Departmentalisation , Allocation and Apportionment of Overheads

Introduction

One of the classifications of costs is on the basis of ‘Nature’ in which costs are classified
as ‘Direct’ and ‘Indirect’. Direct costs are those which are identifiable with a cost object or
a cost centre while indirect costs are not traceable to cost object or cost centre. In other
word indirect costs cannot be linked with the product offered by the firm. If a firm
manufactures only one product all costs are direct but if more than one product is offered
the indirect costs incurred are not traceable with a particular product. So while direct costs
are allocable to a job process service cost unit or a cost centre indirect costs cannot be so
allocated. These indirect costs are called as ‘Overhead’ costs. Overhead costs are defined
as ‘the total cost of indirect materials indirect labour and indirect expenses.’ Thus all
indirect costs like indirect materials indirect labour and indirect expenses are called as
‘overheads’. Examples of overhead expenses are rent, taxes, depreciation, maintenance,
repair, supervision, selling and distribution expenses, marketing expenses, factory lighting,
printing, stationery etc.

OBJECTIVES

The objects of the present research paper are –

 To understand the management of overheads system

 To standardize of collection, allocation, apportionment and absorption of
overheads is to provide a scientific basis
 To facilitate in taking commercial and strategic management ` decisions such as
resource allocation, product mix optimization etc.

SCOPE

The standard should be followed for treatment of overheads by all enterprises including
companies covered under Cost Accounting Records Rules issued in pursuant to Sec
209(1)(d) of the Companies Act, 1956 or under the provisions of any other Act, Rules and
Regulations.

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RESEARCH METHODOLOGY

The researcher has basically adopted doctrinal method of research. The tool research
method used by the researcher is books, articles, deliberation and, online database and
economic and political weekly. Also the researcher has tried to incorporate an analytical
approach for interpretation and conclusion. The researcher has used the APA form as her
standard form of citation. Research will use the data of Info sys Ltd. for the apportionment
of overheads using the repeated method.

Overhead absorption Rate = Total overheads of the cost centre

Total quantum of base

HYPOTHESIS
Whether there is a standard to be followed for overheads. The repeated method is effective
method to calculate apportionment of overheads of the company.

Types of

Overhead Accounting

The ultimate aim of overhead accounting is to absorb them in the product units produced
by the firm. Absorption of overhead means charging each unit of a product with an
equitable share of overhead expenses. In other words as overheads are all indirect costs it
becomes difficult to charge them to the product units. In view of this it becomes necessary
to charge them to the product units on some equitably basis which is called as
‘Absorption’ of overheads. The important steps involved in overhead accounting are as
follows.

As mentioned above the ultimate of overhead accounting is ‘Absorption’ in the product

units. This is extremely important as accurate absorption will help in arriving at accurate
cost of production. Overheads are indirect costs and hence there are numerous difficulties
in charging the overheads to the product units. In view of this lot of care is to be taken in
the absorption of overheads. The steps in overhead accounting are discussed below.

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Collection, Classification and Codification of Overheads

I. Collection of Overheads: - Overheads collection is the process of recording each item

of cost in the records maintained for the purpose of ascertainment of cost of each cost
center or unit. The following are the source documents for collection of overheads.

i. Stores Requisition

ii. Wages Sheet

iii. Cash Book

iv. Purchase Orders and Invoices

v. Journal Entries

vi. Other Registers and Records

For the purpose of overhead accounting collection of overheads is very important. It is

necessary to identify the indirect expenses and the above mentioned source documents are
used for this.

II. Classification of Overheads: - Classification is defined as ‘the arrangement of items in

logical groups having regard to their nature subjective classification or the purpose to be
fulfilled Objective classification. In other words classification is the process of arranging
items into groups according to their degree of similarity. Accurate classification of all
items is actually a prerequisite to any form of cost analysis and control system.
Classification is made according to following basis.

i. Classification according to Elements: - According to this classification overheads are

divided according to their elements. The classification is done as per the following details.

• Indirect Materials: - Materials which cannot be identified with the given product unit
of cost center is called as indirect materials. For example lubricants used in a machine is
an indirect material similarly thread used to stitch clothes is also indirect material. Small
nuts and bolts are also examples of indirect materials.

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 • Indirect Labour: - Wages and salaries paid to indirect workers i.e. workers who are not
directly engaged on the production are examples of indirect wages.

• Indirect Expenses: - Expenses such as rent and taxes, printing and stationery, power,
insurance, electricity, marketing and selling expenses etc. are the examples of indirect
expenses.

ii. Functional Classification: - Overheads can also be classified according to their

functions. This classification is done as given below.

• Manufacturing Overheads: - Indirect expenses incurred for manufacturing are called as

manufacturing overheads. For example factory power, works manager’s salary, factory
insurance, depreciation of factory machinery and other fixed assets indirect materials used
in production etc. It should be noted that such expenditure is incurred for manufacturing
but cannot be identified with the product units.

• Administrative Overheads: - Indirect expenses incurred for running the administration

are known as Administrative Overheads. Examples of such overheads are office salaries,
printing and stationery, office telephone, office rent, electricity used in the office, salaries
of administrative staff etc.

• Selling and Distribution Overheads: - Overheads incurred for getting orders from
consumers are called as selling overheads. On the other hand overheads incurred for
execution of order are called as distribution overheads. Examples of selling overheads are
sales promotion expenses, marketing expenses, salesmen’s salaries and commission,
advertising expenses etc. Examples of distribution overheads are warehouse charges,
transportation of outgoing goods, packing, commission of middlemen etc.

• Research and Development Overheads: - In the modern days firms spend heavily on
research and development. Expenses incurred on research and development is known as
Research and Development overheads.

iii. Classification according to Behaviour: - According to this classification overheads

are classified as fixed variable and semi-variable. These concepts are discussed below.

• Fixed Overheads: - Fixed overheads are commonly described as those that do not vary
in total amount with increase or decrease in production volume for a given period of time

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may be a year. Salaries, depreciation of fixed assets, property taxes are some of the
examples of fixed costs. Total fixed costs remain same irrespective of changes in volume
of production but per unit of fixed cost is variable. It increases if production decreases
while if production increases it decreases.

• Variable Overheads: - Variable overheads are those which go on increasing if production

volume increases and go on decreasing if the volume decreases. Such increase or decrease
may or may not be in the same proportion. Variable overheads are generally considered to
be controllable as they are directly connected with the production.

• Semi-variable Overheads: - These types of overheads remain constant over a relatively

short range of variation in output and then are abruptly changed to a new level. In other
words they remain same up to a certain level of output and after crossing that level they
start increasing. For example supervisor’s salary is treated as fixed but if a decision is
taken to operate a second shift additional supervisor may have to be appointed which
results into increase in the salary of the supervisor. This indicates that it is a semi-variable
overhead. Similarly maintenance expenditure, fire insurance is also semi-variable
overheads.

III. Codification of Overheads: - It is always advisable to codify the overhead expenses.

Codification helps in easy identification of different items of overheads. There are
numerous items of overheads and a code number to each one will facilitate identification
of these items easily. Codification can be done by allotting numerical codes or alphabetical
codes or a combination of both. Whatever system is followed it should be remembered
that the system is simple for understanding and easy to implement without any
unnecessary complications.

B. Allocation, Apportionment and Reapportionment of Overheads: -

After the collection classification and codification of overheads the next step is allocation,
apportionment wherever allocation is not possible and finally absorption of overheads into
the product units. The following steps are required to complete this process.

• Departmentalization: - Before the allocation and apportionment process starts the first
step in this direction is ‘Departmentalization’ of overhead expenses. Departmentalization
means creating departments in the firm so that the overhead expenses can be conveniently

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allocated or apportioned to these departments. For efficient working and to facilitate the
process of allocation, apportionment and reapportionment process an organization is
divided into number of departments like machining, personnel, fabrication, assembling,
maintenance, power, tool room, stores accounts costing etc. and the overheads are
collected allocated or apportioned to these departments. This process is known as
‘departmentalization’ of overheads which will help in ascertainment of cost of each
department and control of expenses. Thus departmentalization is the first step in allocation
and apportionment process.

• Allocation: - cost allocation is ‘the charging of discrete identifiable items of cost to cost
centers or cost units. Where a cost can be clearly identified with a cost center or cost unit
then it can be allocated to that particular cost center or unit. In other words allocation is
the process by which cost items are charged directly to a cost unit or cost center. For
example electricity charges can be allocated to various departments if separate meters are
installed, depreciation of machinery can be allocated to various departments as the
machines can be identified, salary of stores clerk can be allocated to stores department and
cost of coal used in boiler can be directly allocated to boiler house division. Thus
allocation is a direct process of identifying overheads to the cost units or cost center.

• Apportionment: - Wherever possible the overheads are to be allocated. However if it is

not possible to charge the overheads to a particular cost center or cost unit they are to be
apportioned to various departments on some suitable basis. This process is called as
‘Apportionment’ of overheads. For example if separate meters are provided in each
department the electricity expenses can be allocated to various departments. However if
separate meters are not provided electricity expenses will have to be apportioned to the
departments on some suitable basis like number of light points. Similarly rent will have to
be apportioned to various departments on the basis of floor space, insurance of machinery
on the basis of value of machinery, power on the basis of horse power etc. A statement
showing the apportionment of overheads is called as ‘Primary Distribution Summary’ of
overheads.

• Reapportionment of Overheads: - As discussed above one of the important step in

overhead accounting is ‘Departmentalization’ of overheads. The departments are broadly
divided into Production Departments and Service Departments. Production Departments
are the departments where actual production takes place while Service Departments are

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the departments which render services to the Production Departments. Stores Department,
Maintenance Department, Human Resource Department, after Sales Service Departments
are some of the examples of Service Departments. In Primary Distribution Summary the
overheads are apportioned to all the Departments i.e. Production and Service. For the
purpose of absorption it is necessary that the overheads of the service departments are
reapportioned to the production departments. This process is called as preparation of
‘Secondary Distribution Summary’ of overheads. The following example will clarify this
point.

Suppose there are five departments in a manufacturing firm P1, P2 and P3 are the
production departments and S1 and S2 are the service departments. The following results
are available from the Primary Distribution Summary.

Particulars Dept. P1 Dept. P2 Dept. P3 Dept. S1 Dept. S2

From Primary Distribution 150000 175000 125000 75000 50000
Summary

In the secondary distribution summary the overheads of S1 and S2 will have to be charged
to Production Departments P1, P2 and P3. This will have to be done on some suitable
basis. The matter becomes complicated if S1 and S2 are rendering services to each other in
addition to the services rendered to the production departments. The methods of
reapportionment are divided into two types.

• Non Reciprocal Methods: - Under this method the assumption is that while service
departments render services to the production departments they do not render services to
each other. Hence their overheads are not apportioned to each other. The following
methods are used under non reciprocal methods.

• Services Rendered: - The principle followed in this method is quite simple. A production
department which receives maximum services from service departments should be
charged with the largest share of the overheads. Accordingly the overheads of service
departments are charged to the production departments.

• Ability to Pay: - This method suggests that a large share of service department’s
overhead costs should be assigned to those producing departments whose product
contribute the most to the income of the business firm. However the practical difficulty in

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this method is that it is difficult to decide the most paying department and hence difficult
to operate.

• Survey or analysis Method: - 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. For example
the postage cost could be apportioned on a survey of postage used during a year.

• Reciprocal Method: - Under this method the assumption is that the service departments
do render services to the production departments they also render services to other service
departments. In other words the service department S1 and S2 render services to each
other besides rendering services to the production departments. Hence share of overhead
expenses of S1 and S2 should be charged to each other along with the production
departments. The following method are used under Reciprocal Methods.

• Repeated Distribution Method: - Under this method services rendered by services

departments to the production departments and other services departments are quantified
in the form of percentages. The services departments’ costs are reapportioned to the
production departments on the basis of these percentages. The process is repeated again
and again till a negligible figure is reached. This method becomes complicated for
calculation if the figures are too large.

• Simultaneous Equation Method: - This is an algebraic method in which simultaneous

equations are formed and amount of overhead expenses of each service department are
found out by solving the equations. The total expenses thus obtained are then directly
transferred to the production departments.

Absorption of Overheads

The most important step in the overhead accounting is ‘Absorption’ of overheads.

Absorption is ‘the process of absorbing all overhead costs allocated or apportioned over a
particular cost center or production department by the units produced.’ In simple words
absorption means charging equitable share of overhead expenses to the products. As the
overhead expenses are indirect expenses the absorption is to be made on some suitable
basis. The basis is the ‘absorption rate’ which is calculated by dividing the overhead
expenses by the base selected. A base selected may be any one of the basis given below.
The formula used for deciding the rate is as follows

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Overhead Absorption Rate = Overhead Expenses/ Units of the base selected.

The methods used for absorption are as follows.

• Direct Material Cost: - Under this method the overheads are absorbed on the basis of
percentage of direct material cost. The following formula is used for working out the
overhead absorption percentage.

Budgeted or Actual Overhead Cost/ Direct Material Cost * 100

Thus if the overhead expenses are SR 200000 and Direct Material Cost is SR 400000
the percentage of overheads to direct material cost will be 200000/400000 X 100 = 50%.
Overheads will be thus absorbed on the basis of percentage of 50% to material costs.

Illustration: - A firm produces two products A and B. Direct material costs for A are SR
250000 and for B SR 150000. The overheads will be charged to these products as shown
in the following statement assuming the rate of absorption as 50% as shown above.

Particulars Product A Product B

Direct Materials 250000 150000
Overheads 50% of Direct Materials 125000 75000
Total Materials + Overheads 375000 225000

This method is suitable in those organizations where material is a dominant factor in the
total cost structure. Simplicity to understand and operate is also one of the positive points
of this method. However it has been observed that the material prices are fluctuating and
hence overhead absorption may become difficult.

• Direct Labour Cost Method: - This method is used in those organizations where labour is
a dominant factor in the total cost. Under this method the following formula is used for
calculating the overhead absorption rate.

Budgeted or Actual Overheads/ Direct Labour Cost * 100

Thus if the overheads are SR 300000 and Direct Labour Cost is SR 400000 the % of
absorption will be 300000/400000 * 100 = 75%. Overheads will be charged to each
product as 75% of labour cost.

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This method is also simple to understand and easy to operate. However it ignores the time
taken by each worker for completion of the job. Similarly it ignores the work performed
by machine where a labour is a mere attendant.

• Prime Cost Method: - This method is an improvement over the first two methods. Under
this method the Prime Cost is taken as the base for calculating the percentage of
absorption of overheads by using the following formula.

Budgeted or Actual Overheads/ Prime Cost * 100

Illustration: - A manufacturing firm produces two products A and B. The direct material
cost for A is SR 500000 and for B SR 300000 direct labour cost is SR 300000 and SR
200000 respectively for A and B direct expenses are SR 100000 and SR 200000
respectively for A and B. The overhead expenses are SR 960000. The statement of cost
will appear as follows.

Particulars Product A Product B Total

Direct Materials 500000 300000 800000
Direct Labour 300000 200000 500000
Direct Expenses 100000 200000 300000
Prime Cost [D.M. + D.L. + 900000 700000 1600000
D.E.]
Overheads – 60% of Prime Cost 540000 420000 960000
Works Cost 1440000 1120000 2560000

Note: - Overhead absorption rate is calculated as – 960000/1600000 * 100 = 60%

• Production Unit Method: - This method is used when all production units are similar to
each other in all respects. Total overhead expenses are divided by total production units
for computing the rate per unit of overheads and overheads are absorbed in the product
units. If a firm produces more than one products and if they are not uniform to each other
equivalent units are calculated to find out the rate of overheads per unit. The formula of
absorption of overheads is as follows.

Overhead absorption rate = Budgeted or Actual Overheads/Production Units

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• Direct Labour Hour Method: - Under this method the rate of absorption is calculated by
dividing the overhead expenses by the direct labour hours. The formula is as follows -

Budgeted or Actual Overhead Expenses/Direct Labour Hours

This method takes into account the time spent by the labour in production of each unit
where the production units are not uniform or identical. However it is not suitable if the
firm is capital intensive and highly mechanized.

• Machine Hour Rate: - Where machines are more dominant than labour machine hour rate
method is used. Machine hour rate is ‘actual or predetermined rate of cost apportionment
or overhead absorption which is calculated by dividing the cost to be appropriated or
absorbed by a number of hours for which a machine or machines are operated or expected
to be operated’. In other words machine hour rate is the cost of operating a machine on per
hour basis. The formula for calculating the machine hour rate is -

Budgeted or Actual Overhead Expenses/ Machine Hours – Actual or Budgeted

• Selling Price Method: - In this method selling price of the products is used as a basis for
absorbing the overheads. The logic used is that if the selling price is high the product
should bear higher overhead cost. Ratio of selling price is worked out and the overheads
are absorbed.

CONCLUSION
In Cost Accounting the analysis and collection of overheads, their allocation and
apportionment to different cost centres and absorption to products or services plays an
important role in determination of cost as well as control purposes. A system of better
distribution of overheads can only ensure greater accuracy in determination of cost of
products or services. It is, therefore, necessary to follow standard practices for allocation,
apportionment and absorption of overheads for preparation of cost statements.

Overheads refer to all indirect costs including indirect materials, indirect labour and
indirect expenses. These can be classified according to the functions to which they relate
and according to their variability in relation to the volume of output. Overheads are also
taken into consideration while calculating the total cost per unit. But, they cannot be
directly identified with particular products. Hence, they are distributed among different

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products in an indirect manner. The first step in overhead distribution is the collection of
overheads under various standing order numbers. The next step is to allocate and
apportion them to various production and service departments on some suitable basis. The
guiding principles of apportionment are actual benefit, potential benefit, specific benefit
and ability to pay. The third step is to re-apportion the cost of service departments to
production departments to facilitate the distribution of overheads among different products
manufactured in the factory.

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