Overhead Allocation & Absorption: Methods, Bases & Cycle

TAKEAWAYS:

• Overheads are indirect costs (e.g., rent, depreciation, utilities) that cannot be directly traced to a product; they must be allocated using logical bases (e.g., labor hours, machine hours, area).
• Absorption costing includes all manufacturing costs (direct + allocated overheads) in inventory valuation, while marginal costing excludes overheads—this affects profit reporting and tax liabilities.
• The accounting cycle for overheads involves preparation of overhead budgets, actual overhead tracking, allocation to cost centers, and absorption into work-in-progress (WIP) and finished goods.
• Primary vs. secondary allocation: Primary allocation assigns overheads to cost centers (e.g., production, administration), while secondary allocation redistributes service department costs (e.g., canteen, HR) to production departments.
• Under/over-absorbed overheads arise when allocated overheads ≠ actual overheads; these are adjusted via prorating, write-off, or adjusting inventory values.
• Real-world tie: Daraz uses machine-hour rates to allocate warehouse overheads to different product categories, while Ncell absorbs network maintenance costs into monthly tariffs via absorption costing.

1. What Are Overheads?

Overheads are indirect costs incurred for running a business that cannot be directly attributed to a specific product or service. They include:

• Production overheads: Rent, depreciation of machinery, factory utilities, supervision salaries.
• Administration overheads: Office rent, CEO salary, legal fees.
• Selling & distribution overheads: Advertising, delivery costs, sales team commissions.
• Finance overheads: Interest on loans, bank charges.

Why allocate overheads? Without allocation, products/services appear under-costed (cheaper than they should be), leading to:

• Pricing errors (selling at a loss).
• Misleading profit reports (overstated or understated).
• Poor decision-making (e.g., dropping a profitable product).

2. Methods of Overhead Allocation

Overheads are allocated using bases that logically connect them to products/services. Common methods:

WORKED EXAMPLE: Allocating Overheads for a Kathmandu Retail Shop (Kathmandu Mart) Scenario: Kathmandu Mart has two departments: Electronics and Clothing. Overheads for the month are:

• Rent: NPR 500,000 (allocated based on floor area).
• Salaries (supervisors): NPR 300,000 (allocated based on labor hours).
• Utilities: NPR 200,000 (allocated based on machine hours).

Data:

Calculations:

1. Rent Allocation:

   • Electronics: $\frac{1000}{2500}\times 500,000=\text{NPR }200,000$
   • Clothing: $\frac{1500}{2500}\times 500,000=\text{NPR }300,000$

2. Supervisor Salaries:

   • Electronics: $\frac{4000}{10000}\times 300,000=\text{NPR }120,000$
   • Clothing: $\frac{6000}{10000}\times 300,000=\text{NPR }180,000$

3. Utilities:

   • Electronics: $\frac{8000}{10000}\times 200,000=\text{NPR }160,000$
   • Clothing: $\frac{2000}{10000}\times 200,000=\text{NPR }40,000$

Total Allocated Overheads:

3. Primary vs. Secondary Allocation

Primary Allocation

Directly assigns overheads to cost centers (e.g., production, administration, selling). Example:

• Production Department: Allocate rent, depreciation, supervision.
• Administration Department: Allocate office rent, CEO salary.
• Selling Department: Allocate advertising, sales team salaries.

flowchart TD
    A["Total Overheads"] --> B["Primary Allocation"]
    B --> C["Production Dept"]
    B --> D["Administration Dept"]
    B --> E["Selling Dept"]
    C --> F["Machine Hours Basis"]
    D --> G["Area Basis"]
    E --> H["Sales Value Basis"]

Secondary Allocation (Service Department Charges)

Service departments (e.g., canteen, HR, maintenance) provide support to production departments. Their costs must be reallocated using methods like:

1. Direct Method: Ignore inter-departmental services; allocate only to production.
2. Step Method: Allocate services sequentially (e.g., HR → Production, then Maintenance → Production).
3. Reciprocal Method: Account for mutual services (most accurate but complex).

Example: Secondary Allocation for Kathmandu Mart Assume:

• Canteen (service dept) costs: NPR 50,000 (allocated based on employees).
• Maintenance (service dept) costs: NPR 30,000 (allocated based on machine hours).

Data:

Step 1: Allocate Canteen Costs

• Electronics: $\frac{10}{30}\times 50,000=\text{NPR }16,667$
• Clothing: $\frac{15}{30}\times 50,000=\text{NPR }25,000$
• Maintenance: $\frac{3}{30}\times 50,000=\text{NPR }5,000$ (ignored in direct method)

Step 2: Allocate Maintenance Costs (using step method)

• Electronics: $\frac{8000}{10000}\times 30,000=\text{NPR }24,000$
• Clothing: $\frac{2000}{10000}\times 30,000=\text{NPR }6,000$

Final Overheads After Secondary Allocation:

4. Overhead Absorption

Overhead absorption is the process of charging overheads to products using a predetermined overhead rate (POR). This ensures:

• Accurate inventory valuation.
• Proper profit calculation.

Steps to Absorb Overheads:

1. Estimate Total Overheads: Budgeted for the period.
2. Choose an Absorption Base: Usually direct labor hours or machine hours.
3. Calculate Predetermined Overhead Rate (POR): $$\text{POR}=\frac{\text{Budgeted Overheads}}{\text{Budgeted Base (e.g., labor hours)}}$$
4. Apply POR to Products: Multiply POR by actual base used per product.

Example: POR for Kathmandu Mart

• Budgeted Overheads: NPR 1,200,000
• Budgeted Labor Hours: 12,000
• POR: $\frac{1,200,000}{12,000}=\text{NPR }100\text{ per labor hour}$

Absorption for a Product:

• If a product uses 500 labor hours, absorbed overhead = $500\times 100=\text{NPR }50,000$.

5. Under/Over-Absorbed Overheads

When actual overheads ≠ absorbed overheads, discrepancies arise:

• Under-absorbed: Absorbed < Actual (overheads too low).
• Over-absorbed: Absorbed > Actual (overheads too high).

Causes:

• Poor budgeting (estimated overheads too low/high).
• Efficiency changes (e.g., less machine downtime).
• Volume variations (more/less production than expected).

Adjustment Methods:

1. Prorate to Cost of Goods Sold (COGS), WIP, Finished Goods:
   • Distribute the difference proportionally.
2. Write-off to Profit & Loss (P&L):
   • Adjust net profit directly.
3. Adjust Inventory Values:
   • Increase/decrease WIP or finished goods inventory.

Example: Adjustment for Kathmandu Mart

• Budgeted Overheads: NPR 1,200,000
• Actual Overheads: NPR 1,300,000
• Under-absorbed: NPR 100,000

Proration to COGS, WIP, Finished Goods: Assume:

• COGS: NPR 5,000,000
• WIP: NPR 1,000,000
• Finished Goods: NPR 2,000,000
• Total: NPR 8,000,000

Adjustment:

• COGS: $\frac{5,000,000}{8,000,000}\times 100,000=\text{NPR }62,500$
• WIP: $\frac{1,000,000}{8,000,000}\times 100,000=\text{NPR }12,500$
• Finished Goods: $\frac{2,000,000}{8,000,000}\times 100,000=\text{NPR }25,000$

Final Adjustment:

6. Overhead Absorption in Financial Statements

Under absorption costing (used in Nepal’s financial reporting), overheads are included in inventory valuation and expensed only when goods are sold. This affects:

• Balance Sheet: Higher inventory values (if overheads are absorbed).
• Income Statement: COGS includes absorbed overheads, impacting gross profit.

Example: Impact on Profit

In the Real World

1. Daraz (Nepal’s Amazon)

   • Idea Used: Machine-hour rate for warehouse overheads.
   • How: Daraz allocates warehouse rent, electricity, and staff salaries based on machine hours used to sort and pack orders. Products requiring more sorting (e.g., electronics) absorb higher overheads, justifying premium pricing.

2. Ncell (Nepal Telecom)

   • Idea Used: Absorption costing for network maintenance.
   • How: Ncell’s monthly tariffs include absorbed overheads (e.g., tower maintenance, software updates). If actual maintenance costs exceed absorbed amounts, the difference is prorated across all subscribers via tariff adjustments.

3. Khalti (Digital Payment App)

   • Idea Used: Secondary allocation for IT and customer support.
   • How: Khalti allocates IT infrastructure costs (servers, cybersecurity) to different services (e.g., P2P transfers, bill payments) using transaction volume. Customer support costs are redistributed to high-usage services (e.g., merchant onboarding).

7. Overhead Absorption vs. Marginal Costing

Why Nepal Uses Absorption Costing:

• Tax laws require overheads to be capitalized in inventory.
• Bank loans often require absorption-based financial statements.

Exam Tip

1. Memorize the Formula for Predetermined Overhead Rate (POR): $$\text{POR}=\frac{\text{Budgeted Overheads}}{\text{Budgeted Base}}$$ Always show calculations in exams—never assume marks for correct answers without workings.

2. Practice Allocation Bases:

   • Exams often ask to allocate overheads using different bases (e.g., labor hours vs. machine hours). Compare results to see which is more logical.

3. Under/Over-Absorption Adjustments:

   • Proration is the safest method in exams. If asked to adjust, show the distribution ratio clearly.
   • Example question:

     "A factory has under-absorbed overheads of NPR 50,000. COGS is NPR 2,000,000, WIP is NPR 500,000, and Finished Goods is NPR 1,000,000. Adjust using proration."

4. Real-World Scenarios:

   • Expect questions like:

     "Ncell’s actual overheads for network maintenance exceeded absorbed overheads by NPR 20 million. How would you adjust this in the financial statements?"

   • Answer structure:
     1. Identify under/over-absorption.
     2. Choose an adjustment method (proration/write-off).
     3. Show calculations with clear ratios.

5. Diagrams in Exams:

   • Draw a simple flowchart of the overhead allocation process if asked to explain steps.
   • Example:

     flowchart TD
         A["Estimate Overheads"] --> B["Choose Base"]
         B --> C["Calculate POR"]
         C --> D["Apply to Products"]
         D --> E["Adjust for Under/Over-Absorption"]

6. Common Pitfalls:

   • Ignoring service departments: Always allocate secondary overheads unless specified otherwise.
   • Mismatched bases: Ensure the allocation base logically links to the overhead (e.g., don’t allocate rent based on labor hours).
   • Forgetting to reconcile totals: In tables, ensure allocated overheads = actual overheads (before adjustments).