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apportionment, absorption

Overhead costing involves a series of steps to ensure that indirect costs are accurately assigned to products or services. Two crucial steps in this process are apportionment and absorption.

Apportionment of Overheads 🤝

Apportionment (also known as primary distribution) is the process of distributing or sharing common overhead costs among various departments or cost centers (both production and service departments) on an equitable and rational basis. It's used for overheads that are incurred for the benefit of multiple departments and cannot be directly allocated (i.e., solely assigned) to a single department. The goal is to collect all indirect costs incurred within each department.

Key Aspects of Apportionment:

  • Purpose: To arrive at the total overhead cost attributable to each department, including service departments.
  • Focus: Departments or cost centers.
  • Basis: A suitable basis is chosen for each overhead item to reflect the benefit received or the cause of the cost. The aim is fairness and rationality.

Methods/Bases of Apportionment:

Overhead Item Common Basis of Apportionment Rationale
Rent, Rates, Taxes, Insurance of Building, Building Maintenance Floor Area (Square Footage) occupied by each department These costs are directly related to the space utilized by each department.
Lighting, Heating, Air Conditioning Number of Light Points, Floor Area, or Meter Readings Reflects energy consumption or space heated/cooled.
Power, Fuel, Steam Machine Hours, Horsepower (HP) of Machines, KWH Meter Readings Directly relates to the energy consumed by machinery or operations.
Supervision, Canteen, Welfare, Personnel Dept. Costs Number of Employees/Workers in each department These services are generally provided for the benefit of employees.
Depreciation, Repairs & Maintenance (Machinery) Capital Value (Cost) of Machinery, Machine Hours Higher value or greater usage of machinery typically incurs more of these costs.
Storekeeping Costs Number of Material Requisitions, Value/Weight of Materials Issued Reflects the volume of materials handled for each department.
Works Manager's Salary, General Overheads Direct Wages, Direct Labour Hours, or Survey These are broad costs, and their apportionment may require judgment or detailed analysis of time spent.

Steps in Apportionment:

  1. Identify all overhead costs to be apportioned.
  2. Identify all departments (production and service) that will share these costs.
  3. Select the most appropriate basis for each overhead item.
  4. Calculate the proportion for each department and distribute the overhead cost accordingly.

Absorption of Overheads ➡️

Absorption (also known as secondary distribution or recovery of overheads) is the process of charging or applying the overhead costs that have been accumulated in the production departments (after primary and secondary distribution) to the cost units (products, jobs, or services). This is done using a predetermined overhead absorption rate. The ultimate goal is to include a share of overheads in the final cost of each product manufactured.

Key Aspects of Absorption:

  • Purpose: To include indirect costs in the cost of specific products, jobs, or services for inventory valuation, pricing, and profitability analysis.
  • Focus: Cost units (products, jobs, services).
  • Mechanism: Uses a predetermined overhead absorption rate, which is applied to the actual activity of the cost units.

Steps in Absorption:

  1. Accumulate total overheads for each production department: This includes allocated overheads, apportioned overheads from common expenses, and re-apportioned overheads from service departments.
  2. Select an appropriate absorption base (activity base) for each production department. This should be a measure of activity that best drives or correlates with the overhead costs in that department (e.g., direct labor hours, machine hours, units produced).
  3. Calculate the Predetermined Overhead Absorption Rate for each production department. This rate is usually calculated at the beginning of an accounting period based on estimated figures. $$\text{Overhead Absorption Rate} = \frac{\text{Estimated Total Overhead for Production Department}}{\text{Estimated Total Activity (Base) for Production Department}}$$
  4. Apply (Absorb) Overheads to Cost Units: Multiply the predetermined overhead rate by the actual amount of the absorption base consumed by each product/job. $$\text{Overheads Absorbed by a Product/Job} = \text{Actual Activity (Base) Consumed} \times \text{Overhead Absorption Rate}$$

Under or Over Absorption of Overheads:

Since absorption rates are predetermined using estimated figures, there's often a difference between the overhead absorbed by products and the actual overheads incurred.

  • Under-absorption: Occurs when actual overheads incurred are greater than overheads absorbed (applied) to products. This means not enough overhead cost has been charged to products.
  • Over-absorption: Occurs when actual overheads incurred are less than overheads absorbed (applied) to products. This means too much overhead cost has been charged to products. These differences are typically adjusted at the end of the accounting period, usually by adjusting the Cost of Goods Sold or prorating the variance to WIP, Finished Goods, and Cost of Goods Sold.

Difference between Apportionment and Absorption:

Feature Apportionment (Primary/Secondary Distribution) Absorption (Recovery/Application)
What it does Distributes common overheads to departments/cost centers. Charges overheads from production departments to individual products/jobs.
Stage First stage of overhead distribution. Second/Final stage of overhead distribution.
Focus Cost Centers (Departments) Cost Units (Products, Jobs, Services)
Basis Uses various logical bases (e.g., floor area, number of employees, machine HP) to share common costs. Uses a single predetermined absorption rate (e.g., per direct labor hour, per machine hour, per unit) for each production department.
Output Total overhead cost accumulated for each department. Overhead cost attached to each specific product/job.
Purpose To departmentalize overheads for better control and rate calculation. To determine the full cost of a product for pricing, valuation, and profitability.
Relationship Apportionment must happen before absorption can take place. Absorption uses the results of apportionment to calculate product costs.
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