Overhead: Allocation, Apportionment and Absorption

Learning objectives

• Allocate and apportion overheads to cost centres using suitable bases so that shared costs are distributed fairly and consistently.
• Re-apportion service cost centre costs to production cost centres using step-down and reciprocal approaches.
• Calculate overhead absorption rates (OARs) and absorb manufacturing overheads into product costs using an activity base.
• Identify and correct under- and over-absorption so that absorbed overheads are aligned with actual overheads, using practical adjustment methods.
• Recognise common sources of error in overhead distribution (poor bases, capacity effects, inconsistent activity measures, rounding) and apply safeguards.

Overview & key concepts

Overheads are indirect costs that support operations but cannot be traced economically to a single unit of output. Because they are shared, they must be collected and then distributed in a structured way so that product costs, inventory valuation, and profitability analysis are not distorted.

A cost centre is a part of an organisation where costs are accumulated for costing and control (for example, a department or function). For overhead distribution, cost centres are commonly classified as:

• Production cost centres: directly involved in making the product (e.g. Cutting, Assembly).
• Service cost centres: provide support to other centres (e.g. Maintenance).

Overhead distribution is usually performed in stages:

1. Allocation: charging a whole cost to one cost centre when it relates solely to that centre.
2. Apportionment: splitting a shared cost between cost centres using an equitable basis.
3. Re-apportionment: transferring service cost centre costs to production cost centres so production centres carry the full cost of support services.
4. Absorption: charging manufacturing overheads to units of output using an overhead absorption rate (OAR).

What you should have at the end of each stage

• After allocation/apportionment → overhead totals by cost centre (including service cost centres).
• After re-apportionment → total manufacturing overhead by production cost centre only.
• After absorption → overhead charged into product cost using actual activity (affecting WIP/finished goods and cost of sales when sold).
• After variance → under/over absorption identified and adjusted.

Core theory and frameworks

1) Allocation and apportionment

Allocation charges an entire overhead to one cost centre when the cost belongs wholly to that centre. Examples include:

• A supervisor’s salary dedicated entirely to Cutting
• Depreciation of machinery used only in Assembly

Apportionment shares an overhead across cost centres using a reasoned basis. The basis should be consistent, measurable, and linked to how the cost arises or who benefits.

Common apportionment bases (illustrative):

• Rent, rates, heating: floor area (or cubic metres where height differs materially)
• Power for machinery: machine hours (or kWh readings if available)
• Canteen or welfare costs: headcount (or meal counts)
• Stores costs: number of requisitions or value/volume of issues
• Maintenance support: maintenance hours or number of work orders

A strong basis reflects cause-and-effect where possible; where not, it should at least represent a fair measure of benefit received.

2) Re-apportionment of service cost centres

Service cost centres exist to support production, so their costs must ultimately be borne by production centres for product costing.

Step-down (sequential) method

Service cost centres are re-apportioned one at a time in a chosen order. A common ordering rule is to start with the service department that provides the greatest proportion of its services to other departments (including other service centres), and work down to the one that provides the least.

Once a service cost centre has been re-apportioned, it does not receive further allocations from centres transferred later. This makes the method straightforward, but it only partially reflects inter-service support.

Reciprocal method

Where service centres support each other, the reciprocal method uses simultaneous equations so each service cost centre’s total includes support received from the other service centres before those costs are transferred to production.

Mini-illustration (two service centres):

Assume two service departments, S1 and S2, with initial overheads:

• S1 = 10,000
• S2 = 6,000

S1 provides 20% of its service to S2.
S2 provides 25% of its service to S1.

Let:

• T1 = total cost of S1 after receiving service from S2
• T2 = total cost of S2 after receiving service from S1

Then:

T1 = 10,000 + 0.25T2
T2 = 6,000 + 0.20T1

Solve these two equations to find T1 and T2, then re-apportion T1 and T2 to production departments using the relevant service proportions. The key point is that each service department’s final cost includes the “loop” of mutual support.

3) Which overheads go into product cost?

For product costing and inventory valuation, include overheads that are necessary to manufacture the goods (for example, factory supervision, depreciation of production equipment, factory utilities, and other production support costs). Costs linked to selling, distribution, and general administration are normally charged to profit when incurred because they do not form part of manufacturing the inventory.

In practice, apply a simple test: if the cost is needed to bring the inventory to its manufactured condition, it belongs in manufacturing cost; if it is incurred after manufacture (or does not contribute to manufacture), it is treated as a period cost. Abnormal or avoidable waste costs are not treated as part of normal product cost.

4) Overhead absorption rates (OARs)

An OAR is the rate used to absorb budgeted manufacturing overhead into product costs based on an activity driver (such as machine hours or labour hours). OARs are normally set in advance using budgets to support planning and consistent job costing.

OAR (general formula)
OAR = budgeted manufacturing overhead / budgeted activity

If departments differ in processes and cost structure, separate departmental OARs are often preferable. Departmental rates reduce the risk that one product line is unfairly loaded with overheads generated in a different area of production (often described as avoiding cross-subsidisation between products).

5) Absorbing overheads and the link to financial statements

Absorption is a costing process that affects inventory and cost of sales because manufacturing overhead is included in product cost.

• When goods are produced but not sold, absorbed manufacturing overhead is included ininventory(WIP/finished goods).
• When goods are sold, the absorbed overhead within those goods is included incost of sales.

Non-manufacturing overheads (such as selling and general administration) are typically expensed in the period incurred and are not included in inventory valuation.

6) Under- and over-absorption

Because OARs are budget-based, absorbed overhead will rarely equal actual overhead incurred.

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

Absorption variance (general formula)
Under/over-absorption = actual manufacturing overhead − absorbed manufacturing overhead
(A positive result is under-absorption; a negative result is over-absorption.)

Interpret absorption variances with two drivers in mind:

• aspending effect(actual overhead differs from budget), and/or
• avolume/activity effect(actual activity differs from budget, so the OAR is applied to a different level of activity than planned).

7) Journal entries: a consistent control account framework

Many systems use a manufacturing overhead control account to capture actual overheads and compare them with absorbed overheads.

(a) When manufacturing overheads are incurred (record actual overheads)
Dr Manufacturing overhead control
Cr Cash / Payables / Accruals (as appropriate)

• UseCr Cashfor immediate payment.
• UseCr Payablesfor credit purchases/services.
• UseCr Accrualswhere the cost is incurred but not yet invoiced/paid.

(b) When overheads are absorbed into production (charge overhead to output)
Dr Work in progress (or Finished goods, depending on the system)
Cr Manufacturing overhead control

This single-control approach makes the under/over absorption visible as the remaining balance on the control account at period end.

(c) Period-end adjustment for under-/over-absorption (simple write-off approach)
If under-absorbed (debit balance remaining on the control account):
Dr Cost of sales (or profit and loss)
Cr Manufacturing overhead control

If over-absorbed (credit balance remaining on the control account):
Dr Manufacturing overhead control
Cr Cost of sales (or profit and loss)

Where the variance is material, the adjustment can be split between cost of sales and inventories using a consistent basis (for example, based on the amount of absorbed overhead included in WIP, finished goods, and cost of sales).

Worked example

Narrative scenario

A manufacturing company has two production departments (Cutting and Assembly) and one service department (Maintenance). The company budgets total manufacturing overheads of £100,000 for the year. Production activity is measured using machine hours.

Overhead items are distributed as follows:

• Factory rent is apportioned by floor area.
• Power is apportioned by machine hours (where applicable).
• Indirect wages are allocated where they relate solely to one department.
• Maintenance department costs are re-apportioned to production departments based on maintenance hours provided.

Budgeted and actual activity and overhead information:

Budgeted machine hours

• Cutting: 6,000
• Assembly: 4,000
• Total: 10,000

Actual machine hours

• Cutting: 5,700
• Assembly: 3,800
• Total: 9,500

Actual manufacturing overhead incurred (total): £105,000

Overhead analysis (budgeted):

1. Factory rent: £36,000
2. Floor area (square metres): Cutting 3,000; Assembly 2,000; Maintenance 1,000.
3. Power: £20,000
4. Machine hours for power apportionment (budgeted): Cutting 6,000; Assembly 4,000. (Maintenance has negligible machine power usage.)
5. Indirect wages: £44,000
6. Allocated as: Cutting supervisor £12,000; Assembly supervisor £10,000; Maintenance staff £22,000.

Maintenance department provides maintenance hours (budgeted) to production departments: Cutting 1,500 hours; Assembly 2,500 hours.

Required

1. Allocate and apportion the budgeted overheads to cost centres and re-apportion Maintenance to production departments.
2. Calculate the OAR for each production department.
3. Absorb overheads using actual machine hours.
4. Calculate under- or over-absorption and state appropriate financial statement adjustments.

Solution

1) Allocate and apportion overheads to cost centres (budgeted)

(a) Factory rent apportioned by floor area

Total floor area = 3,000 + 2,000 + 1,000 = 6,000 sq m

• Cutting: 36,000 × (3,000/6,000) = 18,000
• Assembly: 36,000 × (2,000/6,000) = 12,000
• Maintenance: 36,000 × (1,000/6,000) = 6,000

(b) Power apportioned by machine hours (production only)

Total production machine hours (budgeted) = 10,000

• Cutting: 20,000 × (6,000/10,000) = 12,000
• Assembly: 20,000 × (4,000/10,000) = 8,000
• Maintenance: 0

(c) Indirect wages allocated

• Cutting: 12,000
• Assembly: 10,000
• Maintenance: 22,000

(d) Total overhead before re-apportionment

• Cutting: 18,000 + 12,000 + 12,000 = 42,000
• Assembly: 12,000 + 8,000 + 10,000 = 30,000
• Maintenance: 6,000 + 0 + 22,000 = 28,000

Check: 42,000 + 30,000 + 28,000 = 100,000 (agrees to budget)

2) Re-apportion Maintenance to production departments

Maintenance overhead to re-apportion = 28,000

Maintenance hours (budgeted): Cutting 1,500; Assembly 2,500; total 4,000

• Cutting share = 28,000 × (1,500/4,000) = 10,500
• Assembly share = 28,000 × (2,500/4,000) = 17,500

Re-apportioned production overhead totals:

• Cutting: 42,000 + 10,500 = 52,500
• Assembly: 30,000 + 17,500 = 47,500

Check: 52,500 + 47,500 = 100,000

3) Calculate departmental OARs

OAR (departmental)
OAR = budgeted production overhead (after re-apportionment) / budgeted machine hours

Cutting:
OAR (Cutting) = 52,500 / 6,000 = £8.75 per machine hour

Assembly:
OAR (Assembly) = 47,500 / 4,000 = £11.875 per machine hour

Using departmental OARs here helps prevent products being charged overheads that arise mainly in a different department (reducing cross-subsidisation between products).

4) Absorb overheads using actual machine hours

Cutting absorbed overhead:
5,700 hours × £8.75 = 49,875

Assembly absorbed overhead:
3,800 hours × £11.875 = 45,125

Total absorbed overhead = 49,875 + 45,125 = 95,000

Absorbed manufacturing overhead (total)
Absorbed overhead = 95,000

5) Under- or over-absorption

Actual manufacturing overhead incurred = 105,000
Absorbed manufacturing overhead = 95,000

Under-absorption
Under-absorption = 105,000 − 95,000 = 10,000

This under-absorption can reflect higher-than-planned overhead spending, lower-than-planned activity (or both).

6) Financial statement adjustment (practical)

If the £10,000 is immaterial, it is commonly written off to profit through cost of sales.

Write-off entry (under-absorption, simple approach)
Dr Cost of sales 10,000
Cr Manufacturing overhead control 10,000

If the variance is material, it should be apportioned between inventories (WIP and finished goods) and cost of sales on a consistent basis, so that inventory valuation and profit are not misstated.

Interpretation of the results

Departmental OARs reflect that Assembly is more overhead-intensive per machine hour than Cutting. Applying separate rates improves the fairness of product costs when departments differ and reduces the risk of one product line absorbing overheads generated primarily elsewhere.

Although budgeted overhead totalled £100,000, the company absorbed only £95,000 because actual machine hours were below budget overall. With actual overheads of £105,000, the combined effect is an under-absorption of £10,000. Without adjustment, profit would be overstated because too little overhead has been charged to cost of sales (and, if applicable, inventories would also be misstated).

Common pitfalls and misunderstandings

• Choosing a weak apportionment base: overheads become arbitrary, and product costs lose credibility.
• Including non-manufacturing overhead in inventory costs: selling and general administration costs are usually period costs and do not form part of manufacturing cost.
• Forgetting the ordering logic in step-down: the re-apportionment order should be defendable and linked to service patterns.
• Ignoring reciprocal service support where it matters: step-down can understate service costs transferred to production when mutual support is significant.
• Using an unsuitable activity base: machine-related overhead absorbed on labour hours can distort departmental product costs.
• Misreading capacity effects: low activity can cause under-absorption even if overhead spending is controlled.
• Rounding too early: round at the final stage where possible to reduce cumulative errors.
• No reconciliation check: overhead schedules should always cross-check back to the original overhead total.

Summary and further reading

Overhead distribution supports fair and consistent product costing. The process typically moves from allocation and apportionment to re-apportionment of service departments and then absorption into product costs using an OAR based on a suitable activity driver. Because OARs are set using budgets, absorbed overhead will often differ from actual overhead; under- and over-absorption must be identified and adjusted so that profit and inventory are not misstated.

Further study should focus on selecting cost drivers that reflect how overheads arise, handling mutual service support using reciprocal methods where relevant, and interpreting absorption variances in terms of both spending and activity effects.

FAQ

What is the difference between allocation and apportionment of overheads?

Allocation charges a whole cost to one cost centre when it relates solely to that centre. Apportionment shares a cost across multiple cost centres using a reasoned basis that reflects usage or benefit.

How do you calculate an overhead absorption rate (OAR)?

An OAR is calculated by dividing budgeted manufacturing overhead by budgeted activity (such as machine hours or labour hours). Departmental OARs are often used when departments differ materially in cost structure or processes.

What causes under- and over-absorption?

They arise because OARs are budget-based while actual overheads and actual activity levels differ from budget. Under-absorption can be driven by higher overhead spending, lower activity, or both; over-absorption can arise from the reverse.

Why does the choice of apportionment base matter?

The base determines how much overhead each cost centre receives. A poor base can shift costs unfairly, leading to unreliable product costs, weak pricing decisions, and misleading performance comparisons.

When is the reciprocal method worth using?

It is most useful when service departments support each other to a meaningful extent. In those cases, reciprocal costing better reflects the full cost of providing services before charging production departments.

How should under- or over-absorption be adjusted in the financial statements?

If immaterial, it is usually written off to profit (commonly via cost of sales). If material, it is apportioned between inventories and cost of sales so that inventory valuation and profit are not misstated.

Glossary

Overhead
Indirect cost that supports operations but cannot be traced economically to a single unit of output.

Cost centre
A unit (department, function, location) where costs are accumulated for costing and control.

Production cost centre
A cost centre that carries out production work and is part of the manufacturing process.

Service cost centre
A support cost centre that provides services to other departments (often to production centres).

Allocation
Charging a cost entirely to one cost centre when the cost relates solely to that centre.

Apportionment
Sharing a cost across multiple cost centres using a rational basis.

Re-apportionment
Transferring service cost centre costs to production cost centres so production overhead totals reflect support costs.

Overhead absorption rate (OAR)
A budget-based rate used to absorb manufacturing overhead into product costs using an activity driver.

Absorbed overhead
Manufacturing overhead charged to production output based on actual activity using the OAR.

Under-absorption
Actual manufacturing overhead exceeds absorbed overhead; an additional charge is needed to avoid overstating profit.

Over-absorption
Absorbed overhead exceeds actual manufacturing overhead; a credit adjustment is needed to avoid understating profit.

Activity base (cost driver)
The measure used to absorb overheads (e.g. machine hours, labour hours, units, or another suitable driver).

Reciprocal service support
A situation where service departments provide support to each other; simultaneous equations can be used so that each service department’s total cost includes support received before re-apportionment to production.