Allocation, Apportionment & Absorption - Overheads, Cost Accounting B Com Notes | EduRev

Cost Accounting

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B Com : Allocation, Apportionment & Absorption - Overheads, Cost Accounting B Com Notes | EduRev

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Allocation and Apportionment of Overheads (Depart-Mentalisation of Overheads)

Most of the manufacturing process functionally are different and performed by different departments in a factory. Where such a division of functions has been made, some of the departments would be engaged in actual production of goods while others in providing services ancillary thereto.

For the efficient working, a factory is divided into a number of sub-divisions. Such sub-divisions are referred to as departments. In other words, departmentalisation of overhead means dividing the factory into several segments called departments or cost centres to which expenses are charged. This sub-division is done in such a manner so that each department represents a division of activity of the organisation such as repairs department, power department, tools department, stores department, cost department, cash department, etc. The following factors are taken care of while dividing an organisation into number of departments:

  1. Every manufacturing process is divided into its natural divisions in order to maintain natural flow of raw materials from the time of its purchase till its conversion into finished goods and sale.
  2. The sequence of operations are taken into consideration while determining the location of various departments.
  3. Division of responsibility as far as possible should be clear, without ambiguity and dual control.

The departments in a factory can be broadly categorised into the following types:

  1. Producing or manufacturing departments: A manufacturing or producing department is one in which manual/machine operations and other process of production of articles or commodities take place. The number of such departments will depend upon the nature of industry, type of work performed and the size of the factory.
  2. Service departments: These departments are not directly engaged in production but they render special type of service for the benefit of other departments.
  3. Partly producing departments: In every organisation a few departments such that it is not possible to place these departments into a particular category, since they fall within the purview of both categories, i.e. producing and service departments. For example, if a toolroom manufactures some special tools for utilisation in the main job orders, it is acting as a productive department though it is a service department.

Advantages of Departmentalisation:

  1. It segregates factory overhead costs and computes the total cost of each service departments.
  2. It makes possible the establishments of control to keep costs at a minimum.
  3. Ascertainment of cost of different departments helps in computing the cost of different jobs or products which pass through these departments.

Allocation of Overheads 

After having collected the overheads under proper standing order numbers the next step is to arrive at the amount for each department or cost centre. This may be through allocation or absorption. According to the Chartered Institute of Management Accountants, London, cost allocation is “that part of cost attribution which charges a specific cost to a cost centre or cost unit”. Thus, the wages paid to maintenance workers as obtained from wages analysis book can be allocated directly to maintenance service cost centre. Similarly indirect material cost can also be allocated to different cost centres according to use by pricing stores requisitions.

Apportionment of Overheads

Apportionment refers to the distribution of overheads among departments or cost centres on an equitable basis. In other words, apportionment involves charging a share of the overheads to a cost centre or cost unit. CIMA, London has defined it as “that part of cost attribution which shares costs among two or more cost centres or cost units in proportion to the estimated benefit received, using a proxy”. Apportionment is done in case of those overhead items which cannot be wholly allocated to a particular department. For example, the salary paid to the works manager of the factory, factory rent, general manager’s salary etc. cannot be charged wholly to a particular department or cost centre, but will have to be charged to all departments or cost centres on an equitable basis.

1. Primary distribution of overheads

Primary distribution of overhead involves allocation or apportionment of different items of overhead to all departments of a factory. This is also known as departmentalisation of overheads. While making primary distribution the distinction between production departments and service departments disregarded since it is of little use. The distribution of different items of overhead in different departments is attempted on some logical and reasonable basis.

Basis of apportioning overhead expenses: It is stated that the total overhead expenses of a department comprises direct overhead expenses incurred in the departments itself as well as the apportioned overhead expenses of other service departments. Expenses directly incurred in the departments which are jointly incurred for several departments have also to be apportioned e.g. expenses on rent, power, lighting, insurance etc. In other words, common expenses have to be apportioned or distributed over the departments on some equitable basis. The following basis are most commonly used for apportioning items of overhead expenses among production and service departments.

BasisItems of Overheads
1. Floor areaRent, rates and taxes paid for the building, air conditioning, etc.
2. No. of employees or wages of each departmentGroup insurance, canteen expenses, E.S.I. contribution, general welfare expenses, compensation and other fringe benefits, supervisions etc.
3. Capital valuesInsurance and depreciation of plants, machinery and equipments.
4. Direct labour hoursWorks manager’s remuneration, general overtime expenses, cost of inter-department transfers etc.
5. No. of light pointsElectric light
6. Horse power of machines or machine hoursElectric power
7. Audit feeSales or total cost
8. Value or weight of direct materialStores overheads
9. Weight, volume, tonne, mile.Delivery expenses

2. Re-apportionment of service department overheads (Secondary Distribution)

Normally products do not pass through service departments, but service departments do benefit the manufacture of products. Therefore, it is logical that product cost should bear and equitable share of the cost of service departments. The process of redistribution of the cost of service departments among the production departments is known as secondary distribution.

Criteria for secondary distribution

  1. Service or use method: Under this method overheads are distributed over various production departments on the basis of service received. The greater is the amount of service received by a production department, the greater should be the share to be apportioned to that department. This criterion has greatest applicability in cases where overhead costs can be easily and directly traced to departments receiving the benefits. Since this method is based upon the extent of the benefit received by a department, the expenses are equitably apportioned. This method is considered to be fair as it takes into account the time element and consistent results.
  2. Analysis or survey: In certain cases it may not be possible to measure exactly the extent of benefit which the various departments receive as this may vary from period to period. Therefore, overheads are apportioned on the basis of analysis and survey of existing conditions. This basis of apportionment includes arbitrary elements.
  3. Ability to pay: This method presumes that higher the revenue of a production department, higher should be the proportionate charge for services. This method is simple to apply but it is generally considered inequitable because it penalises the efficient and profitable units of a business to the advantage of the inefficient ones.
  4. Efficiency or incentive method: This basis facilitates scientific distribution of service department cost to production departments. Under this 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. Opposite is the effect if the assumed levels are not reached. Thus, the department whose sales are increasing is able to show a greater profit and thereby is able to earn greater goodwill and appreciation of the management.
  5. General use of indices: If data relating to actual services rendered can not be obtained in some situations this method is adopted. The index selected is closely related to assured flow of service department cost to production departments. For instance, the service of cost accounting department can be apportioned to production departments on the basis of number of employees in each department.

Following is a list of basis, which are frequently used for apportionment of cost of service departments among production departments:

Service department costsBasis of apportionment
1. Maintenance departmentHours worked for each department.
2.Employment/personnel departmentRate of labour turnover or number of employees in each department.
3.Payroll or time departmentDirect labour hours, machine hours number of employees.
4.Stores keeping departmentNo. of requisitions, quantity or value of materials.
5.Welfare departmentNo. of employees in each department.
6.Internal transport serviceTruck hours, truck mileage or tonnage.
7.Building service departmentRelative area of each department.
8. Power houseFloor area, cubic contents

Methods of Re-apportionment or Re-distribution 

At first expenses of all departments are compiled without making a distinction between production and service departments but, then, the expenses of the service departments are apportioned among the production departments on a suitable basis. It is also possible that expenses of one service department may also be apportioned in part to another service department to arrive at the total expenses incurred on the latter department, which will then be distributed among production department.

Following are the methods of re-distribution of service department costs to production departments:

(i) Direct distribution method: Under this method, the cost of service department are directly apportioned to production departments, without taking into consideration any service from one service departments to another service department.

(ii) Step method: In this method the cost of most serviceable department is first, apportioned to other service departments and production departments. The next service department is taken up and its cost is apportioned and this process is going on till the cost of last service department is apportioned. The cost of last service department is apportioned among production departments only.

(iii) Reciprocal service method: This method gives cognizance to the fact that where there are two or more service departments, they may render service to each other and therefore these interdepartmental services are to be given due weight in distributing the expenses of service departments. There are three methods available for dealing with inter service department transfer :

  • Simultaneous equation method: Under this method, the true cost of service departments are ascertained first with the help of simultaneous equations. These are then distributed among the production departments on the basis of given percentages.
  • Repeated distribution method: According to this method service department costs are apportioned over other departments, production as well as service according to the agreed percentages and this process is repeated until the total costs of the service departments are exhausted or the figures become to small to be considered for further apportionment.
  • Trial and error method: In this method the cost of one service department is apportioned to another service department. The cost of another service department plus the share received from the first service department is again apportioned to first service department and this process is continued until the balancing figure becomes nil. For instance, suppose there are two service departments x and y. These service departments render service to each other. Cost of service department x will be distributed to service department y. Again cost of service department y plus the share from service department x will be apportioned to x. The amount so apportioned to x will continue to be repeated till amount involved becomes negligible.


Absorption of Overheads

Absorption of overheads refers to charging of overheads to individual products or jobs. The overhead expenses pertaining to a cost centre are ultimately to be charged to the products, jobs etc. which pass through that cost centre. For the purpose of absorption of overhead to individual jobs, processes or products, overheads absorption rates are applied. The overhead rate of expenses for absorbing them to production may be estimated on the following three basis.

  1. The figure of the previous year or period may be adopted as the overhead rate to be charged on production in the current year.
  2. The overhead rate for the year may be determined on the basis of the estimated expenses and anticipated volume of production or activity.
  3. The overhead rate for the year may be determined on the basis of normal volume of output or capacity of the business.

Actual and pre-determined overhead rate: The overhead absorption rate may be computed either based on actual cost or on the basis of estimated cost:

Actual Overhead Rate

This is also known as historical overhead rate. This rate is obtained by dividing the overhead expenses incurred during the accounting period by the actual quantum (quantity/value) of the base selected. This rate is determined as follows:

Actual overhead rate = Actual overhead for the period / Actual quantuty or value of the base for the period

This method suffers from the following limitations:

  1. Actual overhead rate cannot be determined until the end of the period.
  2. Seasonal or cyclical influences cause wide fluctuations in the actual overhead cost and actual volume of activity.
  3. Actual cost is generally used for comparison with the predetermined figures for the purpose of control. Thus, it is useful only when compared with the established norms or standards.

Pre-determined Overhead Rate

Pre-determined overhead rate is determined in advance of the actual production and is computed by dividing the budgeted overhead expenses for the accounting period by the budgeted base for the period i.e.

Pre-determined overhead rate = Budgeted overhead for the period / Budgeted base for the period

This computation of a pre-determined overhead rate is more practical and has the following advantages:

  1. Pre-determined overhead rate facilitates product cost determination immediately after production is completed.
  2. In those concerns where the budgetary control system is in operation, all the data for the purpose of calculation of pre-determined overhead rate is available without any extra clerical cost.
  3. It is useful when cost plus contracts are undertaken.
  4. Cost estimating and competitive pricing offer ideal situations for use of pre-determined overhead rates.

Blanket and Multiple Overhead Rates

Blanket overhead rate refers to the use of one single or general overhead rate for the whole factory. The blanket rate is used in those factories :
(a) Where only one major product in continuous process is being produced.
(b) Where several products are produced it can be applied only if:
(i) all products pass through all departments; and
(ii) all products are processed for the same length of time in each department.

This rate is calculated as follows:

Blanket overhead rate = Overhead cost for the entire factory / Base for the period

 

When different rates are computed for each producing department, service department, cost centre, each product or product line, each production factor, and for fixed overhead and variable overhead, then they are known as multiple rates. It is calculated as under:

Overhead Rate = Overhead cost allocated and apportioned to each cost entre / Corresponding base

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