CIMA - C1 Fundamentals of Management Accounting
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
1 Overhead allocation
The first step in absorption costing is allocation. Allocation is the process by which whole cost items are charged direct
to a cost unit or cost centre.
Allocation is 'to assign a whole item of cost, or of revenue, to a single cost unit, centre, account or time period'.
CIMA Official Terminology
Cost centres may be one of the following types.
(a) A production department, to which production overheads are charged.
(b) A production area service department, to which production overheads are charged.
(c) An administrative department, to which administration overheads are charged.
(d) A selling or a distribution department, to which sales and distribution overheads are charged.
(e) An overhead cost centre, to which items of expense which are shared by a number of departments, such
as rent and rates, heat and light and the canteen, are charged.
The following are examples of costs which would be charged direct to cost centres via the process of allocation.
(a) The cost of a warehouse security guard will be charged to the warehouse cost centre.
(b) Paper on which computer output is recorded will be charged to the computer department.
1.1 Example: overhead allocation
Consider the following costs of a company.
Wages of the supervisor of department A $200
Wages of the supervisor of department B $150
Indirect materials consumed in department A $50
Rent of the premises shared by departments A and B $300
The cost accounting system might include three cost centres.
Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, ie $200 + $50 to cost centre 101, $150 to cost centre
102 and $300 to cost centre 201. The rent of the factory will be subsequently shared between the two production
departments, but for the purpose of day to day cost recording in this particular system, the rent will first of all be
charged in full to a separate cost centre.
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
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2 Overhead apportionment
The second step in absorption costing is overhead apportionment. This involves apportioning general overheads to cost
centres and then reapportioning the costs of service cost centres to production departments.
Apportion is 'to spread indirect revenues or costs over two or more cost units, centres, accounts or time periods'.
CIMA Official Terminology
2.1 First stage: apportioning general overheads
Overhead apportionment follows on from overhead allocation. The first stage of overhead apportionment is to identify all
overhead costs as production department, production service department, administration or selling and distribution
overhead. This means that the costs for heat and light, rent and rates, the canteen and so on (that is, costs which have
been allocated to general overhead cost centres) must be shared out between the other cost centres.
2.1.1 Bases of apportionment
Overhead costs should be shared out on a fair basis. You will appreciate that because of the complexity of items of cost
it is rarely possible to use only one method of apportioning costs to the various departments of an organisation. The
bases of apportionment for the most usual cases are given below.
Overhead to which the basis applies
Basis
Rent, rates, heating and light, repairs and depreciation of buildings Floor area occupied by each cost centre
Depreciation, insurance of equipment
Cost or book value of equipment
Personnel office, canteen, welfare, wages and cost offices, first aid
Number of employees, or labour hours worked in
each cost centre
Heating, lighting (see above)
Volume of space occupied by each cost centre
Question
Bases of apportionment
The following bases of apportionment are used by a factory.
A Volume of cost centre
B Value of machinery in cost centre
C Number of employees in cost centre
D Floor area of cost centre
Complete the table below using one of A to D to show the bases on which the production overheads listed in the table
should be apportioned.
Production overheads Basis
Rent
Heating costs
Insurance of machinery
Cleaning costs
Canteen costs
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
Answer
Production overheads Basis
Rent D
Heating costs A
Insurance of machinery B
Cleaning costs D
Canteen costs C
2.1.2 Example: overhead apportionment
McQueen Co has incurred the following overhead costs.
$'000
Depreciation of factory
100
Factory repairs and maintenance
60
Factory office costs (treat as production overhead)
150
Depreciation of equipment
80
Insurance of equipment
20
Heating
39
Lighting
10
Canteen
90
549
Information relating to the production and service departments in the factory is as follows.
Department
Production Production Service Service Totals
1 2 100 101
Floor space (square metres) 1,200 1,600 800 400 4,000
Volume (cubic metres) 3,000 6,000 2,400 1,600 13,000
Number of employees 30 30 15 15 90
Book value of equipment $30,000 $20,000 $10,000 $20,000 $80,000
Required
Determine how the overhead costs should be apportioned between the four departments.
Solution
Costs are apportioned using the following general formula.
base entapportionm of valueTotal
cost overhead Total
× value of apportionment base of cost centre
For example, heating for department 1 =
3,000
13,000
$39,000
×
= $9,000
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
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Total
To Department
Item of cost
Basis of apportionment
cost
1
2
100
101
$
$
$
$
$
Factory depreciation
(floor area)
100
30.0
40
20.0
10.0
Factory repairs
(floor area)
60
18.0
24
12.0
6.0
Factory office costs
(number of employees)
150
50.0
50
25.0
25.0
Equipment depreciation
(book value)
80
30.0
20
10.0
20.0
Equipment insurance
(book value)
20
7.5
5
2.5
5.0
Heating
(volume)
39
9.0
18
7.2
4.8
Lighting
(floor area)
10
3.0
4
2.0
1.0
Canteen
(number of employees)
90
30.0
30
15.0
15.0
Total
549
177.5
191
93.7
86.8
Question
Apportioning overheads
Pippin Co has three production departments (forming, machines and assembly) and two service departments
(maintenance and general).
The following is an analysis of budgeted overhead costs for a twelve-month period.
$
$
Rent and rates
8,000
Power
750
Light, heat
5,000
Repairs, maintenance:
Forming
800
Machines
1,800
Assembly
300
Maintenance
200
General
100
3,200
Departmental expenses:
Forming
1,500
Machines
2,300
Assembly
1,100
Maintenance
900
General
1,500
7,300
Depreciation:
Plant
10,000
Fixtures and fittings
250
Insurance:
Plant
2,000
Buildings
500
Indirect labour:
Forming
3,000
Machines
5,000
Assembly
1,500
Maintenance
4,000
General
2,000
15,500
52,500
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
Other available data are as follows
Effective
Direct
Labour
Machine
Floor
Plant
Fixtures
horse –
cost for
hours
hours
area
value
& fittings
power
year
worked
worked
sq.ft
$
$
$
Forming
2,000
25,000
1,000
40
20,500
14,400
12,000
Machines
4,000
60,000
500
90
30,300
20,500
21,600
Assembly
3,000
7,500
2,000
15
24,200
20,200
2,000
Maintenance
500
7,500
1,000
5
–
–
–
General
500
–
500
–
–
–
–
10,000
100,000
5,000
150
75,000
55,100
35,600
The overheads apportioned to:
(a) Forming is $
(b) Machines is $
(c) Assembly is $
(d) Maintenance is $
(e) General is $
Answer
(a) Forming $
11,250
(b) Machines $
22,175
(c) Assembly $
8,025
(d) Maintenance $
6,750
(e) General $
4,300
Workings
Basis Forming Machines Assembly Maint'nce General Total
$
$
$
$
$
$
Directly allocated overheads:
Repairs, maintenance
800
1,800
300
200
100
3,200
Departmental expenses
1,500
2,300
1,100
900
1,500
7,300
Indirect labour
3,000
5,000
1,500
4,000
2,000
15,500
Apportionment of other overheads:
Rent, rates
1
1,600
3,200
2,400
400
400
8,000
Power
2
200
450
75
25
0
750
Light, heat
1
1,000
2,000
1,500
250
250
5,000
Dep'n of plant
3
2,500
6,000
750
750
0
10,000
Dep'n of F & F
4
50
25
100
50
25
250
Insurance of plant
3
500
1,200
150
150
0
2,000
Insurance of buildings
1
100
200
150
25
25
500
11,250
22,175
8,025
6,750
4,300
52,500
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
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Basis of apportionment:
1 Floor area
2 Effective horsepower
3 Plant value
4 Fixtures and fittings value
2.2 Second stage: service cost centre cost apportionment
The second stage of overhead apportionment concerns the treatment of service cost centres. A factory is divided into
several production departments and also a number of service departments, but only the production departments are
directly involved in the manufacture of the units. In order to be able to add production overheads to unit costs, it is
necessary to have all the overheads charged to (or located in) the production departments. The next stage in absorption
costing is, therefore, to apportion the costs of service cost centres to the production cost centres. Examples of possible
apportionment bases are as follows.
Service cost centre Possible basis of apportionment
Stores Number of materials requisitions
Maintenance Hours of maintenance work done for each cost centre
Production planning Direct labour hours worked in each production cost centre
There are two main methods of reapportioning the service department overheads to production departments.
•
Direct method (ignores inter-service department work)
•
Repeated distribution method (recognises inter-service department work)
Re-apportion is 'the re-spread of costs apportioned to service departments to production departments'.
CIMA Official Terminology
2.2.1 Example: service centre cost apportionment
A company has two production and two service departments (stores and maintenance). The following information about
activity in the recent costing period is available.
Production departments Stores Maintenance
A B department department
Overhead costs $10,030 $8,970 $10,000 $8,000
Cost of material requisitions $30,000 $50,000 – $20,000
Maintenance hours needed 8,000 1,000 1,000 –
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
(a) Direct method
If service department overheads were apportioned directly to production departments, the apportionment would
be as follows.
Service
department Basis of apportionment Total cost A B
$ $ $
Stores
Material requisitions
10,000
(3/8)
3,750
(5/8)
6,250
Maintenance
Maintenance hours
8,000
(8/9)
7,111
(1/9)
889
18,000
10,861
7,139
Overheads of departments A and B
19,000
10,030
8,970
37,000
20,891
16,109
(b) Repeated distribution method
If, however, recognition is made of the fact that the stores and maintenance department do work for each other,
and the basis of apportionment remains the same, we ought to apportion service department costs as follows.
Dept A Dept B Stores Maintenance
Stores (100%) 30% 50% – 20%
Maintenance (100%) 80% 10% 10% –
This situation where the service departments do work for each other is known as reciprocal servicing. The re-
apportionment of service department costs in this situation can be done using the repeated distribution method
of apportionment.
Production
Production
dept A
dept B
Stores
Maintenance
$
$
$
$
Overhead costs
10,030
8,970
10,000
8,000
First stores apportionment
(see note (a))
3,000
5,000
(10,000
)
2,000
0
10,000
First maintenance apportionment
8,000
1,000
1,000
(10,000
)
1,000
0
Second stores apportionment
300
500
(1,000)
200
Second maintenance apportionment
160
20
20
(200)
Third stores apportionment
6
10
(20)
4
Third maintenance apportionment
4
–
–
(4
)
(see note (b))
21,500
15,500
0
0
Notes
(a) The first apportionment could have been the costs of maintenance, rather than stores; there is no
difference to the final results.
(b) When the repeated distributions bring service department costs down to small numbers (here $4) the final
apportionment to production departments is an approximate rounding.
You should note the difference in the final overhead apportionment to each production department using the different
service department apportionment methods. Unless the difference is substantial, the direct apportionment method
might be preferred because it is clerically simpler to use.
Important!
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
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Question
Repeated distribution method
Using your answer to the previous question (apportioning overheads) and the following information, apportion the
overheads of the two service departments using the repeated distribution method.
Service department costs are apportioned as follows
Maintenance
General
%
%
Forming
20
20
Machines
50
60
Assembly
20
10
General
10
–
Maintenance
–
10
100
100
(a) The forming department overheads after service department apportionment are $
(b) The machines department overheads after service department apportionment are $
(c) The assembly department overheads after service department apportionment are $
Answer
(a) The forming department overheads after service department apportionment are $
13,705
(b) The machines department overheads after service department apportionment are $
28,817
(c) The assembly department overheads after service department apportionment are $
9,978
Workings
Apportionment of service department overheads to production departments, using the repeated distribution method.
Forming
Machines
Assembly
Maintenance
General
Total
$
$
$
$
$
$
Overheads
11,250
22,175
8,025
6,750
4,300
52,500
Apportion maintenance (2:5:2:1)
1,350
3,375
1,350
(6,750)
675
4,975
Apportion general (2:6:1:1)
995
2,985
498
497
(4,975)
Apportion maintenance (2:5:2:1)
99
249
99
(497)
50
Apportion general (2:6:1:1)
10
30
5
5
(50)
Apportion maintenance (2:5:2:1)
1
3
1
(5
)
13,705
28,817
9,978
0
0
52,500
Apportioning service department overheads is only useful if the resulting product costs reflect accurately the amounts
expended by service departments. If, however, the apportionment is arbitrary or ill-considered, the absorption of service
department costs into product costs may be misleading.
Remember!
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3: Overhead costs – absorption costing⏐ Part A Cost determination and behaviour
Question
Reciprocal servicing
ABC Co has a production department in Block H of the building and another in Block F. There are also two service
departments namely the canteen and the maintenance department. Fixed overheads are incurred as follows:
Department Overheads
$'000
H Block 400
F Block 700
Canteen 550
Maintenance 800
The canteen provides food for H Block (40%), F Block (40%) and the maintenance department (20%). Maintenance does
work for H Block and F Block in the ratio 2:3.
What would be the total fixed overhead of H Block if all service department overheads are allocated to production
departments?
A $546,000
B $364,000
C $984,000
D $1,466,000
Answer
C
H Block
F Block
Canteen
Maintenance
$'000 $'000 $'000 $'000
Overheads
400
700
550
800
Canteen (2:2:1)
220
220
(550
)
110
620
920
–
910
Maintenance (2:3)
364
546
(910
)
984
1,466
–
–
3 Overhead absorption
3.1 Introduction
Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add them to, or absorb
them into, the cost of production or sales.
Production overheads are added to the prime cost (direct materials, labour and expenses), the total of the two being the
factory cost, or full cost of production. Production overheads are therefore included in the value of inventories of
finished goods.
3.2 Predetermined absorption rates
In absorption costing, it is usual to add overheads into product costs by applying a predetermined overhead absorption
rate. The predetermined rate is set annually, in the budget.
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Part A Cost determination and behaviour ⏐ 3: Overhead costs – absorption costing
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Overhead absorption rate is 'a means of attributing overhead to a product or service, based for example on direct labour
hours, direct labour cost or machine hours'. CIMA Official Terminology
Overheads are not absorbed on the basis of the actual overheads incurred but on the basis of estimated or budgeted
figures (calculated prior to the beginning of the period). The rate at which overheads are included in cost of sales
(absorption rate) is predetermined before the accounting period actually begins for a number of reasons.
(a) Goods are produced and sold throughout the year, but many actual overheads are not known until the end
of the year. It would be inconvenient to wait until the year end in order to decide what overhead costs
should be.
(b) An attempt to calculate overhead costs more regularly (such as each month) is possible, although
estimated costs must be added for occasional expenditures such as rent and rates (incurred once or twice
a year). The difficulty with this approach would be that actual overheads from month to month would
fluctuate randomly; therefore, overhead costs charged to production would depend on a certain extent on
random events and changes. A unit made in one week might be charged with $4 of overhead, in a
subsequent week with $5, and in a third week with $4.50. Only units made in winter would be charged
with the heating overhead. Such charges are considered misleading for costing purposes and
administratively and clerically inconvenient to deal with.
(c) Similarly, production output might vary each month. For example actual overhead costs might be $20,000
per month and output might vary from, say, 1,000 units to 20,000 units per month. The unit rate for
overhead would be $20 and $1 per unit respectively, which would again lead to administration and control
problems.
3.3 Calculating predetermined overhead absorption rates
The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of activity. For production
overheads the level of activity is often budgeted direct labour hours or budgeted machine hours.
Overhead absorption rates are therefore predetermined as follows.
(a) The overhead likely to be incurred during the coming period is estimated.
(b) The total hours, units, or direct costs on which the overhead absorption rates are to be based (activity
level) are estimated.
(c) The estimated overhead is divided by the budgeted activity level to arrive at an absorption rate for the
forthcoming period.
3.4 Selecting the appropriate absorption base
Management should try to establish an absorption rate that provides a reasonably 'accurate' estimate of overhead
costs for jobs, products or services.
There are a number of different bases of absorption (or 'overhead recovery rates') which can be used. Examples are as
follows.
• A percentage of direct materials cost • A rate per machine hour
• A percentage of direct labour cost • A rate per direct labour hour
• A percentage of prime cost • A rate per unit
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FAST FORWARD
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