Examining methods for allocating overhead costs Essay

Overhead cost is an ongoingA expenseA of runing a concern and is normally used to group disbursals that are necessary to the continued operation of the concern, but can non be instantly associated with the products/services being offered as in the costs do non straight generateA net incomes.

Overhead cost includes indirect merchandise cost or indirect cost of duty Centre. Indirect merchandise cost is known as fabrication overhead whereas indirect cost of duty Centre is known as non-manufacturing cost. Manufacturing operating expense is those fabricating costs that are incurred to a assortment of merchandises. It can non be traced to single merchandises like depreciation and insurance of fabrication equipment, cost of busying, managing and keeping a production installation. Manufacturing operating expense is the cost that could be traced to single merchandise but it is non deserving the problem to wish cost of lubricators and gum used. Manufacturing operating expense besides include cost that is more suitably to be treated as cost of all end products like overtime premium, cost of idle clip, public-service corporations cost.

Non-manufacturing cost includes client service, selling and research & A ; development cost.

ALLOCATING Operating expense COSTS

Normally, merely fabricating operating expense is allocated to merchandises. However, depending on the industry the concern is in and to obtain more comprehensive estimations of merchandise cost, direction comptroller may apportion non-manufacturing cost to merchandises. One illustration is Apple Co. with high research & A ; development cost, to obtain accurate merchandise costing, they allocate portion of the research & A ; development cost to merchandise cost.


Production operating expense, or normally refer to as fabricating operating expense, is recovered by absorbing them into the cost of a merchandise. This procedure is known as soaking up costing. Absorption bing agencies that all of the fabrication costs areA absorbedA by the units produced. In other words, the cost of a finished unit in stock list will include direct stuffs, direct labour, and both variableA andA fixed fabricating operating expense. As a consequence, soaking up costing is besides referred to as full costing or the full soaking up method.

Absorption costing is frequently contrasted with variable costing or direct costing. The fixed fabrication operating expense costs are non allocated or assigned to ( non absorbed by ) the merchandises manufactured under variable or direct costing. Variable costing is frequently utile for direction ‘s decision-making. However, soaking up costing is frequently required for external fiscal coverage and for income revenue enhancement coverage.

Absorption bing includes 3 phases, viz. allotment of operating expenses, reallotment or allotment of service ( non-production ) cost Centre operating expenses and besides soaking up of operating expense.

For allotment of operating expenses, there are no difficult and fast regulations for which footing of allotment to utilize except that whichever method is used to allocate operating expenses, it must be just. Unlike direct cost, indirect cost is normally allocated to be objects and is non straight traced to be objects. Cost object is defined as point that is assigned separate step of cost. To ease allotment of overhead cost, overhead cost that have common allotment base is pooled together and is known as cost pool. For each cost pool, bases of allotment are chosen. Bases of allotment are some factors or variables that allow us to apportion costs in a cost pool to be objects. The choice of the base of allotment should be on causal-and-effects evidences, which mean it should be a cost driver. Some illustrations of bases of apportionment include floor country, net book value of fixed assets and figure of employees. Floor country is normally used for rent and rates overhead. It is assumed that the greater the floor infinite occupied by the production centres, the more rent, cleansing and electricity use are consumed. Net book value of fixed assets is used for depreciation and insurance of machinery. It is based on the premise that – Number of employees is used for canteen cost. The premise is when the figure of employees additions, the canteen cost will increase.


ABC Ltd has two production sections ( Assembly and Finishing ) and two service sections ( Maintenance and Canteen ) . The following are budgeted costs for the following period:

The 2nd phase of soaking up costing is reapportionment or allotment of service cost Centre costs overhead to production cost centres. Service cost centres ( sections ) are non straight involved in doing merchandises. Therefore the fixed production operating expenses of service cost centres must be shared out between the production cost centres utilizing suited footing. Examples of service cost centres or besides referred to as support section cost centres include care section, paysheet section, shops and canteen. In contrast to operating or production section which engages in production of the merchandises and straight adds value to a merchandise or service, support or service section provides the service that aid and complements the smooth operation of the production sections in the company.

Methods of apportioning support or service section cost to production section include direct method, step-down method and mutual method.


TheA direct methodA is the most widely-used method where it allocates each service section ‘s entire costs straight to the production sections. It ignores the fact that service sections may besides supply services to other service sections. Under this method, there is no interaction between service sections prior to allotment.


Machining and Assembly are the lone production sections that used the services of the Human Resources Department in March. Costss from Human Resources are allocated based on the figure of new hires. Machining hired seven employees in March and Assembly hired three employees. Human Resources incurred entire costs of RM93, 000 in March.

Allotment of H.R. Department costs to Machining:70 % of RM 93,000 = RM 65,100

Allotment of H.R. Department costs to Assembly:30 % of RM 93,000 = RM 27,900

No information is necessary about whether any service sections utilised services of the Human Resources Department is the characteristic characteristic of the direct method. It does non take history whether no other service section hired anybody, or whether three other service sections each hired five employees ( connoting that more than 50 % of the hiring occurred in the service sections ) . Service section to service section services are ignored, and no costs are allocated from one service section to another when utilizing the direct method.


Thestep-down methodor known as consecutive method allocates the costs of some service sections to other service sections. However, one time a service section ‘s costs have been allocated, no subsequent costs are allocated back to it.

The pick of which section to get down with is really of import. The sequence in which the service sections are allocated normally effects the ultimate allotment of costs to the production sections, in that some production sections addition and some lose when the sequence is changed. Hence, production section directors normally prefer over the sequence. The most defendable sequence is to get down with the service section that provides the highest per centum of its entire services to other service sections, or the service section with the highest costs, or the service section that provides services to the most figure of service sections, or some similar standard.


Human Resources ( H.R. ) , Data Processing ( D.P. ) , and Risk Management ( R.M. ) provide services to the Machining and Assembly production sections, and in some instances, the service sections besides provide services to each other:


The sums in the far left column are the costs incurred by each service section. Any services that a section provides to itself are ignored, so the intersection of the row and column for each service section shows zero. The rows sum to 100 % , so that all services provided by each service section are charged out.

The company decides to apportion the costs of Human Resources foremost, because it provides services to two other service sections, and provides a greater per centum of its services to other service sections. However, a instance could be made to apportion Data Processing foremost, because it has greater entire costs than either of the other two service sections. In any instance, the company decides to apportion Data Processing second.

In the tabular array below, the row for each service section allocates the entire costs in that section ( the original costs incurred by the section plus any costs allocated to it from the old allotment of other service sections ) to the production sections every bit good as to any service sections that have non yet been allocated.

After the first service section has been allocated, in order to deduce the per centums to use to the production sections and any staying service sections, it is necessary to “ normalise ” these per centums so that they sum to 100 % . For illustration, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The per centums for the staying service and production sections sum to 92 % ( 7 % + 30 % + 55 % ) , non 100 % . Therefore, these per centums are normalized as follows:

For illustration, in the tabular array above, 59.78 % of RM136,000 ( = RM 81,304 ) is allocated to Assembly, non 55 % .

The characteristic characteristic of the step-down method is that one time the costs of a service section have been allocated, no costs are allocated back to that service section. As can be seen by adding RM 105,522 and RM 134,478, all RM 240,000 incurred by the service sections are finally allocated to the two production sections. The intermediate allotments from service section to service section better the truth of those concluding allotments.


Thereciprocal method is the most accurate among the three methods for apportioning service section costs. It is because it recognizes mutual services among service sections. However, it is besides the most complicated method, because it requires work outing a set of coincident additive equations.

Using the information from the step-down method illustration, the coincident equations are:

H.R. =RM80,000 + ( 0.08 ten D.P. )

D.P. =RM 120,000 + ( 0.20 ten H.R. )

R.M. = RM40,000 + ( 0.10 ten H.R. ) + ( 0.07 ten D.P. )

Where the variables H.R. , D.P. and R.M. stand for the sum costs to apportion from each of these service sections. For illustration, Human Resources receive services from Data Processing, but non from Risk Management. 8 % of the services that Data Processing provides, it provides to Human Resources. Therefore, the entire costs allocated from Human Resources should include non merely the RM 80,000 incurred in that section, but besides 8 % of the costs incurred by Data Processing. Solving for the three terra incognitas ( which can be performed utilizing spreadsheet package ) :

To exemplify the derivation of the sums in this tabular array, the RM36,423 that is allocated from Human Resources to Machining is 40 % of H.R. ‘s entire cost of RM 91,057.


Direct method allocates support cost merely to operational sections and there in no interaction between support sections prior to allotment. On the other manus, step down method allocates support costs to other support sections and to runing sections that partly recognizes the common services provided among all support sections. Under this method, there is one-way interaction between support sections prior to allotment. Reciprocal method allocates support section costs to runing sections by to the full acknowledging the common services provided among all support sections. It is full bipartisan Interaction between support sections prior to allotment.

Direct, step-down and mutual methods of support section cost allotment gave somewhat different entire operating expense cost and overhead rates for each production section. It is because of the different acknowledgment that each method gives to back up relationships. The direct method does non acknowledge any relationships that exist between support sections whereas step-down method gives merely partial acknowledgment to these relationships.

Reciprocal method gives the most accurate consequences when apportioning of multiple service sections ‘ costs to runing sections. The power of mutual method over other methods ( direct method, step-down method ) lies in its sing the common services provided among all service sections which means the costs of service sections are allocated to each service section ( except the service supplier ) besides operating sections.

However the application of this more powerful method is rare. It is because it is more complicated than other methods and it requires sophisticated computing machine assistance. Some houses that use ERP package since this method requires extra alteration in coding. Therefore most of the companies prefer using either of direct or step down methods. Reciprocal method considers common services provided among all service sections, direct method and step-down method ignore this point. Furthermore service section cost used by other service sections are besides ignored in direct method. The drawback of direct method is partly reduced by step-down method by following a hierarchy among service sections while sing cost allotment.

There is a superior among service sections as to which section to get down allotment harmonizing to different regulations which in bend outputs different allotment figures. The drawback of step-down method to mutual method is that one time the cost accumulated in the first in ranking service section is allocated, that section does non take any portion from other service sections. Two chief regulations determine the raking. The first attack considers the figure of sections served by the service sections to judge on which service section to get down allotment and which 1s to travel on. The service section that serves to the highest figure of sections is the first section to get down allotment. In instance of more than one section function the highest figure of sections, the section with highest accrued costs is the first in the ranking and so on.

The 2nd attack adopts the per centum of service in finding the ranking of service section to get down with and to transport on. The service section with highest per centum of service to other sections is the first in the ranking and so on. In instance of more than one section with equal the highest service per centum, the 1 with higher accrued costs is set as the first and so on.

Last mutual method or algebraic allotment method ( REC ) considers all served sections including service sections and runing sections by a service section except the one whose costs are allocated. There is a two manner interaction among service sections unlike step-down method. The method outputs equations with multiple terra incognitas which are equal to the figure of service sections since the method considers all the costs of the service sections to be allocated. As the figure of service sections increase the figure of equations with multiple unknowns addition and therefore a computing machine assistance is required to work out the equations at the same time.


Out of the 3 allotment methods to apportion service/ support section cost to production section cost, mutual method is said to be the most precise method. It is besides the most complicated method as it requires work outing a set of coincident additive equations. However, direct and step-down methods are simple to calculate and easy to understand. Nonetheless, direct method is the most widely used in industry. Direct method allocates each service section ‘s entire costs straight to the production sections, and ignores the fact that service sections may besides supply services to other service sections. The direct method and step-down method have no advantages over the mutual method except for their simpleness, and the step-down method is sometimes non really simple. However, the mutual method is non widely used. Given progresss in calculating power, the mutual method would look to be accessible to many companies that are non utilizing it. Presumably, these companies believe that the benefits obtained from more accurate service section cost allotments do non warrant the costs required to implement the mutual method.