Service Department Reapportionment and Over/Under Absorption

Learning objectives

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

• Explain why service department costs are reapportioned and how this improves product costing and decision-making.
• Apply the direct method and the step-down method to transfer service department overheads to production departments.
• Calculate overhead absorption rates (OARs) and use them to absorb overheads based on activity.
• Identify over- and under-absorption of production overheads and prepare appropriate end-of-period adjustments.

Overview & key concepts

Accurate product costs require a fair share of indirect manufacturing costs (overheads). Overheads are first collected in cost centres. Some cost centres (production departments) make goods; others (service departments) support production but do not make saleable output. Since service departments exist to enable production, their costs must ultimately be charged to production departments so that product costs reflect the full cost of manufacturing.

This chapter covers:

• Reapportionment: transferring service department overheads to production departments using suitable allocation bases.
• Overhead absorption: charging production department overheads to output using an overhead absorption rate (OAR).
• Over/under absorption: reconciling absorbed overhead to the overhead actually incurred (and adjusting where appropriate).

Service departments and production departments

Service department

A service department is a cost centre that provides internal support to other departments. It does not normally produce goods for external customers. Examples include maintenance, stores, canteen, security, and production planning.

Production department

A production department is a cost centre where goods are manufactured or processed. Its costs are ultimately included in the cost of inventories and cost of sales through overhead absorption.

Reapportionment

What reapportionment achieves

Service department costs are initially recorded in their own cost centre totals. Reapportionment transfers these totals to production departments using an allocation base that reflects usage or benefit received.

A good allocation base should be:

• linked to the service provided (a sensible cost driver),
• measurable and reliable,
• consistently applied.

Typical bases include:

• Maintenance → machine hours, maintenance hours, number of service calls.
• Canteen → meals served, headcount, labour hours.

Core theory and frameworks

Reapportionment methods

Direct method

The direct method transfers each service department’s cost straight to production departments only. It ignores service-to-service support.

Use this method when:

• service departments provide little or no service to each other, or
• simplicity is prioritised over precision.

Mini-illustration (no numbers): If Maintenance supports Cutting, Finishing and the Canteen, the direct method allocates Maintenance costs only to Cutting and Finishing. Any Maintenance support provided to the Canteen is ignored for costing purposes.

Step-down method

The step-down method transfers service department costs in a sequence. Once a service department’s cost has been allocated out, it is “closed” and does not receive any further allocations.

This method recognises one-way service-to-service support (but not mutual, two-way support).

Choosing the sequence

If the question does not specify the order, a practical rule is:

• allocate first the service department that supports other service departments the most (largest inter-service support), or
• if service patterns are unclear, allocate first the service department with the largest overhead cost (materiality-driven order).

State the rule briefly and apply it consistently.

Overhead absorption rate (OAR)

Purpose

An OAR is used to charge production overheads to units based on activity. It supports consistent product costing and helps value inventories where applicable.

Calculation

OAR = Budgeted production overhead ÷ Budgeted activity level

Activity may be machine hours, labour hours, or units, depending on what best drives overhead in that department.

Absorbing overhead

Absorbed overhead = OAR × Actual activity

Over- and under-absorption

Definitions

• Over-absorptionoccurs when overhead absorbedexceedsoverhead actually incurred.
• Under-absorptionoccurs when overhead absorbed islessthan overhead actually incurred.

Differences arise because:

• actual activity differs from budget,
• actual overhead spending differs from budget,
• the chosen activity base is an imperfect driver.

End-of-period treatment

Common approaches:

1. Write off to cost of sales(often used when the variance is small and inventories are not material).
2. Prorateacross work in progress, finished goods and cost of sales (used when inventories are significant, to avoid distortion).

Worked example

Narrative scenario

A manufacturing business operates two production departments—Cutting and Finishing—and two service departments—Maintenance and Canteen.

The following figures are budgeted overheads after initial allocation to cost centres:

• Cutting: £40,000
• Finishing: £30,000
• Maintenance: £12,000
• Canteen: £8,000

Budgeted service usage (expected usage) for reapportionment:

Maintenance (hours of repairs provided):

• Cutting: 300 hours
• Finishing: 200 hours
• Canteen: 100 hours

Canteen (meals served):

• Cutting: 600 meals
• Finishing: 400 meals
• Maintenance: 200 meals

The step-down method is used for reapportionment. The Canteen is allocated first, followed by Maintenance.

Budgeted production activity for OARs:

• Cutting budgeted machine hours: 10,400
• Finishing budgeted labour hours: 7,600

Actual production activity for the period:

• Cutting actual machine hours: 11,000
• Finishing actual labour hours: 8,000

Required

1. Reapportion Canteen and Maintenance costs to Cutting and Finishing using the step-down method.
2. Calculate the OARs for Cutting and Finishing.
3. Determine overhead absorbed using actual activity.
4. Identify any over- or under-absorption and prepare the adjustment required if the variance is written off to cost of sales.

Solution

Rounding policy

Monetary allocations are shown to the nearest penny. Final departmental totals are presented to the nearest pound where this improves readability.

1) Reapportionment using the step-down method

Step 1: Allocate Canteen cost (first in sequence)

Total meals served:

600 + 400 + 200 = 1,200

Allocate £8,000 based on meals:

• Cutting: 600/1,200 = 50% → £8,000 × 50% =£4,000.00
• Finishing: 400/1,200 = 33.333% → £8,000 × 33.333% =£2,666.67
• Maintenance: 200/1,200 = 16.667% → £8,000 × 16.667% =£1,333.33

Updated totals:

• Cutting: £40,000 + £4,000.00 =£44,000.00
• Finishing: £30,000 + £2,666.67 =£32,666.67
• Maintenance: £12,000 + £1,333.33 =£13,333.33
• Canteen: £8,000 allocated out →£0.00

Step 2: Allocate Maintenance cost (second in sequence)

Rule: Because Canteen is closed after Step 1, Maintenance is allocated only to Cutting and Finishing.

Maintenance hours to production departments:

300 + 200 = 500

Allocate £13,333.33 based on 300:200:

• Cutting: 300/500 = 60% → £13,333.33 × 60% =£8,000.00
• Finishing: 200/500 = 40% → £13,333.33 × 40% =£5,333.33

Final budgeted production department overheads (after reapportionment):

• Cutting: £44,000.00 + £8,000.00 =£52,000.00
• Finishing: £32,666.67 + £5,333.33 =£38,000.00

Check:

Total budgeted overheads initially = £40,000 + £30,000 + £12,000 + £8,000 = £90,000
Final budgeted production overheads = £52,000 + £38,000 = £90,000 ✔

2) Calculate OARs

The departmental totals after reapportionment are treated as budgeted production overheads used to set predetermined OARs.

• Cutting OAR: £52,000 / 10,400 =£5.00 per machine hour
• Finishing OAR: £38,000 / 7,600 =£5.00 per labour hour

3) Absorb overhead using actual activity

Absorbed overhead:

• Cutting: £5.00 × 11,000 =£55,000
• Finishing: £5.00 × 8,000 =£40,000

4) Over/under absorption and adjustment

Note on budget vs actual (for this illustration)

To keep the focus on the absorption mechanism, assume that actual overhead incurred equals the budgeted overhead totals after reapportionment (Cutting £52,000; Finishing £38,000). Therefore, any over/under absorption arises only because actual activity differs from budgeted activity.

Compare absorbed vs actual overhead:

• Cutting: absorbed £55,000 vs actual £52,000 →over-absorbed £3,000
• Finishing: absorbed £40,000 vs actual £38,000 →over-absorbed £2,000

Total over-absorption = £5,000.

Adjustment (variance written off to cost of sales)

In a control-account system, overhead is accumulated in an overhead control account and overhead absorbed is posted during the period using the OAR. The end-of-period entry below clears the remaining balance by writing the variance to cost of sales.

Over-absorption means cost of sales has been charged with too much overhead. Writing it off reduces cost of sales and increases profit.

Journal entry (combined):

• Dr Overhead control account £5,000
• Cr Cost of sales £5,000

(Separate departmental entries are also acceptable.)

Interpretation of the results

Reapportionment ensures that support costs from service departments are included within production department overhead totals, improving the completeness of product costs.

The OARs convert departmental overheads into a cost per unit of activity. Because actual activity exceeded budget in both departments, overhead absorbed exceeded overhead incurred (given the simplifying assumption that actual overhead equals budget). The resulting over-absorption is adjusted so that cost of sales reflects the period’s overhead cost more appropriately.

What often goes wrong in exam answers

• Wrong recipients in the step-down method: once a service cost centre is closed, it must not receive further allocations—so the denominator changes as the sequence progresses.
• Sequence not justified: if the order is not stated, apply a clear rule (allocate first from the service department that supports other service departments the most, or the one with the largest cost if patterns are unclear).
• Weak cost driver: choosing a base that does not reflect consumption makes the allocation hard to defend (e.g., allocating maintenance by floor area without a clear link).
• Mixing budget and actual in the OAR: the rate is normally set in advance using budget/normal activity, then applied to actual activity.
• Variance sign errors: when writing off to cost of sales, over-absorption reduces cost of sales; under-absorption increases it.
• Ignoring inventory significance: if inventories are material, writing the whole variance to cost of sales may distort profit; proration may be more appropriate.

Extension: reciprocal service allocations (beyond this chapter)

Where service departments provide significant support to each other in both directions, the step-down method can understate mutual service effects. In such cases, a reciprocal approach can be used (for example, repeated distribution or simultaneous equations) to share service costs more fully before charging them to production departments. This is usually required only when explicitly stated.

Summary

• Service department costs are transferred to production departments so product costs include a fair share of total manufacturing overhead.
• The direct method is simpler but ignores service-to-service support.
• The step-down method allocates service department costs in sequence and captures one-way inter-service support; the order chosen can affect results.
• OARs are predetermined using budgeted overhead and budgeted activity, then applied to actual activity to absorb overhead.
• Differences between absorbed and actual overhead create over- or under-absorption, which is adjusted—often by writing off to cost of sales or by proration when inventories are significant.

Quick recap (bullet form)

• Reapportion service costs → production departments
• Compute OARs → budgeted overhead ÷ budgeted activity
• Absorb overhead → OAR × actual activity
• Compare absorbed vs actual → over/under absorption
• Adjust → clear variance to cost of sales (or prorate)

FAQ

What is the key difference between the direct and step-down methods?

The direct method sends each service department’s cost straight to production departments only, so any support exchanged between service departments is left out. The step-down method transfers costs out in an order, so earlier service departments can pass some cost to later ones—but not the other way around once a department has been closed.

How do you choose an allocation base?

Choose a base that best reflects consumption of the service. For example, meals served (or headcount) is usually suitable for canteen costs, while machine hours (or maintenance hours) is often suitable for maintenance costs.

Why does the step-down sequence matter?

Because once a service department is allocated out, it is closed and cannot receive further allocations. If later departments also support earlier ones, that support is ignored, so the chosen order can change the final production department overhead totals.

What causes over- and under-absorption?

Over/under absorption arises when actual activity or actual overhead differs from budget, or when the activity base does not closely track overhead behaviour.

How do adjustments affect profit?

If written off to cost of sales:

• Over-absorption reduces cost of sales and increases profit.
• Under-absorption increases cost of sales and reduces profit.

Glossary

Absorbed overhead
Overhead charged to production based on an absorption rate and actual activity.

Allocation base
A measurable driver used to distribute overheads, intended to reflect usage or benefit received.

Direct method
A reapportionment approach that transfers service department costs directly to production departments only.

Over-absorption
A situation where overhead absorbed is greater than overhead actually incurred.

Overhead absorption rate (OAR)
A predetermined rate used to charge overhead to output, typically budgeted overhead divided by budgeted activity.

Production department
A cost centre that manufactures or processes goods; its costs are included in product costs.

Reapportionment
The transfer of service department overheads to production departments using appropriate allocation bases.

Service department
A cost centre that supports production activities but does not itself produce saleable output.

Step-down method
A sequential allocation approach where service department costs are transferred out one department at a time. After a service department is allocated, it is closed, so later allocations cannot flow back into it. This captures only one-direction inter-service support.

Under-absorption
A situation where overhead absorbed is less than overhead actually incurred.