Overhead Allocation & Absorption: Methods, Bases & Cycle

What Are Overheads?

Overheads (or indirect costs) are expenses that cannot be directly traced to a specific product or service. They include:

• Production overheads: Rent, depreciation, factory lighting, insurance.
• Administration overheads: Office salaries, rent, utilities.
• Selling & distribution overheads: Advertising, sales commissions, delivery costs.

Why allocate overheads? Without allocation, product costs are understated, leading to incorrect pricing, profit margins, and financial decisions.

IMAGE: factory overhead cost breakdown | Types of overheads in a Kathmandu garment factory

Methods of Overhead Allocation

1. Direct Allocation (Primary Distribution)

Overheads are allocated directly to cost centers (departments) based on physical or monetary links. Example: Rent is allocated to departments based on floor area.

2. Stepwise Allocation (Secondary Distribution)

Overheads are allocated in stages (e.g., service departments → production departments → products). Example: A factory’s maintenance department (service center) allocates its costs to cutting and sewing departments before reaching the final product.

3. Reciprocal Allocation (Simultaneous Equation Method)

Used when service departments (e.g., canteen, maintenance) mutually use each other’s services. Example: The canteen uses the maintenance department’s repair services, and maintenance uses the canteen for meals.

IMAGE: overhead allocation flowchart | Stepwise vs. reciprocal allocation in a Daraz warehouse

flowchart TD
    A["Total Overheads\n(Rent, Salaries, etc.)"] --> B["Direct Allocation\nto Departments"]
    B --> C["Cutting Dept."]
    B --> D["Sewing Dept."]
    D --> E["Reciprocal Allocation\n(Canteen ↔ Maintenance)"]
    E --> F["Final Cost per Unit"]
    C --> F

Bases for Overhead Absorption

Overheads are absorbed into production costs using absorption rates. Common bases:

In the Real World

1. Daraz (Nepal’s Amazon)

   • Overhead Allocation: Warehouse rent, security, and packaging costs are allocated to each product category (electronics, groceries) based on storage space used.
   • Absorption Basis: Overheads are absorbed into product costs using units sold per category.

2. Ncell (Telecom)

   • Overhead Allocation: Marketing (TV ads, billboards) and network maintenance costs are allocated to prepaid vs. postpaid services based on customer base size.
   • Absorption Basis: Overheads are absorbed per SIM card or data usage.

3. Khalti (Digital Payment)

   • Overhead Allocation: IT infrastructure (servers, cybersecurity) and customer support costs are allocated to merchant vs. user transactions.
   • Absorption Basis: Overheads are absorbed per transaction fee charged.

Worked Example: Overhead Allocation in a Kathmandu Retail Shop

Business: Thapa’s General Store (sells groceries, stationery, and electronics). Data for January 2024:

• Total Overheads: ₹500,000
  • Rent: ₹150,000
  • Salaries (staff): ₹200,000
  • Utilities (electricity, water): ₹50,000
  • Depreciation (shelves, cash register): ₹50,000
  • Advertising: ₹50,000
• Bases for Allocation:
  • Rent: Allocated based on floor area (Groceries: 60%, Stationery: 30%, Electronics: 10%).
  • Salaries: Allocated based on number of staff (Groceries: 50%, Stationery: 30%, Electronics: 20%).
  • Utilities: Allocated based on electricity usage (Groceries: 40%, Stationery: 35%, Electronics: 25%).
  • Depreciation: Allocated based on value of assets used (Groceries: 50%, Stationery: 30%, Electronics: 20%).
  • Advertising: Allocated based on sales revenue (Groceries: 60%, Stationery: 25%, Electronics: 15%).

Step 1: Allocate Overheads to Departments

Step 2: Absorb Overheads into Products Assume:

• Groceries: 10,000 units sold (e.g., rice, sugar).
• Stationery: 5,000 units sold (e.g., notebooks, pens).
• Electronics: 2,000 units sold (e.g., batteries, chargers).

Absorption Rate per Unit:

• Groceries: ₹265,000 / 10,000 = ₹26.50 per unit
• Stationery: ₹140,000 / 5,000 = ₹28 per unit
• Electronics: ₹85,000 / 2,000 = ₹42.50 per unit

Final Cost per Unit (including overheads):

Overhead Absorption vs. Under/Over-Absorption

Example (Under-Absorption):

• Actual Overheads: ₹500,000
• Absorbed Overheads: ₹450,000
• Under-Absorption: ₹50,000
• Adjustment:

  Dr. Overhead Control A/c       50,000
      Cr. Costing P&L A/c        50,000
  

IMAGE: t-account for overhead absorption adjustment | Under-absorption correction entry

  Overhead Control A/c
  Dr. (₹50,000) | Cr.

  Costing P&L A/c
  Dr.           | Cr. (₹50,000)

The Accounting Cycle for Overheads

flowchart TD
    A["1. Identify Overheads\n(Rent, Salaries, etc.)"] --> B["2. Allocate to Cost Centers\n(Direct/Stepwise/Reciprocal)"]
    B --> C["3. Absorb into Production\n(Using Basis: Labour, Machine Hrs, etc.)"]
    C --> D["4. Close Overhead A/c to WIP\n(Work in Progress)"]
    D --> E["5. Transfer to Finished Goods\n(When Production Completes)"]
    E --> F["6. Adjust for Under/Over-Absorption\n(At Year-End)"]
    F --> G["7. Final Accounts\n(Profit & Loss, Balance Sheet)"]

Advantages and Disadvantages of Overhead Allocation

✅ Advantages

• Accurate Pricing: Helps set competitive prices (e.g., Daraz adjusts prices based on warehouse costs).
• Better Decision-Making: Managers can identify cost-saving areas (e.g., Ncell reduces underused network maintenance).
• Compliance: Required for tax filings (NEB, NRA) and financial reporting (Nepal Stock Exchange).
• Inventory Valuation: Ensures GAAP compliance (overheads are part of product cost).

❌ Disadvantages

• Complexity: Requires detailed record-keeping (small businesses may struggle).
• Arbitrary Bases: Some allocation methods (e.g., machine hours) may not perfectly reflect usage.
• Subjectivity: Reciprocal allocation involves complex calculations (simultaneous equations).
• Overhead of Overheads: The process itself can be costly for small enterprises.

Exam Tip

1. Memorize Key Formulas:

   • Overhead Absorption Rate = Total Overheads / Base (Labour Hrs, Machine Hrs, etc.)
   • Under/Over-Absorption = Actual Overheads – Absorbed Overheads

2. Practical Questions:

   • Expect worked examples (like Thapa’s General Store above).
   • Compare allocation methods (direct vs. reciprocal) in exam questions.

3. Real-World Links:

   • Relate Daraz’s warehouse costs to overhead allocation.
   • Explain how Ncell’s marketing costs are absorbed into prepaid/postpaid plans.

4. Common Mistakes to Avoid:

   • Ignoring service departments in reciprocal allocation.
   • Mismatching bases (e.g., using labour hours for a machine-heavy industry).
   • Forgetting year-end adjustments for under/over-absorption.

5. Diagrams in Exams:

   • Draw t-accounts for overhead adjustments.
   • Sketch flowcharts of the accounting cycle (like the Mermaid diagram above).

Final Checklist for Full Marks

✔ Define overheads and classify them (production, admin, selling). ✔ Explain 3 allocation methods (direct, stepwise, reciprocal) with examples. ✔ Calculate absorption rates using different bases (labour, machine hours, etc.). ✔ Show worked examples (like Thapa’s General Store) with tables and t-accounts. ✔ Discuss under/over-absorption and adjustment entries. ✔ Link to real-world Nepali businesses (Daraz, Ncell, Khalti). ✔ Highlight exam tips (formulas, common errors, diagram expectations).