Allocation, Apportionment & Absorption of Overheads

Allocation of overhead

Overheads are the common expenses incurred for a number of departments and cost centers or cost units. Certain items of overheads can be directly identified with a particular department or cost centre. The process of charging such items of overhead to a particular department or cost centre is known as allocation of overhead. Allocation of overhead can be made only when the amount of overhead incurred by a particular department or cost centre is known. Therefore, allocation of overheads means charging all the amount of cost to a particular department or cost centre. For example repairs and maintenance for a machine should be charged or allocated to that department where the machine is installed.

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Importance of Overhead Allocation

Allocation of overhead is important for the following reasons:

• It helps to determine the product cost.

• It helps to fix the price of a product.

• It helps to measure the effectiveness of a particular department or cost centre.

• It helps to supply the cost information to the management.

• It helps to evaluate the profitability of a product line in multi-product business.

• It helps to make a proper judgment for measurement of departmental efficiency.

• It helps to provide cost information for planning, controlling and managerial decision making.

• It helps to make accurate pricing for the competitive market.

• It can be used to control wastage and defective.

Apportionment of Overhead

There are certain overheads, which are common to a number of departments or cost centres. They cannot be directly identified or allocated to a particular department or cost centre. The distribution of such overhead to several departments or cost centers proportionately on some equitable basis is known as apportionment of overheads. For example, salary paid to the general manager should be distributed to the production, administration and selling departments as the general manager looks after all the departments. Some other common expenses are electricity, rent, lighting, etc.

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Basis of Apportionment of Overhead

The overheads which cannot be associated with the specific department distributed among the related departments on suitable basis are technically known as apportionment. Apportionment of overheads is made on the basis of:

• Benefits or services received
• Capacity to bear costs
• Efficiency achieved
• Analysis and research

Absorption of Overhead

The process of the overhead of a cost center or department to different cost units or product is called absorption of overhead. In other words, it is the process of sharing of overheads by all products or jobs of the department. A basis for absorption of overhead for each department is found out so that each job or product gets due share of overhead for each department when it passes through that department.

Method of Absorption of Overhead

To determine the amount of overhead shared by the product or job of a particular department, the overhead absorption rate or overhead rate should be found out. There are several methods of absorption of overhead. The two common methods are explained as under:

• On the basis of Labour hour rate

Under this, the overheads are apportioned on the basis of labour hours consumed by a job. Labour hour rate is calculated by dividing the total overhead by total labour hours for a certain period of time.

Overhead rate per labour hour = \(\frac{Total overheads}{Total labour hours}\)

• On the basis of Machine hour rate

Under this, the overheads are apportioned on the basis of machine hours charged to a job. It is calculated by dividing the total machine hours.

Overhead rate per machine hour = \(\frac{Total overheads}{Total machine hours}\)

References:

Koirala, Madhav et.al., Principles of Accounting-XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy-XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu