Overhead Cost Allocation & Apportionment: Methods, Bases & Practical Applications

TAKEAWAYS:

• Overhead costs are indirect costs (e.g., rent, depreciation, utilities) that cannot be directly traced to a product or service but must be allocated for accurate costing.
• Allocation assigns overheads to departments based on a physical relationship (e.g., machine hours), while apportionment distributes costs to production/service departments using logical bases (e.g., floor area, employee count).
• Common allocation bases include direct labor hours (DLH), machine hours (MH), and production units, with DLH being the most traditional but MH gaining prominence in automated industries.
• Under-absorption (actual overhead > allocated overhead) and over-absorption (actual overhead < allocated overhead) distort profit figures and require adjustments in financial statements.
• Reciprocal allocation is used when departments provide services to each other (e.g., maintenance department servicing multiple production lines), requiring simultaneous equations or matrix methods.
• Nepali businesses like Nepal Pharmaceuticals (medicine manufacturing) or Kathmandu-based garment factories use overhead allocation to price orders for Daraz or export markets.

1. Definitions and Classification of Overhead Costs

Overhead costs are indirect manufacturing costs that cannot be directly attributed to a specific product or service. They include:

• Production Overheads: Rent, depreciation, insurance, power, and maintenance of factory premises.
• Administration Overheads: Salaries of office staff, office rent, and stationery.
• Selling and Distribution Overheads: Salesmen’s salaries, advertising, and delivery costs.

Why allocate overheads? Without allocation, product costs become inaccurate, leading to:

• Pricing errors (e.g., underpricing for Daraz orders, losing profit).
• Misleading financial statements (e.g., overstated profits due to under-absorption).
• Poor decision-making (e.g., dropping a product line that is actually profitable when overheads are considered).

2. Methods of Overhead Cost Allocation

Overhead costs are allocated using three primary methods, each suited to different business scenarios.

A. Direct Allocation (Primary Distribution)

• Definition: Overheads are directly charged to a specific department or cost center based on a physical relationship (e.g., a machine used only by one department).
• Example:
  • A garment factory in Kathmandu has a sewing machine used only by the cutting department. Its depreciation (Rs 50,000) is directly allocated to the cutting department.
  • No further distribution is needed.

B. Step Allocation (Secondary Distribution)

• Definition: Overheads are allocated sequentially to departments in a predefined order (e.g., service departments first, then production departments).
• Steps:
  1. Identify service departments (e.g., maintenance, canteen, security).
  2. Allocate their costs to production departments in a logical order (e.g., maintenance → production lines).
  3. Ignore inter-departmental services (e.g., if maintenance also serves the canteen, its cost is not reallocated).
• Example:
  • Nepal Pharmaceuticals has:
    • Service Departments: Maintenance (Rs 200,000), Canteen (Rs 100,000).
    • Production Departments: Tablets (Rs 500,000), Syrups (Rs 300,000).
  • Allocation:
    • Maintenance is allocated to Tablets (60%) and Syrups (40%) based on machine hours.
    • Canteen costs are allocated to Tablets (70%) and Syrups (30%) based on employee count.
    • No reciprocal allocation (canteen does not use maintenance services).

flowchart TD
    A["Service Departments\n(Maintenance, Canteen)"] -->|"Allocated first"| B["Production Departments\n(Tablets, Syrups)"]
    B --> C["Final Cost per Unit"]

C. Reciprocal Allocation (Simultaneous Distribution)

• Definition: Used when service departments provide services to each other (e.g., maintenance repairs the canteen’s equipment, and the canteen serves maintenance staff).
• Methods:
  1. Algebraic Method: Solve simultaneous equations.
  2. Matrix Method: Use inverse matrices (advanced).
• Example:
  • Kathmandu Hotel has:
    • Service Departments:
      • Housekeeping (Rs 150,000) → 40% used by Rooms, 60% by Laundry.
      • Laundry (Rs 100,000) → 30% used by Rooms, 70% by Housekeeping.
    • Production Department: Rooms (Rs 500,000).
  • Step 1: Let $x$ = Housekeeping cost allocated to Rooms, $y$ = Laundry cost allocated to Rooms.
  • Equations: $$x=150,000\times 0.4+y\times 0.3\text{(Housekeeping to Rooms)}$$ $$y=100,000\times 0.3+x\times 0.7\text{(Laundry to Rooms)}$$
  • Solution:
    • Solve the equations to find $x=78,000$ and $y=48,600$.
    • Total allocated to Rooms: Rs 500,000 (original) + Rs 78,000 (Housekeeping) + Rs 48,600 (Laundry) = Rs 626,600.

3. Bases for Overhead Allocation

The choice of allocation base significantly impacts cost accuracy. Common bases include:

Which base to choose?

• DLH is traditional but overstates labor-intensive products (e.g., handmade carpets).
• MH is better for automated industries (e.g., pharmaceuticals).
• Production units work well for standardized products (e.g., biscuits, bottles).

4. Overhead Absorption and Under/Over-Absorption

Overhead absorption refers to charging overheads to products using a predetermined overhead rate (POR).

A. Predetermined Overhead Rate (POR)

$$\text{POR}=\frac{\text{Total Estimated Overhead}}{\text{Allocation Base (e.g., DLH or MH)}}$$ Example:

• Kathmandu Retail Shop (selling electronics):
  • Estimated Overhead: Rs 500,000
  • Estimated DLH: 10,000 hours
  • POR: Rs 50/hour

B. Under-Absorption vs. Over-Absorption

Worked Example:

• Nepal Electronics (producing TVs):
  • Estimated Overhead: Rs 600,000
  • Actual Overhead: Rs 650,000
  • Allocation Base (DLH): 12,000 hours
  • POR: Rs 50/hour
  • Allocated Overhead: Rs 600,000 (12,000 × Rs 50)
  • Under-Absorption: Rs 50,000 (Rs 650,000 - Rs 600,000)

Adjustment Entry:

Dr. Cost of Goods Sold (COGS)       Rs 50,000
    Cr. Manufacturing Overhead      Rs 50,000

Impact on Income Statement:

• Before Adjustment: COGS = Rs 800,000 → Profit = Rs 200,000
• After Adjustment: COGS = Rs 850,000 → Profit = Rs 150,000

5. Practical Applications in Nepali Businesses

A. Nepal Pharmaceuticals (Medicine Manufacturing)

• Problem: Overhead costs include rent for large warehouses, depreciation of mixing machines, and electricity for production.
• Solution:
  • Allocate rent based on floor area (e.g., Tablets department occupies 60% of space).
  • Allocate machine depreciation based on machine hours (e.g., Tablet machines run 80% of the time).
  • Result: Accurate pricing for Daraz orders and government tenders.

B. Kathmandu Hotel (Service Industry)

• Problem: Overheads include housekeeping salaries, laundry costs, and maintenance.
• Solution:
  • Use reciprocal allocation for inter-departmental services (e.g., laundry uses housekeeping’s cleaning services).
  • Allocate room service costs based on number of rooms (e.g., single vs. double rooms).

C. Himal Biscuit Factory (Food Manufacturing)

• Problem: Overheads include flour storage costs, oven electricity, and packaging labor.
• Solution:
  • Allocate electricity based on machine hours (ovens run 24/7).
  • Allocate packaging labor based on number of biscuit packs produced.

In the Real World

1. Nepal Pharmaceuticals (Nepal’s largest medicine manufacturer)

   • Idea Used: Machine Hours Allocation
   • How: Depreciation of tablet compression machines is allocated based on hours each machine operates. This ensures that high-volume drugs (e.g., paracetamol) bear a proportionate share of overheads, while low-volume specialty drugs are not overcosted. This directly impacts pricing for NEPSE-listed products and government tenders.

2. Daraz Nepal (E-commerce Platform)

   • Idea Used: Overhead Absorption in Fulfillment Centers
   • How: Daraz’s warehouse overheads (rent, salaries, logistics) are absorbed into product costs based on order volume per product category. If Daraz under-absorbs overheads (e.g., due to unexpected demand spikes), it may lose money on certain orders until adjusted in financial statements. This affects seller pricing strategies and discount offers.

3. NTC (Nepal Telecom)

   • Idea Used: Step Allocation for Network Maintenance
   • How: NTC’s maintenance department costs (e.g., engineers’ salaries, spare parts) are first allocated to regional offices (e.g., Kathmandu, Pokhara) based on number of towers. Then, costs are further allocated to service departments (e.g., customer support, billing) based on call volume. This ensures accurate costing of network expansion projects and tariff pricing.

6. Worked Numerical Example: Kathmandu Retail Shop

Scenario: Kathmandu Retail Shop sells electronics (TVs, refrigerators, mobiles). The shop has two departments:

1. Sales Department (retail counter)
2. Service Department (repair and maintenance)

Given Data:

Additional Info:

• The Service Department provides repair services to the Sales Department worth 20% of its total overhead.
• Sales Department sells 1,000 TVs/month at Rs 20,000 each.
• Direct Cost per TV: Rs 15,000 (purchase cost).

Steps:

1. Allocate Rent, Salaries, Electricity, and Depreciation to Sales and Service Departments.
2. Adjust for inter-departmental services (Service Dept. → Sales Dept.).
3. Calculate overhead absorption rate for Sales Dept.
4. Determine final cost per TV and profit per TV.

Solution:

Step 1: Primary Allocation

Step 2: Reciprocal Allocation (Service Dept. to Sales Dept.)

• Service Dept. provides 20% of its overhead to Sales Dept.
• Amount: 20% of Rs 126,000 = Rs 25,200
• Adjusted Overheads:
  • Sales Dept.: Rs 214,000 + Rs 25,200 = Rs 239,200
  • Service Dept.: Rs 126,000 - Rs 25,200 = Rs 100,800

Step 3: Overhead Absorption Rate (Sales Dept.)

• Allocation Base: Number of TVs sold (1,000 units)
• POR: Rs 239,200 / 1,000 TVs = Rs 239.20 per TV

Step 4: Final Cost and Profit per TV

Conclusion:

• The shop makes a profit of Rs 4,760.80 per TV.
• If overheads were under-absorbed, the profit would appear higher than actual.

Exam Tip

1. Understand the Difference:

   • Allocation = Physical relationship (e.g., machine in one department).
   • Apportionment = Logical distribution (e.g., rent based on floor area).
   • Reciprocal allocation = Used when departments serve each other (solve equations!).

2. Common Exam Questions:

   • Calculate POR and under/over-absorption.
   • Allocate overheads using step or reciprocal methods.
   • Adjust financial statements for under/over-absorption.

3. Tips for Full Marks:

   • Show all steps in allocation (e.g., primary → secondary).
   • Label tables clearly (Dr/Cr, departments, allocation bases).
   • Explain adjustments for under/over-absorption in words (not just journal entries).
   • Use real-world examples (e.g., "Like Nepal Pharmaceuticals, this company would...").

4. Avoid Mistakes:

   • Don’t ignore inter-departmental services (use reciprocal allocation if needed).
   • Double-check calculations (especially in reciprocal allocation).
   • Match allocation bases to the question (e.g., if asked for DLH, don’t use machine hours).

Summary Table: Allocation Methods

Final Checklist Before Exam

• Can you define overhead allocation vs. apportionment?
• Can you calculate POR and identify under/over-absorption?
• Can you solve reciprocal allocation problems (algebraically)?
• Can you explain real-world applications (e.g., Nepal Pharmaceuticals, Daraz)?
• Can you adjust financial statements for under/over-absorption?