemanydepartmentsorcostcen tersofanycompanybecausewhenweknowtheover headcostofeachdepartment,wecanfindthetot alcostofdepartment. Withthis,wecancomparetherevenueofeachdep artmentwiththeirtotalcost. to Apportion Overhead Costs To Classify the Cost Centers Cost Centersshould be classified into production department and service Step To Divide Total Overhead on Different Basis of Apportionment One of best step to apportion overhead costs is to know the basis of Apportionment of overhead expenses and then to use them. All overhead will be allocated to the different Step :9 Basis for Overhead Apportionment 10 Overheads common to all these departments Apportioned on some suitable basisRent, rates & taxesFloor space occupied by each department , office, factoryRepair to Plant or Department,Depreciation on office buildingPlant or Department's Value or any asset'sFloor space occupied by each department For Legal fees No of cases handled as the basis For Salaries of common staff Ratio of salaries of departments as the basis For Typist poolNo of documents typed as the basisFor General Lighting and electricityNo.

4 Of light points or Area or Units of Sub-meter in each DepartmentFor Telephones No. of extensions in a department For Material handling No. of material requisitions or Value of material Of PlantSupervision, Employer's liabilityNo. of EmployeesFire InsuranceValue of Stock in any DepartmentIndirect Labour CostTotal duty hours in any departmentCanteen Service Cost and other welfare expensesNo. of Employees in Any DepartmentTransport CostNo. of boxes or containers or weight of containers, hours of spending vehicle in any departmentExample Total rent is Rs. 5000. Area of production department is A 100 Sq. foot. B 200 Sq. foot. C 700 Sq. foot. Now total ratio of A : B : C is 1 : 2 : 7 Total Rent Expense of A Department will be = 5000 X 1 /10 = Rs. 500 B Department will be = 5000 X 2 / 10 = Rs. 1000 C Department will be = 5000 X 7 / 10 = Rs. 3500So, Total overhead cost will be apportioned to different department on some basis.

5 Basis of Rent Apportionment is the area of department11 Distinction between Allocation & Apportionment12 Althoughthepurposeofbothallocationandapp ortionmentisidentical, ,botharenotthesame. Allocationdealswiththewholeitemsofcostan dapportionmentdealswithproportionofitems ofcost. Allocationisdirectprocessofdepartmentali zationofoverheads,whereasapportionmentne edsasuitablebasisforsub-divisionofthecos t. Whetheraparticularitemofexpensecanbeallo catedorapportioneddoesnotdependsonthenat ureofexpense, of Apportionment of Overhead Cost Aproductiondepartmentwhichreceivesmaximu mservicesfromservicedepartmentsshouldbec hargedwiththelargestshareoftheoverheads. Accordingly, Alargeshareofservicedepartment soverheadcostsshouldbeassignedtothosepro ducingdepartmentswhoseproductcontributes themosttotheincomeofthebusinessfirm. Howeverthepracticaldifficultyinthismetho disthat, of Apportionment of Overhead Cost This method is used where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable.

6 For example, the postage cost could be apportioned on a survey of postage used during a year. 3. Survey or Analysis Method The Apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the department. 4. Efficiency Method 14 Example Afactoryhas3productiondepartments(P1,P2, P3)and2servicedepartments(S1&S2).Thefoll owingoverheads& ,000 Repair3,600 Depreciation2,700 Lighting600 Supervision9,000 Fire Insurance for stock3,000 ESI contribution900 Power5,400 ParticularsP1P2P3S1S2 Area sq ft40030027015080No. of workers5448362418 Wages18,00015,00012,0009,0006,000 Value of plant72,00054,00048,0006,000-Stock Value45,00027,00018,000--Horse power of plant60040030015050 Allocate or apportion the Overheads among the various departments on suitable basis.

7 The primary distribution of Overheads is as follows16 Expense/BasisTotalP1P2P3S1S2 Rent(Area sq ft)6,0002,000(6000*400/1200)1,500(6000*3 00/1200)1,350(6000*270/1200)750(6000*150 /1200)400(6000*80/1200)Repair(Plant value)3,6001,4401,080960120 NilDepreciation(Plant value)2,7001,08081072090 NilLighting(Area sq ft)6002001501357540 Supervision(No of workers )9,0002,7002,4001,8001,200900 Fire Insurance for stock(Stock Value)3,0001,500900600 NilNilESI contribution(Wages)90027022518013590 Power(Horse power of plant)5,4002,1601,4401,080540180 Total31,20011,3508,5056,8252,9101,610 Cost Absorption 17 TheultimateaimofOverheadAccountingistoab sorbthemintheproductunitsproducedbythefi rm. Thus,theindirectcostsoroverheadwillhavet obedistributedoverthefinalproductssothat thechargeiscomplete. Thisprocessisknownascostabsorptionor Absorption ofoverheads Itmeanscostsisabsorbedbytheproduction(or productunits)duringtheperiodorchargingea chunitofaproductwithanequitableshareofov erheadexpenses.

8 Usuallyanyofthefollowingmethodsareadopte dforcostabsorption- DirectMaterialCostPercentage DirectLabourCostPercentage PrimeCostPercentage DirectLabourHourRateMethod MachineHourRate, of overheads18 Accurateabsorptionwillhelpinarrivingatac curatecostofproduction. Overheadsareindirectcostsandhencetherear enumerousdifficultiesinchargingtheoverhe adstotheproductunits. Thebasisshouldbeselectedaftercarefulmaxi mumaccuracyofCostDistributiontovariouspr oductionunits. and Over- Absorption of Overhead ,butabsorbedasoverheads. a predetermined rate worked out on the basis of anticipated or budgeted overheadand base is applied to the actual base, the amount absorbed may not be identical with the amount of overhead expenses incurred if either the actual base or the actual expenses or both deviate from the estimates or the budget. Under- Absorption and Over- Absorption of OverheadUnder- Absorption Iftheamountabsorbedislessthantheamountin curred,thedifferencedenotesunder-absorpt ion.

9 Itisalsotermedas'underrecovery' Itmaybedueto Actualexpensesexceedingtheestimate;and/o r Outputorthehoursworkedmaybelessthanthees timateOver- Absorption Iftheamountabsorbedismorethantheexpendit ureincurredthiswouldindicateover-absorpt ion,whichgoestoinflatethecosts. Over-absorptionisalsoformedas'overrecove ry'. Itmaybedueto Expensebeinglessthanestimate;and/or Outputorhoursworkedmaybeexceedingtheesti mate20 Under Costing and Over Costing Restaurant bill for most recent get togetherItemsAnnieJoePaulaJamesTotalAver agePizza110200150140Rs600Rs150 Dessert0804040160Rs 40 Drinks40140806032080 Total150420270240108027021 ProductunderAbsorption:Aproductconsumesa highlevelofresourcesbutisreportedtohavea lowcostperunit(Joe sDinner) ProductOverAbsorption:Aproductconsumesal owlevelofresourcesbutisreportedtohaveahi ghcostperunit(Annie sDinner)Causes of Under or Over Absorption of OverheadError in estimating overhead expenses.

10 Error in estimating the level of production, the base. Major unanticipated changes in the methods of production. Unforeseen changes in the production capacity. Seasonal fluctuations in the overhead expenses from period to period. Overhead rate may be applied to the Normal Capacity which may be less than the full operating capacity of the undertaking. Example: iftheoverheadsabsorbedonapredeterminedba sisareRs:1,00,000 ,20,000, ,000. Example: Iftheoverheadrateispredeterminedtobe$20p erdirectlaborhourconsumed Buttheactualamountshouldhavebeen$18perho ur Thenthe$ are the strategic consequences of product under costing and over costing? Undercostedproducts Underpriced-increasing demand-lowering profits (losses) Overpricing-products lose market share to competitors producing similar products Product over-costing and under-costing leads to managerial attention to wrong products23 Direct Material Cost Method Actual Overhead Cost / Direct Material Cost X 100 Direct Labour Cost Method Actual Overhead Cost / Direct Labour Cost X 100 Prime Cost Method Budgeted Overhead Expenses / Anticipated Prime Cost Direct Labour Hour Method Overhead Cost / Direct labour Hours Rate Per Unit of Production Method Budgeted Overhead Cost / Budgeted Units of Production Sales Price Method Budgeted Overhead Expenses / Sales of Units of Production Machine Hour Rate Method Total Overhead Cost / Total Machine HoursMethods of Overhead Absorption25 Example.