Absorption of Overheads: 3 Stages (2024)

There are three stages in the absorption of overheads which are discussed in detail below:

Stage I: Allocation and Apportionment of Overhead:

The first stage in the absorption of overhead costs is to identify and collect overhead costs for different production and cost centres. The first stage is known as ‘primary distribution.’

Primary Distribution:

Some overhead costs can be directly identified with a particular department or cost centre as having been incurred for that cost centre. These items of overhead cannot be traced to products or jobs but can be allocated specifically to departments. Examples of such overhead costs are repairs and maintenance expenses incurred in specific departments, supervision, indirect labour, overtime, indirect materials and factory supplies, equipment depreciation.

Expenses, such as power, light, rent, depreciation of factory building, expenses shared by all departments, cannot be charged directly to a department, be it production or service. They are incurred for all and must, therefore, be apportioned or prorated to any or all departments using such items. Cost apportionment is the process of charging expenses in an equitable proportion to the vari­ous cost centres or departments.

The Institute of Cost and Management Accountant (U.K.) defines cost apportionment “as the allotment of proportions of items of cost to cost centres or cost units”. The apportionment should be done on some rational and equitable bases. In cost accounting this is known as primary distribution of overhead.

It would be difficult to give a comprehensive list of the bases of apportionment, but the following bases are in common use:

1. Floor Area Occupied:

Overheads such as lighting and heating, rent and rates, depreciation on building, building repairs, caretaking, watching and patrolling.

2. Capital Values:

Depreciation on plant and machinery, insurance on building, and plant and machinery, maintenance of plant and machinery.

3. Direct Labour Hours And /Or Machine Hours:

Insurance on Jigs, tools and fixtures, power, works management remuneration, repairs and maintenance cost.

4. Number of Workers Employed:

Canteen, accident insurance, medical, dental and first aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time office, wages department.

5. Technical Estimate:

Fire prevention, oil and grease, steam, water without meter.

Example:

The Modern Company has four departments. A, B and C are the production departments and D is a servicing department.

The actual costs for a periods are as follows:

Stage II: Apportionment of Service Departments Overhead to Producing Departments:

In stage II, overhead costs of service departments are apportioned to production departments. Such apportionment is termed as ‘Secondary Distribution’.

Secondary Distribution:

The primary distribution of factory overhead apportions all overhead costs to the different departments or cost centres — production and service departments. It is necessary that overhead costs of service departments (accumulated through direct allocation or primary distribution) should be further assigned to producing departments.

This is due to the reason that service departments do not themselves manufacture anything and it is the production departments or cost centres which are involved in manufacturing activities. The reassignment or reapportionment of service departments overhead to producing departments or centres is termed as secondary distribution.

Secondary distribution is useful in the following matter:

1. It helps in determining the cost of products or jobs sold and inventory figures.

2. It helps in determining the effect of various managerial decisions and actions on the total cost of the business firm. For example, decisions as to add or to drop a product line require information about its cost effect which can be estimated after secondary distribution has been made.

3. It helps subsequently in determining the price of the product or job. In case of contracts based on cost in place of market price, secondary distribution helps in fixing a selling price which is advantageous to the parties concerned.

4. It promotes motivation among employees of the producing departments to take up service department activities.

Bases for Secondary Distribution:

It is difficult to suggest a sample list of service departments and equitable bases of distribution of overhead costs. The objective is to find the allocation base that best measures the causal or beneficial relationship between the department whose costs are being apportioned and the departments receiving the service.

The general basis for apportioning service department overheads to producing department are the following:

1. Service Rendered (Benefits Obtained):

This is perhaps the most popular method of apportioning service department costs. The service rendered to different departments, i.e., benefits obtained by them can be a suitable basis.

2. Ability to Pay:

This method suggests that a large share of servicing department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of a business enterprise. However, it is difficult to measure the ability to pay of different departments and also this method is not based on equity.

3. Survey or Analysis:

This method is applied where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.

4. Efficiency or Incentives:

This method uses standards and budgets and apportions the over­head costs on the basis of a present budget or standard. Sometimes this method is used along with the bases of services rendered or ability to pay method.

In selecting a suitable base for apportioning service department overheads, consideration should be given to practicability, simplicity, economy, theoretical soundness and assistance in accurate costing and cost control. If a service department overhead is allocated on the basis over which the production manager has no control, the prorated cost may result in an inappropriate charge to the producing department.

The following list gives a few service departments and bases commonly used to apportion the respective overhead costs:

Stage III: Absorption of Overhead Costs:

After all service departments overhead costs have been apportioned to producing departments, the next step is to spread factory overhead to different products or jobs produced. This is termed as “Overhead absorption” in cost accounting. The Institute of Cost and Management Accounts (U.K.) define overhead absorption as “the allotment of overhead to cost units.” Known by different names, such as recovery, overhead application, overhead costing, levy, burden rate, etc. the term “absorption” implies that expenses pertaining to a producing department or cost centre are finally charged to or absorbed in the cost of products, jobs, etc. passing through it. As a result of absorption, the cost of each unit of product of the producing department includes an equitable share of the total overhead of that department.