Overheads - Allocation, Apportionment, and Absorption

Learning objectives

• Explain how indirect production costs are assigned to cost centres through allocation and apportionment, using suitable bases.
• Reapportion service cost centre costs to production cost centres using appropriate methods.
• Calculate predetermined overhead absorption rates (OARs) and apply them to cost units using a consistent activity measure.
• Identify under- and over-absorption of overheads and explain practical treatments.
• Evaluate how overhead assignment influences product cost, inventory valuation, and performance reporting.

Overview & key concepts

In many organisations, indirect costs are substantial. These costs support production and operations but cannot be traced economically to a single unit of output. Examples include factory rent, utilities, maintenance, and production supervision.

To produce meaningful product costs, overheads are built up in three stages:

• Stage 1: Primary distribution— allocate or apportion overheads to cost centres (production and service centres).
• Stage 2: Secondary distribution (reapportionment)— transfer service centre costs to production centres.
• Stage 3: Absorption— charge production overheads to cost units using predetermined absorption rates.

Allocation and apportionment organise overheads by department (cost centre accounting). Absorption applies production overheads to products or jobs (product costing).

Where absorption costing is used for inventory valuation, these stages affect the split between inventory (asset) and cost of sales (expense) as output is produced and sold.

Overheads and cost centres

Overheads

Overheads are indirect costs incurred to run a function, department, or facility, where tracing to individual units is not cost-effective. This chapter focuses on production overheads, which form part of the cost of manufacturing.

Cost centres

A cost centre is a location, function, or department for which costs are collected and analysed. Common types are:

• Production cost centres: departments where products are worked on (e.g., machining, assembly).
• Service cost centres: support areas that assist production (e.g., maintenance, stores, IT).

Allocation and apportionment

Allocation

Allocation charges an entire cost item to one cost centre because the cost relates wholly to that centre.

Example: a machining supervisor’s salary charged fully to the machining department.

Apportionment

Apportionment splits a shared cost across cost centres using a rational basis.

Example: factory rent split by floor area.

What allocation and apportionment change

Allocation and apportionment do not change total overhead; they determine where overhead is collected for analysis. The financial statement impact arises later, when overheads are absorbed into production and may be included in inventories rather than expensed immediately through cost of sales.

Reapportionment of service cost centres

Service cost centres exist to support production. Their costs must be reassigned to production departments so that product costs include a fair share of support activity.

Common methods:

• Direct method: service costs are distributed only to production centres (ignores service-to-service support).
• Step-down method: service centres are ranked; costs are allocated in sequence, partly recognising service-to-service support.
• Reciprocal method: fully recognises mutual support between service centres (most accurate, most computational effort).

The method chosen should be consistent with the detail required and the significance of interactions between service centres.

Overhead absorption

Overhead absorption rate (OAR)

To charge production overhead to products, a predetermined absorption rate is calculated for each production department:

OAR = Budgeted production overhead ÷ Budgeted activity level

The activity level might be machine hours, labour hours, or another measure that best reflects how overhead is consumed in that department. Different departments can use different bases where this better reflects their cost drivers.

Applying absorbed overhead

Absorbed overhead = Actual activity used × OAR

Because the rate is based on budgets, absorbed overhead will rarely equal the overhead actually incurred, giving rise to under- or over-absorption.

Under- and over-absorption of overheads

• Under-absorption: absorbed overhead is less than actual overhead incurred.
• Over-absorption: absorbed overhead exceeds actual overhead incurred.

Differences arise because OARs use budgeted overhead and budgeted activity, but are applied to actual activity, and then compared with actual overhead.

Practical treatments (common exam answers)

• Write off to cost of sales / profit or losswhen the difference is immaterial.
• Prorate between cost of sales and closing inventorieswhen the difference is material and inventory values would otherwise be distorted (so both inventory and cost of sales contain a fair share of overhead).
• Carry forward to the next periodis sometimes used for internal reporting where the difference is clearly a short-term timing effect, but it must be applied consistently and with care.

Core theory and frameworks

Choosing apportionment bases

A strong base is:

• closely related to the cause of the cost (a reasonable driver)
• measurable and reliable
• stable enough to support comparison over time

Illustrative pairings:

• Rent and rates → floor area
• Power (machine-intensive) → machine hours (or metered usage where available)
• Canteen or welfare costs → headcount
• Maintenance support → maintenance hours, work orders, or time spent

Poor bases distort departmental costs and can lead to misleading product margins.

Reapportionment methods in brief

• Direct: simplest; best when service centres mainly support production, not each other.
• Step-down: better where one service centre clearly supports another; results depend on the chosen sequence.
• Reciprocal: best where service centres provide material support to each other; requires simultaneous equations or repeated distribution.

Impact on financial statements (high-level)

Internal cost centre accounting is primarily for planning, control, and decision-making. Where absorption costing is used:

• manufacturing overhead absorbed into production becomes part of product cost
• closing inventories may increase or decrease depending on absorption
• cost of sales changes when goods are sold (product costs flow out of inventory)

Under-/over-absorption differences are adjusted when necessary to avoid materially misstating reported performance and inventory values.

Examining grey areas

Areas that commonly test judgement and technique include:

• selecting a defensible base (and explaining why it is appropriate)
• handling service centre interactions (especially step-down sequencing)
• rounding OARs consistently and reconciling totals
• interpreting under-/over-absorption and stating a sensible treatment

Exam tip: Always state the apportionment basis used, show clear workings, and include a reconciliation check that total overhead remains unchanged after distribution.

Worked example

Narrative scenario

A manufacturer operates two production departments—Machining and Assembly—supported by a Maintenance service department.

For the month, the following budgeted production overheads are set:

• Rent: £18,000
• Power: £9,600
• Supervisors’ salaries: £12,000 (Machining £7,000; Assembly £5,000)
• Maintenance wages: £8,400 (all in Maintenance)

Departmental budget data:

• Floor area (m²) used to apportion rent:Machining 3,000; Assembly 2,000; Maintenance 1,000
• Machine hours (MH) used to apportion power:Machining 4,800; Assembly 1,200; Maintenance 0
• Maintenance hours provided (basis for reapportionment):Machining 180; Assembly 120

Additional budget data for absorption:

• Budgeted machine hours for absorption:Machining 5,000 MH; Assembly 1,400 MH

Required

1. Allocate and apportion overheads to cost centres (Stage 1: primary distribution).
2. Reapportion Maintenance costs to Machining and Assembly (Stage 2: secondary distribution).
3. Calculate OARs for Machining and Assembly (Stage 3: absorption set-up).
4. Absorb overheads into a specific job (Stage 3: absorption).
5. Identify and interpret any under- or over-absorption.

Solution

Stage 1: Primary distribution (allocation and apportionment)

Rent (apportion by floor area)

Total floor area = 3,000 + 2,000 + 1,000 = 6,000 m²

• Machining: £18,000 × (3,000/6,000) =£9,000
• Assembly: £18,000 × (2,000/6,000) =£6,000
• Maintenance: £18,000 × (1,000/6,000) =£3,000

Power (apportion by machine hours)

Total MH = 4,800 + 1,200 + 0 = 6,000 MH

• Machining: £9,600 × (4,800/6,000) =£7,680
• Assembly: £9,600 × (1,200/6,000) =£1,920
• Maintenance:£0

Supervisors’ salaries (allocate as given)

• Machining:£7,000
• Assembly:£5,000
• Maintenance:£0

Maintenance wages (allocate)

• Maintenance:£8,400

Total overhead after primary distribution

• Machining: £9,000 + £7,680 + £7,000 =£23,680
• Assembly: £6,000 + £1,920 + £5,000 =£12,920
• Maintenance: £3,000 + £8,400 =£11,400

Check: Total = £23,680 + £12,920 + £11,400 = £48,000 (total budgeted overhead).

Stage 2: Secondary distribution (reapportion Maintenance)

Reapportion Maintenance based on maintenance hours supplied:

• Machining: 180 hours
• Assembly: 120 hours
• Total = 300 hours

Maintenance cost to reapportion = £11,400

• To Machining: £11,400 × (180/300) =£6,840
• To Assembly: £11,400 × (120/300) =£4,560

Totals after reapportionment

• Machining: £23,680 + £6,840 =£30,520
• Assembly: £12,920 + £4,560 =£17,480
• Maintenance:£0

Check: £30,520 + £17,480 = £48,000.

Stage 3: Calculate OARs

Assume machine hours are used as the absorption base in both production departments. (In practice, bases can differ between departments if overhead consumption is driven by different activities.)

Budgeted machine hours for absorption:

• Machining: 5,000 MH
• Assembly: 1,400 MH

OARs:

• Machining OAR = £30,520 / 5,000 =£6.104 per MH
• Assembly OAR = £17,480 / 1,400 =£12.4857 per MH

(Apply rounding consistently throughout the question.)

Stage 3: Absorb overhead into Job J17

Job J17 uses:

• Machining: 22 MH
• Assembly: 8 MH

Absorbed overhead:

• Machining: 22 × £6.104 =£134.288
• Assembly: 8 × £12.4857 =£99.8856

Total absorbed overhead = £234.1736, say £234.17.

Under-/over-absorption for the month

Actual machine hours worked in the month:

• Machining: 4,700 MH
• Assembly: 1,350 MH

Absorbed overhead (using the predetermined OARs):

• Machining: 4,700 × £6.104 =£28,688.80
• Assembly: 1,350 × £12.4857 =£16,855.71

Total absorbed = £45,544.51

Actual production overhead incurred for the month was £48,000.
Actual overhead matched budget this month; the under-absorption arises because actual activity was below the budget activity used to set the OAR.

Under-absorption = £48,000 − £45,544.51 = £2,455.49 under-absorbed (≈ £2,455)

Interpretation

Under-absorption indicates that the overhead charged to production using a budget-based rate was insufficient to recover the actual overhead incurred. Here, the key factor is the shortfall in activity (actual hours below budget), which reduces absorbed overhead even though total overhead incurred matched budget.

Common pitfalls and misunderstandings

• Using a convenient base instead of a logical one: bases should reflect cost behaviour, not just data availability.
• Skipping the reconciliation check: total overhead must remain £48,000 after both primary and secondary distribution.
• Mixing budget and actual inconsistently: OARs use budgeted overhead and budgeted activity; absorption uses actual activity.
• Rounding inconsistently: rounding the OAR early can create avoidable differences—state your rounding approach and stick to it.
• Forgetting service centre reapportionment: production centres must carry service support costs before absorption to jobs.
• Treating under-/over-absorption as a separate overhead category: it is a difference arising from using predetermined rates.

Summary and further reading

Overheads are indirect production costs that must be assigned systematically to produce credible product costs. The process begins with allocating and apportioning overheads to all cost centres, then reapportioning service centre costs to production departments. Production overheads are absorbed into jobs or units using predetermined rates based on budgeted overhead and budgeted activity.

Because predetermined rates are applied to actual activity, under- or over-absorption is common and must be identified. Where material—particularly when inventory valuation is affected—appropriate adjustment ensures reported costs remain reasonable.

Further reading can be found in management accounting texts covering cost centre accounting, absorption costing, and overhead variances, alongside guidance on inventory costing and the inclusion of production overheads in product cost.

FAQ

What is the difference between allocation and apportionment?

Allocation assigns an entire cost to one cost centre because the cost belongs wholly to that centre. Apportionment splits a shared cost across two or more cost centres using a rational basis such as floor area or machine hours.

How do you choose an appropriate apportionment base?

Choose a base that closely reflects the driver of the cost, can be measured reliably, and supports consistent reporting. If a cost is driven by space used, floor area is sensible; if driven by machine usage, machine hours are often appropriate.

What are the main methods for reapportioning service cost centre costs?

The direct method sends service costs only to production centres; the step-down method allocates service costs in sequence and partially recognises service-to-service support; the reciprocal method fully recognises mutual support between service centres.

How is an overhead absorption rate calculated?

An OAR is calculated as budgeted production overhead divided by budgeted activity for a production cost centre. It is then applied to jobs or units based on actual activity consumed.

What causes under- and over-absorption?

Differences between budget and actual activity, unexpected overhead cost changes, operational inefficiencies, or inaccurate budgeting can all cause absorbed overhead to diverge from actual overhead incurred.

How should under- and over-absorption be treated?

Common treatments include writing the difference to cost of sales/profit or loss when immaterial, or prorating between cost of sales and inventories when material and inventory values would otherwise be distorted. Carry-forward may be used internally where the difference is clearly a short-term timing effect and is applied consistently.

Why verify totals after distribution?

Because allocation, apportionment, and reapportionment redistribute costs but do not create or remove costs. If totals do not reconcile, an error has occurred.

Summary (Recap)

This chapter explains how indirect production costs are assigned to departments and then absorbed into product costs. It covers primary distribution (allocation and apportionment), secondary distribution (reapportioning service department costs), and the calculation and application of predetermined overhead absorption rates. It also explains how under- and over-absorption arise and outlines practical treatments to ensure meaningful performance reporting and, where relevant, appropriate inventory valuation.

Glossary

Overhead
An indirect cost that supports production or operations but cannot be traced economically to a single unit of output.

Cost centre
A department, function, or location where costs are collected for analysis and control.

Production cost centre
A cost centre where manufacturing activity takes place and where overheads are ultimately absorbed into products.

Service cost centre
A support cost centre that provides services to other departments; its costs are reassigned to production centres.

Allocation
Charging a whole cost item to one cost centre because the cost relates entirely to that centre.

Apportionment
Splitting a shared cost between cost centres using a rational basis that reflects the cost driver.

Reapportionment (secondary distribution)
Redistributing service cost centre costs to production cost centres so production carries support costs.

Overhead absorption
Charging production overheads to jobs or units using a predetermined rate based on an activity measure.

Overhead absorption rate (OAR)
A predetermined rate per unit of activity (e.g., per machine hour) calculated from budgeted overhead and budgeted activity.

Under-absorption
When absorbed overhead is less than actual overhead incurred for the period.

Over-absorption
When absorbed overhead exceeds actual overhead incurred for the period.

Primary distribution
The initial allocation and apportionment of overheads to all cost centres.

Secondary distribution
The stage where service centre costs are reassigned to production centres before absorption into products.