Allocating costs to different projects or services is necessary for the as Allocating certainment of the actual cost involved in each project or service. The costs that are assigned to cost objects can be divided into direct costs and indirect costs. Direct costs can be accurately traced to cost objects because they can be specifically and exclusively traced to a particular cost object whereas indirect costs cannot. Where a cost can be directly assigned to a cost object, it is known as cost tracing. Indirect costs cannot be traced directly to a cost object because they are usually common to several cost objects. Hence, the concept of cost allocation comes into picture. Cost allocation is the process of assigning costs in a situation wherein a direct measure does not exist for the quantity of resources consumed by a particular cost object. Cost allocations involve the use of surrogate rather than direct measures. The basis that is used to allocate costs to cost objects is called an allocation base or cost driver. Cost is defined as the amount of expenditure, actual or notional, incurred on or attributable to a given item. Cost represents the resources that have been or must be sacrificed to attain a particular objective. Direct costs are those costs that can be specifically and exclusively identified with a particular cost object. Indirect costs cannot be identified specifically and exclusively with a given cost object. Direct costs can be accurately traced because they can be physically identified with a particular object whereas indirect costs cannot. Prime cost refers to the direct costs of the product and consists of direct labor costs plus direct materials and direct expenses. Overheads are the indirect costs that cannot be allocated to any specific job or process as they are not capable of being identified with any specific job or process. It includes cost of indirect material, indirect labor and indirect expenses that cannot be conveniently charged to any job or process. The CIMA defines overhead cost as “the total cost of indirect materials, indirect labor and indirect expenses. In short, it is the cost of materials, labor and expenses that cannot be economically identified with specific saleable cost unit.
Manufacturing OH includes all the indirect expenses incurred by the operations of the manufacturing divisions of a concern. Expenses like depreciation, insurance charges on fixed assets etc. are considered as manufacturing overheads. Administration OH refers to all the expenses incurred towards the control and administration of an undertaking. Examples include office rent, salaries and wages of employees, showroom expenses etc. Selling and distribution OH refers to the costs incurred towards marketing, distribution and sales. Examples include all selling expenses, office expenses, salesman salaries, advertisement charges etc. Research expenses refer to the costs incurred for researching on new and improved products, new application of materials or improved methods. Development costs refer to the costs incurred towards commercial application of the discoveries made. Fixed overhead refers to those costs that will not vary with output but remain constant. Rent, rates, insurance, salaries etc. are fixed in nature irrespective of the level of capacity utilized or units produced. Variable OH costs are those that vary in direct proportion to the volume of output. Examples are power consumption, consumption of indirect materials and indirect labor etc. Semi-variable overheads are neither perfectly variable nor absolutely fixed in relation to the changes in volume. They change in the same direction as volume but not in direct proportion thereto. For example, in telephone charges, fixed cost is the rental element, variable cost is charges for calls made.
The costs incurred in materials used to further the manufacturing process, that is necessarily built into the product are called indirect materials. For example, cutting oil used in cutting surface, threads and buttons used in stitching clothes etc, are considered as indirect materials. Indirect labor consists of all salaries and wages paid to the staff for the purpose of carrying tasks incidental to goods or services, which will not form part of salaries and wages paid while working directly upon the product. Indirect expenses are those that are incurred by the organization while carrying out their total business activities and cannot be conveniently allocated to job, process, cost unit or cost centre.
The collection of overhead details is carried out using different documents. The documents that are used for the collection, allocation and apportionment of OH are standing order numbers, departmental distribution summary, journal, invoice and payroll.
The second step is the primary distribution of OH, i.e. the allocation and apportionment of expenses to cost centers. The allotment of whole item of cost, to cost centers or cost units is called cost allocation. Certain costs cannot be traced to particular cost units or cost centers. The proportionate allotment of costs over two or more cost centers or units is called cost apportionment. Cost allocation can be done directly, but cost apportionment needs a suitable basis for subdivision of costs. The third step is the reapportionment of service department costs to production departments. The reapportionment of service department costs to the production departments or cost centers is known as secondary distribution. The methods of redistribution of service department costs to production departments are direct redistribution method, step method and reciprocal service method. Under the direct redistribution method, the costs of service departments are directly apportioned to production departments without taking into account any service rendered by one service department to another service department. Thus, proper apportionment cannot be made and the production department may either be overcharged or under charged. As budgeted OH for each department cannot be prepared thoroughly, the department OH rates cannot be ascertained correctly. As per the step method, the cost of most serviceable departments is first apportioned to other service departments and production departments. The next service department is taken up and its cost is apportioned. This process goes on till the cost of the last service department is apportioned. Thus, the cost of the last service department is apportioned only to the production departments. The reciprocal service method considers the fact that every department should be charged for the services rendered to it. If two service departments provide service to each other, each department should be charged for the cost of service rendered by the other. The methods used under this approach can be classified as Simultaneous equation method Repeated distribution method; and Trial and error method When the simultaneous equation method is used, the equations are initially established. The steps include (a) the ascertainment of the true cost of service departments with the help of simultaneous equation; and (b) the redistribution to production departments on the basis of given percentage. When the repeated distribution method is used, the service department costs are repeatedly allocated in the specified percentages until the figures become too small to be significant. Under the trial and error method, the cost of one service department is apportioned to another center. The cost of another center plus the share received from the first center is again apportioned to the first cost center and this process is repeated till the balancing figure becomes negligible.
Under direct allocation, OH is directly allocated to various departments on the basis of expenses for each department respectively. Overtime premium of workers engaged in a particular department, jobbing repairs etc. are examples of direct allocation Under the direct labor hour basis, the OH expenses are distributed to various departments in the ratio of total number of labor hours worked in each department. Salaries of people like supervisors are apportioned on this basis On the basis of direct wages, expenses are distributed amongst various departments in the ratio of direct wage bills of the various department The total number of workers working in each department is taken as the basis for apportioning OH expenses among departments. Relative Areas of Departments Capital Values Light Points Kilowatt Hours Technical Estimates The area occupied by different departments forms the basis for the apportionment of certain expenses. Examples include lighting, rent, rates etc. Capital values are used as the basis of apportioning expenses like depreciation, insurance charges of the building etc. Light points are considered as the basis for apportioning lighting expenses. Kilowatt hours can be considered as the basis for apportioning the expenses incurred for power. Technical estimates is used as a basis for the apportionment of those expenses for which it is difficult to find out any other basis of apportionment.
The basic assumption of this method is that when one service department’s costs are apportioned, that particular department is then eliminated from any apportionment of the other service departments. This method ignores the concept of reciprocal services. Thus, this method ignores the complexity of situations in which two or more service departments simultaneously provide services to each other, as well as to production departments.
Cost allocation and cost absorption is the portioning of a cost among a set of cost objectives. For this purpose, the cost object could be production units, machines, groups of machines, individual products or groups of products. Companies that price all or a large part of their output on a cost-plus basis certainly need to include overheads in their cost of production. The absorption of overheads is also known as levy or recovery of overheads. The absorption process involves the distribution of overhead relating to a particular department among the units produced in that department during the relevant time period.
Actual rate The actual rate is computed by dividing the actual OH expenses incurred during a period of time by the actual quantum (quantity of value) of the base selected for that period. Predetermined rate In practice, actual OH costs are not always readily available for application since the total figure of OH cost incurred during the period will be ascertained only at the end of the accounting period and application of actual OH absorption is not possible. To overcome the difficulty, a predetermined OH absorption rate is calculated at the beginning of the accounting period and is applied to the completed units during the period. The major objective of using predetermined absorption rates is to recover the OH as soon as the product has been completed, to arrive at the product cost. It is calculated with the budgeted figures of the forthcoming accounting period based on the expected level of activity. Moving average rates These rates are a compromise between the actual rate and predetermined rate. It is computed by dividing the average of the past twelve months or six months actual OH cost by the estimated base for the months. Blanket and multiple rates A common absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they were produced is called blanket absorption arte. Such rate is not appropriate where there are number of departments in the factory and jobs do not spend an equal amount of time in each department. In some cases, all the jobs or units may not pass through all the departments, in the factory. In such circumstances departmental OH rate of respective departments is applied to the jobs or units depending on time spent in each department, to ensure that all jobs are charged with their fair share.
Under the rate per unit of production method, the OH rate is calculated by dividing the budgeted OH expense by the budgeted production. This method is simple and suitable for extractive industries. The OH rate for a particular job is determined as a percentage of direct wages under the direct wages method. The percentage is arrived at by dividing the OH expenses by direct wages and multiplying the result by hundred. Under the production hour method, the OH rate is calculated by dividing the OH expenses by the total productive hours of direct labor. Machine hour rate is suitable when the job is performed predominantly by machines. The machine hour rate is calculated by dividing the total running expenses of a machine during a particular period by the number of hours the machine is estimated to work during the period. The percentage of factory expenses to the value of direct material consumed in production is calculated to absorb the manufacturing overheads under the direct material cost method. The method can be used where output is uniform, where the prices of the materials are stable, where the proportion of OH to the total cost is significant. The rate under prime cost method is calculated by dividing the budgeted OH expenses by the prime cost incurred by cost center. The OH rate under sale price method is calculated by dividing the budgeted OH expenses by the sale price of units of production.
The OH rate is calculated by dividing the budgeted OH expense by the budgeted production under the rate per unit of production method. The method is more suitable for extractive industries.
The OH rate for a particular job is determined as a percentage of direct wages under the direct wages method. The percentage is arrived at by dividing the OH expenses by direct wages.
The overhead rate under the production hour method is calculated by dividing the OH expenses by the total productive hours of direct labor.
The OH rate under this method is calculated by dividing the total running expenses of a machine during a particular period by the number of hours the machine is estimated to work during the period.
The percentage of factory expenses to the value of direct material consumed in production is calculated to absorb the manufacturing over heads. The method is widely used in situations where the output is uniform, prices of materials are stable and also, where the proportion of OH to the total cost is significant.
The OH recovery rate under the prime cost method is calculated by dividing the budgeted OH expenses by the prime cost incurred by cost center.
Under the sale price method, the OH recovery rate is calculated by dividing the budgeted OH expenses by the sale price of units of production
The usage of supplementary rates facilitates the absorption of actual OH incurred for production. Correction of costs through supplementary rates is necessary for maintaining data for comparison. But, the rates can be determined only after the end of the accounting period. This method also requires a lot of clerical work.
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