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allocation and apportionment of overheads

ALLOCATION AND APPORTIONMENT OF OVERHEADS

Posted on February 16, 2020 By commerceiets No Comments on ALLOCATION AND APPORTIONMENT OF OVERHEADS

Table of Contents

    • Allocation and Apportionment of overheads is also known as departmentalization of overheads.
  • ALLOCATION OF OVERHEADS
  • APPORTIONMENT OF OVERHEADS
  • ACCOUNTING OF ALLOCATION AND APPORTIONMENT OF OVERHEADS

Allocation and Apportionment of overheads is also known as departmentalization of overheads.

ALLOCATION OF OVERHEADS

Allocation is the process of identification of overheads with cost centers. An expense which is directly identifiable with a specific cost centre is allocated to that centre. Thus it is allotment of a whole item of cost to a cost centre or cost unit.

ACCORDING TO CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANTS, LONDON

“Cost Allocation is the charging of discrete, identifiable items of cost to cost centres or cost units”.

EXAMPLE

The total overtime wages of workers of a department should be charged to that department. The electricity charges of a department if separate meters are there should be charged to that particular department only.

APPORTIONMENT OF OVERHEADS

Cost apportionment is the allotment of proportions of cost to cost centers or cost units. If a cost is incurred for two or more divisions or departments then it is to be apportioned to the different departments on the basis of benefit received by them. Apportionment is done in case of those overhead items which cannot be wholly allocated to a particular department. Common items of overheads are rent and rates, depreciation, repairs and maintenance, lighting, works manager’s salary etc.

ACCORDING TO CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANTS, LONDON

“Apportionment of overheads is that part of cost attribution which shares costs among two or more cost centers or cost units in proportion to the estimated benefit received, using a proxy”.

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 centers on an equitable basis.

Principles of Apportionment of Overhead Cost

The following are the principles of apportionment of overhead costs:

(i) 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.

(ii) 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 contributes the most to the income of the business firm. However the practical difficulty in this method is that, it is difficult to decide the most paying department and hence difficult to operate.

(iii) 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.

(iv) Efficiency Method

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. If the target is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the department.

ACCOUNTING OF ALLOCATION AND APPORTIONMENT OF OVERHEADS

There are two methods of allocation and apportionment of overheads i.e. Primary Distribution and Secondary Distribution.

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 departmentalization 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 is most commonly used for apportioning items of overhead expenses among production and service departments.

Basis Items of Overheads
1. Floor area Rent, rates and taxes paid for the building, air conditioning, etc.
2. No. of employees or wages of each Department Group insurance, canteen expenses, E.S.I. contribution, general welfare expenses, compensation and other fringe benefits, supervisions etc.
3. Capital values Insurance and depreciation of plants, machinery and equipments.
4. Direct labour hours Works manager’s remuneration, general overtime expenses, cost of inter-department transfers etc.
5. No. of light points Electric light
6. Horse power of machines or machine hours Electric power

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

 (i) 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.

(ii) 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.

(iii) 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 penalizes the efficient and profitable units of a business to the advantage of the inefficient ones.

(iv)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.

(v) General use of indices: If data relating to actual services rendered cannot 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 costs Basis of apportionment
1. Maintenance department Hours worked for each department.
2. Employment/personnel department Rate of labor turnover or number of employees in each department.
3. Payroll or time department Direct labor hours, machine hour’s number of employees.
4. Stores keeping department No. of requisitions, quantity or value of materials.
5. Welfare department No. of employees in each department.
6. Internal transport service Truck hours, truck mileage or tonnage.
7. Building service department Relative area of each department.
8. Power house Floor 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 inter-departmental 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:

(a) 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.

(b) 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 too small to be considered for further apportionment.

(c) 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.

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ALLOCATION AND APPORTIONMENT OF OVERHEADS
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