Overheads: Allocation, Apportionment & Absorption

Learning objectives

By the end of this chapter, you should be able to:

• Explain why overhead allocation, apportionment, and absorption are used in product costing and how they influence inventory valuation and reported profit.
• Distinguish between production cost centres and service cost centres, and select appropriate bases for apportionment and absorption.
• Re-apportion service department costs to production departments using the direct method, step-down method, and reciprocal method.
• Calculate predetermined overhead absorption rates (OARs) and apply them to absorb overheads into units, batches, or jobs.
• Identify under- and over-absorption of overheads, explain why they arise, and outline appropriate accounting treatments.

Overview & key concepts

Many costs support production without being traceable to a single unit of output. These overheads (indirect costs) must still be included in product costs to support pricing, performance measurement, and inventory valuation.

Overheads influence:

• Inventory values(work in progress and finished goods) through the overhead element of production cost.
• Cost of saleswhen goods are sold.
• Reported profit, particularly when overhead absorbed into production differs from overhead actually incurred.

Overheads are often described by behaviour within a normal operating range:

• Fixed overheads: total cost is broadly stable over a relevant range (e.g. factory rent).
• Variable overheads: total cost changes with activity (e.g. indirect materials tied to output).
• Mixed overheads: contain both fixed and variable elements.

The relevant range is the activity band within which these assumptions remain reasonable. Outside that range, cost behaviour may change and absorption rates may become unreliable.

Identifying and classifying overheads

What counts as an overhead?

An overhead is a cost of running production (or supporting production) that cannot be traced to a single unit without disproportionate effort. Examples include:

• Factory rent and rates
• Factory utilities
• Factory supervision and indirect labour
• Maintenance department costs
• Depreciation of factory machinery
• Factory insurance and safety costs

To organise overheads for costing, businesses typically use:

• Cost centres: locations or functions where costs are collected (e.g. Assembly, Finishing, Maintenance).
• Cost pools: groups of overheads with a similar driver (e.g. occupancy costs, machine-related costs).

A key distinction is:

• Production cost centres: directly involved in manufacturing.
• Service cost centres: provide support to production.

Allocation, apportionment, and absorption

Allocation

Allocation is used when an overhead item belongs entirely to one cost centre.

Examples:

• The salary of the Assembly supervisor is allocated to Assembly.
• Depreciation of a machine used only in Finishing is allocated to Finishing.

Apportionment

Apportionment is used when an overhead is shared by more than one cost centre and must be split using a rational basis.

Common bases include:

• Rent, heating, lighting:floor area
• Machine power and machine servicing:machine hours
• Canteen and welfare costs:headcount
• Stores costs:material issuesorrequisition counts

The best base reflects why the cost is incurred, not simply what is convenient to measure.

Re-apportionment of service department costs

Service departments exist to support production, so their costs must be transferred to production departments before product costs are calculated.

Three methods are commonly used:

• Direct method: simplest; transfers service costs only to production departments and ignores service provided between service departments.
• Step-down (sequential) method: a compromise; transfers service costs in a chosen sequence, recognising some service-to-service support.
• Reciprocal method: most realistic; fully recognises mutual services between service departments (often via simultaneous equations).

The method chosen affects the overhead cost carried by each production department and therefore affects product costs.

Absorption of overheads

Absorption charges production overheads to output using a predetermined overhead absorption rate (OAR).

OAR (set in advance) = Budgeted production overhead ÷ Budgeted activity

Once set, overhead is absorbed using actual activity:

Overhead absorbed = Actual activity × OAR

OARs are often set departmentally (for example, one rate for Assembly and another for Finishing), because departments may have different cost structures and different activity drivers. A single “blanket” rate is used when production is relatively uniform.

Inventory valuation note (production overheads only)

Inventory values include production costs only. This means:

• Onlyproduction overheadsare absorbed into inventory (for example, factory rent, factory supervision, maintenance support).
• Selling, distribution, and general administration costsare treated as period costs and are not included in inventory.
• Fixed production overhead is allocated using a level of activity that reflectsnormal capacity. If output is unusually low, any fixed overhead not allocated to production is expensed in the period.
• Variable production overhead is allocated usingactual activity, as variable costs arise with actual production.

Under- and over-absorption of overheads

Because an OAR is based on budgets, absorbed overhead will rarely equal actual overhead incurred.

• Under-absorption: absorbed overhead < actual overhead incurred.
• Over-absorption: absorbed overhead > actual overhead incurred.

Common reasons include:

• Volume differences: actual activity differs from budgeted (often the main cause).
• Spending differences: actual overhead differs from budgeted.
• Outdated planning assumptions: rates are not updated as processes or capacity change.

Accounting treatment (high level)

If the variance is immaterial, it is commonly transferred to cost of sales, affecting profit for the period.

If the variance is material, it is more appropriate to share it across work in progress, finished goods, and cost of sales, so that inventory values and profit are not distorted.

Core theory and frameworks

Choosing bases: practical decision rules

When selecting bases for apportionment and absorption:

1. Choose a driver that has a clear link to the cost being incurred.
2. Use data that can be measured consistently and at reasonable cost.
3. Avoid drivers that create perverse incentives or hide inefficiencies.
4. Review bases and rates when capacity, technology, or product mix changes.

Control-account logic (typical double-entry)

Many systems track overheads using a production overhead control account:

Record actual overhead incurred:

• Dr Production overhead control
• Cr Cash / Payables / Accruals

Absorb overhead into production:

• Dr Work in progress (or production)
• Cr Production overhead control

Dispose of under-/over-absorption at period end:

• Transfer to cost of sales (if immaterial), or
• Apportion across inventories and cost of sales (if material).

Worked example

Narrative scenario (revised and reconciled)

ABC Manufacturing makes standard widgets in two production departments—Assembly and Finishing—and one service department—Maintenance.

For the year, the following information applies.

Actual overheads incurred (total = $100,000)

• Factory rent:$40,000(shared; apportion by floor area)
• Utilities (machine-related):$10,000(shared; apportion by machine hours)
• Maintenance department costs:$20,000(direct to Maintenance; then re-apportion to production)
• Other production overheads (e.g. indirect labour, factory insurance):$30,000(allocate directly to production as: Assembly$18,000, Finishing$12,000)

Activity data

• Budgeted machine hours(used to set the OAR):
  • Assembly7,500, Finishing5,000(total12,500)
• Actual machine hours(incurred during the year; used to absorb):
  • Assembly5,000, Finishing3,000(total8,000)

Floor area

• Assembly4,000 m²
• Finishing3,000 m²
• Maintenance1,000 m²

Overhead absorption rate (based on budget)

OAR = Budgeted production overhead ÷ Budgeted machine hours
OAR = $100,000 ÷ 12,500 hours = $8 per machine hour

Required

1. Apportion rent and utilities to the cost centres.
2. Re-apportion Maintenance using the direct method (based on production machine hours).
3. Calculate the overhead absorbed using the OAR.
4. Determine under- or over-absorption.
5. Explain the impact on inventory valuation and profit.

Solution

1) Primary distribution: apportion rent and utilities (and allocate other overheads)

(a) Rent ($40,000) apportioned by floor area

Total area = 4,000 + 3,000 + 1,000 = 8,000 m²

• Assembly: 40,000 × 4,000/8,000 =20,000
• Finishing: 40,000 × 3,000/8,000 =15,000
• Maintenance: 40,000 × 1,000/8,000 =5,000

(b) Utilities ($10,000) apportioned by machine hours (production hours)

Total production machine hours = 5,000 + 3,000 = 8,000

• Assembly: 10,000 × 5,000/8,000 =6,250
• Finishing: 10,000 × 3,000/8,000 =3,750
• Maintenance:0(assumed not to operate production machinery)

(c) Other production overheads ($30,000) allocated directly

• Assembly:18,000
• Finishing:12,000
• Maintenance:0

Totals after primary distribution

• Assembly: Rent 20,000 + Utilities 6,250 + Other 18,000 =44,250
• Finishing: Rent 15,000 + Utilities 3,750 + Other 12,000 =30,750
• Maintenance: Rent 5,000 + Maintenance costs 20,000 =25,000

Check: 44,250 + 30,750 + 25,000 = 100,000 (reconciles to actual overhead incurred)

2) Secondary distribution: re-apportion Maintenance (direct method)

Maintenance total to re-apportion = 25,000

Basis: production machine hours (Assembly 5,000; Finishing 3,000)

• Assembly: 25,000 × 5,000/8,000 =15,625
• Finishing: 25,000 × 3,000/8,000 =9,375

Total overheads carried by production departments after re-apportionment

• Assembly: 44,250 + 15,625 =59,875
• Finishing: 30,750 + 9,375 =40,125

(These departmental totals explain the build-up, but absorption into output uses the predetermined OAR.)

3) Overhead absorbed using the OAR

OAR = $8 per machine hour (set using budgeted hours)

Absorption uses actual machine hours:

• Assembly: 5,000 × 8 =40,000
• Finishing: 3,000 × 8 =24,000

Total overhead absorbed = 40,000 + 24,000 = 64,000

4) Under- or over-absorption

Actual production overhead incurred = 100,000
Overhead absorbed = 64,000

Under-absorption = 100,000 − 64,000 = 36,000 under-absorbed

Interpretation: The shortfall is mainly a volume effect: the OAR is set using budgeted hours (12,500), but absorption is based on actual hours (8,000). With fewer hours worked than planned, less overhead is absorbed.

5) Impact on inventory valuation and profit

• Product costs during the year include absorbed overhead at$8 per machine hour.
• Because overhead isunder-absorbed by $36,000, profit would be overstated unless an adjustment is made.

High-level treatment:

• Ifimmaterial: charge the $36,000 tocost of sales, reducing profit.
• Ifmaterial: apportion the $36,000 betweenwork in progress, finished goods, and cost of sales, so that inventory values are not understated and cost of sales is not overstated (or vice versa).

Common pitfalls and misunderstandings

• Confusingbudgetandactualdata: budget sets the OAR; actual activity absorbs; actual overhead is compared to absorbed.
• Using weak apportionment bases (chosen for ease rather than relevance).
• Re-apportioning only the service department’s “own” costs and forgetting its share of shared overheads (such as rent).
• Applying one blanket OAR where departmental rates would better reflect different production drivers.
• Treating under-/over-absorption as “error” rather than an expected outcome of budgeting.
• Disposing of significant variances to cost of sales without considering the impact on inventory valuation.

Summary and further reading

Overheads are indirect production costs that must be assigned to products for meaningful costing and appropriate inventory valuation. The standard costing sequence is:

1. Allocateoverheads that belong wholly to one cost centre.
2. Apportionshared overheads, thenre-apportionservice department totals to production departments.
3. Absorbproduction overheads into output using a predetermined rate based on budgeted overhead and budgeted activity.

Under- or over-absorption arises because actual overhead and actual activity rarely match budget. The resulting variance must be adjusted in a way that avoids material misstatement of profit and inventory.

FAQ

What is the difference between allocation and apportionment of overheads?

Allocation charges an overhead item entirely to one cost centre because it clearly belongs there. Apportionment shares a joint overhead across cost centres using a basis that reasonably reflects usage (such as space, hours, or headcount).

How do you choose an appropriate base for apportioning overheads?

Select a base that best explains why the cost is incurred. Rent is commonly linked to floor area, while machine-related costs are commonly linked to machine hours. The chosen base should be measurable, consistent, and sensible.

What are the main methods for re-apportioning service department costs?

• Direct method: simplest; ignores service-to-service support.
• Step-down method: more realistic; recognises some service-to-service support in a chosen order.
• Reciprocal method: most realistic; fully recognises mutual services between service departments.

How is an overhead absorption rate (OAR) calculated and used?

The OAR is set using budgets: budgeted production overhead ÷ budgeted activity. Overhead is then absorbed using actual activity (for example, actual machine hours × OAR).

What causes under- and over-absorption?

Most commonly, actual activity differs from budgeted activity (volume), actual overhead spending differs from budget (spending), or the budget assumptions are outdated.

How should under- and over-absorption be treated?

If immaterial, transfer the variance to cost of sales. If material, share it across work in progress, finished goods, and cost of sales to avoid distorting inventory values and profit.

Summary (Recap)

This chapter covered overhead allocation, apportionment, re-apportionment, and absorption. Overheads are first gathered in cost centres, shared costs are split using rational drivers, service department costs are passed on to production departments, and production overhead is absorbed into output using a predetermined rate based on budgets. Under- or over-absorption is then calculated by comparing absorbed overhead with actual overhead incurred and is adjusted to avoid misstating profit and inventory.

Glossary

Overheads
Costs of running the production function that can’t be linked to one unit without disproportionate effort (e.g. factory rent, supervision, maintenance support).

Cost centre
A department, location, or function used to collect costs so that overheads can be analysed and assigned to products.

Allocation
Charging an overhead item entirely to one cost centre because it clearly belongs there.

Apportionment
Sharing a joint overhead across cost centres using a basis that reasonably reflects usage (space, hours, headcount, requisitions, etc.).

Service cost centre
A support department that provides services to production departments (for example, Maintenance).

Re-apportionment
Transferring service department total costs to production departments so that full production overhead can be absorbed into output.

Overhead absorption rate (OAR)
A pre-set charging rate used to apply production overhead to output, calculated from budgeted overhead and a budgeted activity measure.

Under-absorption
When the overhead charged to production using the OAR is less than the overhead actually incurred.

Over-absorption
When the overhead charged to production using the OAR is greater than the overhead actually incurred.

Relevant range
The normal activity band within which cost behaviour assumptions and the chosen absorption base are expected to remain valid.

Mixed costs
Costs containing both fixed and variable elements, requiring analysis if more accurate behaviour information is needed.