After completing this chapter, you should be able to:

Prepare cost statements for allocation and apportionment

of overheads, including reciprocal service departments;

Calculate direct, variable and full costs of products,

services and activities using overhead absorption rates to
trace indirect costs to cost units;

Apply cost information in pricing decisions.

An overhead cost is defined in the CIMA Terminology as expenditure on
labor, materials or services that cannot be economically identified with a
specific saleable cost unit.

Overheads may be classified according to the function of the organization

responsible for incurring cost. Examples of overhead cost classifications
include production overhead, selling and distribution overhead and
administrative overhead.

Overheads costs are also referred to as indirect costs. Therefore,

overhead cost compromises indirect material, indirect labor and indirect
expenses. The indirect nature of overheads means that they need to be
shared out among the cost units as fairly and as accurately as possible.

Total Cost = Direct Costs (prime costs) + Overheads

 (Cont.)

It is easy to determine the direct costs, but how do we find the cost per
unit with overheads/indirect costs? We cant ignore these costs (rent,
supervisors) or we wont get the full cost of the item.

In this chapter we will learn how this sharing out is accomplished for
production overheads, using a costing method known as absorption
costing.

A three step process is used:

Step 1: Allocation and apportionment of production overheads to

production and service cost centers.

Step 2: Reapportionment of overheads collected in service cost centers

(from step 1) to production cost centers.

Step 3: Absorption of overheads from production cost centers into cost

units using a predetermined overhead absorption rate (OAR).
The first stage in the analysis of production overheads is the selection of
appropriate cost centers. The selection will depend on a number of factors,
including the level of control required and the availability of information.

Having selected suitable cost centers, the next stage in the analysis is to
determine the overhead cost for each cost center. This is achieved through
the process of allocation and apportionment.

Cost allocation is possible when we can identify a cost as specifically

attributable to a particular cost center. For example, the salary of the
manager of the packing department can also be allocated to the packing
department cost center. It is not necessary to share the salary cost over
several different cost centers.

Cost apportionment is necessary when it is not possible to allocate a cost

to a specific cost center. In this case, the cost is share out over two or
more cost centers according to the estimated benefit received by each cost
center. The basis of apportionment is selected to reflect the benefit
received. For example, the cost of rent and rates might be apportioned
according to the floor space occupied by each cost center.
 PRODUCTION OVERHEAD

PRODUCTION PRODUCTION PRODUCTION PRODUCTION

COST CENTER 1 COST CENTER 1 COST CENTER 1 COST CENTER 1
ILLUSTRATION ILLUSTRATION
Now we have the overhead split between the four cost centers, but one
of them does not directly produce the goods, so we need to share or
reapportion the cost of the service cost center to the production ones,
as follows:

PRODUCTION PRODUCTION PRODUCTION SERVICE

COST CENTER 1 COST CENTER 2 COST CENTER 3 COST CENTER

Again the problem is what basis to use to reapportion the costs; this
should be done to reflect the benefit derived from the service area by
the production areas, but this will be subjective.

We will then be left with just the costs in the three production cost
centers.
If we now return to our WHW Ltd example, the next step is to apportion
the cost of the stores department to the production cost centers.

Item Basis of apportionment Machining Assembly Finishing Stores Total

$ $ $ $ $
B/fwd 39,314 41,840 9,600 7,610 98,364
Stores costs No. of reacquisitions on stores 1,550 5,560 500 (7,610) -
40,864 47,400 10,100 - 98,364

We have now achieved the objective of allocating and apportioning all of the production
overhead costs to the department directly involved in the manufacture of the salable
cost unit.
 Test Your Understanding 1

Match the overhead costs to the most appropriate basis of cost

apportionment. Write the correct letter in the box provided beside each
apportionment basis. An apportionment basis may be selected more than
once.

Overhead cost:

a) Canteen costs
b) Clearing of factory premises
c) Power
d) Rent
e) Insurance of plant and machinery

Apportionment bases:

a) Floor area
b) Plant and equipment at cost
c) Number of employees
d) Machine running hours
e) Direct labor hours
 Test Your Understanding 1

Answer:

a) Number of employees
b) Floor area
c) Machine running hours
d) Floor area
e) Plant and equipment at cost
 Test Your Understanding 2

Maintenance costs are to be apportioned to production cost centers on

the basis of the following number of maintenance hours worked in each
cost center.
Machining Assembly Finishing
Maintenance hours worked 1,000 700 300

Complete the following extract from the overhead analysis sheet:

Overhead cost item Total Machining Assembly Finishing

$ $ $ $
Maintenace cost 38,000
 Test Your Understanding 2

Answer:

$38,000
Overhead cost per maintenance hour = = $19
1,000+700+300

Overhead cost item Total Machining Assembly Finishing

Maintenance cost $ 38,000 $ 19,000 $ 13,300 $ 5,700

 Test Your Understanding 3
After the initial overhead allocation and apportionment has been completed, the
overhead analysis sheet for a car repair workshop is as follows:

Total Overhead Vehicle Crash Tyre Canteen and

cost Servicing repairs fitting vending
$ $ $ $ $
233,000 82,000 74,000 61,000 16,000

The costs of the canteen and vending activity are to be reapportionment to the
other activities on the basis of the number of personnel employed on each activity.

Vehicle Crash Tyre Canteen and

Servicing repairs fitting vending
Number of personnel 20 15 5 2

The canteen and vending cost to be apportioned to the crash repair activity is
$.......................
 Test Your Understanding 3

Answer:

Canteen and vending cost per

$ 16,000
Personnel number in production activities* = = $ 400
20+15+5

*the canteen and vending personnel are not included because the canteen
cannot give a charge to itself.

The canteen and vending cost apportioned to the crash repair activity is
$400*15=$6,000.
 Absorption of overheads into saleable cost units

The last stage in the analysis of overheads is their absorption into the cost units
produced in the production cost centers. This is sometimes referred to as overhead
recovery.

PRODUCTION PRODUCTION PRODUCTION SERVICE

COST CENTER 1 COST CENTER 2 COST CENTER 3 COST CENTER

COST UNITS

To begin with, we need to measure the level of production overhead. There are
many measures which may be used, but the most common are:

Physical units produced

Labor hours worked
Machine hours operated
 Absorption of overheads into saleable cost units

It is quite likely that different production departments will measure their

production in different ways. The objective is to use a measure which reflects the
nature of the work involved. The physical unit measure is in theory the simplest
but it is only valid if all of the items produced require the same amount of
resources.

The overhead costs of each production cost center are then divided by the quantity
of production achieved to calculate the amount of overhead cost to be attributed
to each unit.

This is known as the overhead absorption rate (OAR):

Production cost center overhead

Overhead absorption rate (OAR) =
Quantity of absorption base(units/labor hours/machine hours)
 Illustration 3

Continuing with our WHW Ltd example:

The output of the machining department is to be measured using the number of

machine hours, while the output of the assembly and finishing departments is to be
measured using the number of direct labor hours. The reason for this can be seen
from the number of machine and direct labor hours for each department shown in
the original data for the example. The machining department is clearly machine-
intensive, whereas the other departments are labor-intensive.

The absorption rates are calculated by dividing the costs attributed to the
department by its appropriate measure of output.

Machining Assembly Finishing

Poduction overhead costs obtained by
$ 40,864 $ 47,400 $ 10,100
allocation and apportionment
Number of:
Machine hours 32,000 4,000
Direct labor hours 32,000
Absorption rates:
Per machine hour $ 1.277 $ 2.525
Per labor hour $ 1.481
 Illustration 3

The absorption rate (OARs) have been calculated as follows:

Machining/using machine hours:OAR = $ 40,864 / 32,000 = $ 1.277

Assembly/using labor hours:OAR = $ 47,400 / 32,000 = $ 1.481
Finishing/using machine hours:OAR = $ 10,100 / 4,000 = $ 2.525
 Applying the overhead absorption rate

When using an absorption method based on either on direct labor hours or on

machine hours the cost attributed to each unit is obtained by multiplying the time
taken per unit by the absorption rate per hour.

For example, if a particular cost unit took three machine hours in the machining
department, and five direct labor hours in each of the assembly and finishing
departments, the overhead cost absorbed by the cost unit would be as follows:

Machining: 3 hours*$1.277 $ 3.83

Assembly: 5 hours*$1.481 $ 7.41
Finishing: 5 hours*$2.525 $ 12.63

Overhead absorbed by cost unit $ 23.87

 Other absorption bases

In addition to the three bases of absorption mentioned above, a percentage rate

based on any of the following may be used:

Direct material cost

Direct labor cost
Prime cost
 Other absorption bases
In our WHW Ltd example, if a direct labor cost percentage is used the absorption
rates would be as follows:

Machining Assembly Finishing

$ $ $
Production overhead costs 40,864 4,740 10,100
Direct wages cost 32,600 67,200 7,200
Direct labor cost percentage 125% 71% 140%
If our cost unit had a labor cost of $12 in the machining department, and $20 in
each of the assembly and finishing departments, the overhead cost absorbed by
the cost unit using this method would be as follows:

Machining: 125%*$12 $ 15.00

Assembly: 71%*$20 $ 14.20
Finishing: 140%*$20 $ 28.00

Overhead absorbed by cost unit $ 57.20

 Test Your Understanding 4
The number of machine and labor hours budgeted for three production cost centers
for the forthcoming period as follows:

Machining Assembly Finishing

Machine hours 50,000 4,000 5,000
Labor hours 10,000 30,000 20,000

The most appropriate production overhead absorption basis for each cost center
would be (tick the correct box):

Machining Assembly Finishing

Machine hours
Labor hours
 Test Your Understanding 4

Answer:

Looking at the number of machine and labor hours budgeted for each cost
center it is clear that the machining department is machine intensive.
Therefore, a rate per machine hour would be most appropriate for this
cost center.

The assembly and finishing departments are labor intensive. Therefore, a

rate per labor hour would be most appropriate for each of these cost
centers.
 Test Your Understanding 5

The Crayfield Hotel has completed its initial allocation and apportionment of
overhead costs and has established that the total budgeted annual overhead cost
of its linen services activity is $836,000.

The cost unit used to plan and control costs in the hotel is an occupied room night.
The hotels expect the occupancy rate of its 400 rooms, which are available for 365
nights each year, to be 85% for the forthcoming year.

To the nearest penny, the overhead absorption rate for the linen services activity
is $..................per occupied room night.
 Test Your Understanding 5

Answer:

Budgeted number of occupied room nights=400 rooms*365 nights*85%=124,100

occupied room nights.

Overhead absorption rate for linen services activity=$836,000/124,000=$6.74 per

occupied room night.
 Predetermined overhead absorption rates

Overhead absorption rates are usually predetermined, that is, they are calculated
in advance of the period over which they will be used, using budgeted or expected
costs and activity levels.

The main reason for this is that overhead costs are not incurred evenly throughout
the period. In some months of actual expenditure may be very high and in others it
may be relatively low. The actual overhead rate per hour or per unit will therefore
be subject to wide fluctuations. If the actual rate was used in product costing, then
he product cost would be fluctuate wildly. Such product costs would be very
difficult to use for planning and control purposes.

Fluctuations in the actual level of production would also cause the same problem of
fluctuating product costs.

A further advantage of using predetermined rates is that managers have an

overhead rate permanently available which they can use in product costing, price
quotations and so on. The actual overhead costs and activity levels are not known
until the end of the period. It would not be desirable for managers to wait until
after the end of the period before they had a rate of overhead that they could use
on a day-to-day basis.
 Under-or over-absorption of overheads

The problem with using predetermined overhead absorption rates is that the actual
figures for overhead and for the absorption base are likely to be different from the
estimates used in calculating the absorption rate.

At the end of the period, the company must calculate if it has absorbed too much or
too little overhead into the products. Two things could have changed during the
period:

The amount of the overhead could be more or less than was budgeted.
The quantity of the absorption base (units/labor hours/machine hours) could
have been more or less that budgeted.

It is this difference which causes an under-or over-absorption of production

overhead.
 Illustration 4
We will now return to our WHW Ltd example to see how this is calculated, assuming
that machine/labor hour rates have been used to absorb the overheads.

We will assume that all of the values used in the calculations in our example are
estimates based on WHW Ltd.s budgets.

The actual costs for the same four-week period have now been allocated and
apportioned using the same techniques and bases as shown in our earlier example,
with the following actual costs being attributed to each cost center.

Machining Assembly Finishing

Actual costs $ 43,528 $ 49,575 $ 9,240
Actual labor and machine hours recorded against each cost center were:

Machining Assembly Finishing

Number of:
Machine hours 32,650
Labor hours 3,104 3,925
 Illustration 4 (Cont.)
The amount of overhead cost absorbed into each departments total number of
saleable cost units will be calculated by multiplying the absorption rate calculated
by the actual number of hours. The amounts absorbed are thus:

Machining Assembly Finishing

Amount absorbed:
32,650 hours*$1.277 $ 41,694
31,040 hours*$1.481 $ 45,970
3,925 hours*$2.525 $ 9,911

This is compared with the actual cost incurred and the difference is the under-
/over-absorption of production overhead:

Machining Assembly Finishing

Amount absorbed: $ 41,694 $ 45,970 $ 9,911
Actual cost incurred $ 43,528 $ 49,575 $ 9,240
$ (1,834) $ (3,605) $ 671
If the amount absorbed exceeds the amount incurred, then over-absorption arises;
the opposite is referred to as under-absorption. The terms under-recovery and over-
recovery are sometimes used.
 Why under-or- over-absorption arises?

The under-or over-absorption has arisen because the actual overhead incurred per
hour was different from the predetermined rate per hour. There are two possible
causes of this:

The actual number of hours (machine or direct labor) was different from the
number contained in the budget data. If this happens, then we would expect the
variable element of the overhead to vary in direct proportion to the change in
hours, so this part of the absorption rate would still be accurate. However, the
fixed overhead would not alter with the hours worked and this means that the
actual overhead cost per hour would be different from the predetermined rate.

The actual production overhead incurred may be different from the estimate
contained in the predetermined rate.
 The problem caused by under-or over-absorption of overheads

If overheads are under-absorbed then managers have been working with unit rates
for overheads which are too low. Prices may have been set too low and other similar
decisions may have been taken based on inaccurate information. If the amount of
under-absorption is significant, then this can have a dramatic effect on reported
profit.

If overhead rate have been unnecessarily high, then managers may have set selling
prices unnecessarily high, leading to lost sales. Other decisions would also have
been based on inaccurate information.

Although it is almost impossible to avoid under-or over-absorption altogether, it is

possible to minimize the amount of adjustment necessary at year end. This is
achieved by conducting regular reviews of the actual expenditure and the activity
levels which are arising. The overhead absorption rate can this be reviewed to check
that it is still appropriate to absorb the overheads sufficiently accurately by the year
end. If necessary the overhead absorption rate can be adjusted to reflect more
recent estimates of activity and expenditure levels.
 Test your understanding 6

Budgeted labor hours 8,500

Budgeted overheads $148,750
Actual labor hours 7,928
Actual overheads $146,200

What is the labor hour overhead absorption rate:

1. $17.50 per hour
2. $17.20 per hour
3. $18.44 per hour
4. $18.76 per hour

What is the amount of overhead under-/over-absorbed:

1. $2,550 under-absorbed
2. $2,529 over-absorbed
3. $2,550 over-absorbed
4. $7,460 under-absorbed
 Test your understanding 6

Answer:

1. A
Labor hour overhead absorption rate=$ 148,750/8,500=$17.50 per hour.

2. D

Overhead incurred $146,200

Overhead absorbed=$17.50*7,928hours $138,740

Under-absorbed $7,460
Test your understanding 7

TEST YOUR UNDERSTANDING

 Reciprocal Servicing
Taking account of reciprocal servicing
In our original example of apportionment and reapportionment, there was only
one service center. In many examples there will be more than one and this can
create a compilation when it comes to reapportionment of overheads from the
service cost centers to the production cost centers. The compilation arises when
the service cost centers use each others services.

For example, if two services cost centers were canteen and maintenance, it is
possible that the maintenance staff could use the services of the canteen and
should therefore pick up a share of the canteens costs. It is also possible that the
canteen uses the services of the maintenance department and should therefore
also pick up a share of the maintenance department costs. This is known as
reciprocal servicing.

This can lead to a complicated situation because we do not know the total of the
maintenance costs until a proportion of canteen costs has been charged to it.
Similarly, we do not know the total costs of the canteen costs until the total of the
maintenance costs have been apportioned.

There are two methods which can be used to solve this problem.
Repeated distribution method
Algebra method
 Illustration 5
A company reapportions the costs incurred by two service cost centers- material
handling and inspection- to three production cost centers-machining, finishing and
assembly.

The following are the overhead costs which have been allocated and apportioned to
the five cost centers:
$000
Machining 400
Fininshing 200
Asembly 100
Materials handling 100
Inspection 50

Estimate of the benefits received by each cost centers are as follows:

Materials
Machining Assembly Finishing Inspection
Handling
% % % % %
Material handling 30 25 35 - 10
Inspection 20 30 45 5 -
These percentages indicate the use which each of the cost centers makes of the
materials handling and inspection facilities. Calculate the charge for overhead to
each of the three production cost centers, including the amounts reapportioned from
the service cost centers.
 Illustration 5
Solution: Repeated distribution method

The task of allocating and apportioning the overheads to all cost centers has already
been done (the primary apportionment). The problem now is to reapportion the
costs of the service centers (the secondary apportionment).

Using the repeated distribution method the service cost centers costs are
apportioned backwards and forwards between the cost centers until the figures
become very small. At this stage it might be necessary to round the last
apportionments.

Materials
Machining Assembly Finishing Inspection
Handling
$ $ $ $ $
Initial allocation 400,000 200,000 100,000 100,000 50,000
Apportion Inspection 10,000 15,000 22,500 2,500 (50,000)
Apportion materials handling 30,750 25,625 35,875 (102,500) 10,250
Apportion Inspection 2,050 3,075 4,613 513 (10,250)
Apportion materials handling 154 128 179 (513) 51
Apportion inspection* 11.00 16.00 24.00 (51)
Total charge for overhead 442,965 243,844 163,191 - -

When the service department cost reduced to a small amount, the final
apportionment is adjusted for roundings.