Welcome back. In our previous lessons, we've explored how costs behave, and you've mastered the high-low method for splitting semi-variable costs into their fixed and variable parts. Now, we'll turn our attention to a major category of costs that are essential for product costing: indirect costs, more commonly known as overheads.
This lesson focuses on the critical process of assigning these overheads to the parts of the business that incur them. The learning outcome is to allocate and apportion production overheads to cost centers using a suitable basis. This is the foundational step in determining the full production cost of a product, a multi-stage process that is a cornerstone of the ACCA Management Accounting exam. We will cover the first two stages:
- Primary Distribution: Assigning general factory overheads to all departments (both production and service).
- Secondary Distribution: Re-assigning the costs of service departments to the production departments.
By the end of this lesson, you will be able to take a list of factory-wide overheads and systematically channel them into the specific production departments where goods are actually made.
The Goal: From Factory-Wide Costs to Departmental Costs
Imagine a factory that makes furniture. The factory has a large rent bill, a single electricity meter, and a canteen for all workers. It also has two production departments (Woodworking and Finishing) and one service department (Maintenance). The total rent doesn't tell us how much it costs to run just the Woodworking department.
To find the true cost of making a table, we first need to figure out the total overhead cost for each production department. This process of sharing out the factory-wide costs is what we're learning today. It involves two key activities: allocation and apportionment.
Step 1: Primary Distribution - Allocation and Apportionment
Overheads are first distributed to all departments in a process called Primary Distribution. This uses two techniques: allocation and apportionment. It's crucial you understand the difference, as they are not interchangeable.
A fantastic, clear explanation of this is provided in the following video by FOG Accountancy Tutorials.
ACCOUNTING FOR OVERHEADS (PART 1)
This video clearly outlines the stages of overhead accounting and then provides a simple, effective distinction between allocation and apportionment.
First, watch the overview of the stages of overhead accounting from this segment. This will give you a mental map of the entire process. Then, pay close attention to the explanation of allocation vs. apportionment from this part of the video. The example of a shared electricity meter is a perfect illustration of apportionment.
To summarize the key points from the video:
- Allocation is the process of charging an entire overhead cost directly to a specific cost center. This is only possible when a cost can be uniquely identified with one department. For example, the salary of a supervisor who works exclusively in the Finishing department would be allocated entirely to that department.
- Apportionment is the process of sharing out an overhead cost between multiple cost centers on some logical and fair basis. For example, the factory rent bill, which benefits all departments, must be apportioned among them.
Step 2: Choosing a Suitable Basis for Apportionment
For apportionment to be fair and logical, the basis we choose must reflect how the overhead was consumed by the different departments. A poor choice of basis can lead to inaccurate product costs and can even affect how managers are perceived to be performing. If a department manager feels they are being unfairly charged with costs outside their control, it can be highly demotivating—a small but important psychological aspect to consider in costing.
The following resource provides a comprehensive list of common overheads and the most logical basis for their apportionment.
[PDF] Overhead Cost - Dr.Nishikant Jha Ph.D
This PDF provides the detailed definitions and lists that you will need for your exam. It clearly separates allocation from apportionment and gives you a toolkit of apportionment bases.
First, read the definitions of cost allocation and cost apportionment to solidify the concepts from the video. Next, carefully study the section titled Bases of Apportionment. This lists the most common and examinable bases. Make a mental note of the relationship between the type of cost and the basis used.
Here is a summary of the most common bases you will encounter:
| Overhead Cost Item | Most Suitable Basis of Apportionment |
|---|---|
| Rent, Rates, Heating, Lighting, Building Insurance | Floor Area occupied by each department |
| Depreciation, Insurance of Machinery | Net Book Value (NBV) or Cost of Machinery in each department |
| Canteen, HR, Welfare, General Admin | Number of Employees in each department |
| Power (for machines) | Kilowatt Hours or Horsepower of machines |
| Stores / Material Handling | Value or Volume of materials issued to each department |
Now, let's apply this to a practical, exam-style scenario.
Practice: Primary Overhead Distribution
Let's use the past exam question for 'WRAPWELL LTD' to perform a primary overhead distribution.
The company has three departments: Plastics Moulding (Production), Plastics Extrusion (Production), and Maintenance (Service). Our first task is to take the total fixed overheads and assign them to these three departments.
1. Identify the Overheads to be Apportioned:
- Insurance of machinery: £22,400
- Rent and rates: £60,800
2. Identify the Allocated Overheads:
- Indirect labour costs: These are already given for each specific department. This means they have already been traced and can be directly allocated.
- Plastics Moulding: £90,500
- Plastics Extrusion: £78,300
- Maintenance: £22,800
3. Select the Apportionment Bases:
- Insurance of machinery (£22,400): This relates to the value of the assets. The most suitable basis is the NBV of fixed assets.
- Rent and rates (£60,800): This relates to the space occupied. The most suitable basis is Square metres occupied.
4. Perform the Calculations:
Let's create an overhead analysis sheet:
| Total (£) | Basis of Apportionment | Plastics Moulding (£) | Plastics Extrusion (£) | Maintenance (£) | |
|---|---|---|---|---|---|
| Allocated Costs | |||||
| Indirect labour | 191,600 | (Direct) | 90,500 | 78,300 | 22,800 |
| Apportioned Costs | |||||
| Rent and rates | 60,800 | Floor Area (11:8:1) | 33,440 | 24,320 | 3,040 |
| Insurance of machinery | 22,400 | NBV of Assets (6:3:1) | 13,440 | 6,720 | 2,240 |
| Total Overheads | 274,800 | 137,380 | 109,340 | 28,080 |
Working for Rent and Rates (Total area = 1,100 + 800 + 100 = 2,000 sq m):
- Moulding: (£60,800 / 2,000) * 1,100 = £33,440
- Extrusion: (£60,800 / 2,000) * 800 = £24,320
- Maintenance: (£60,800 / 2,000) * 100 = £3,040
Working for Insurance (Total NBV = 720 + 360 + 120 = £1,200k):
- Moulding: (£22,400 / 1,200) * 720 = £13,440
- Extrusion: (£22,400 / 1,200) * 360 = £6,720
- Maintenance: (£22,400 / 1,200) * 120 = £2,240
At the end of this primary distribution, we have the total overhead cost for each department. However, we cannot leave costs in the 'Maintenance' department, as no products pass through it. This leads us to our final step.
Step 3: Secondary Distribution - Re-apportioning Service Departments
The costs accumulated in service cost centres must be shared out among the production cost centres. This is called Secondary Distribution or Re-apportionment.
There are three common methods for this, which are explained perfectly in the official ACCA Global article. For your exam, the algebraic method is the most important to master for situations with reciprocal services.
This article from ACCA is your go-to guide for secondary distribution. It covers the three key methods with clear, exam-style examples.
Please read the article, focusing on the following: Start with the introduction to the direct method. Understand that this method ignores any services provided between service departments. Next, read the section on the step-down method. Note the key principle: you start with the service department that serves the most other service departments. Finally, read the section on the reciprocal method. Pay very close attention to the final sentence which states the focus for the MA exam will be the algebraic approach. Work through the setup of the simultaneous equations in the algebraic approach example.
Let's complete our WRAPWELL LTD example by re-apportioning the Maintenance department's costs.
- Total Maintenance overhead = £28,080 (from our primary distribution).
- The question states: "70% of the Maintenance department's time is spent maintaining equipment in the Plastics Moulding department."
- Since there are only two production departments, the remaining 30% must be for the Plastics Extrusion department.
- This is a simple one-way service, so we can use a direct re-apportionment.
Re-apportionment Calculation:
- Charge to Plastics Moulding: £28,080 * 70% = £19,656
- Charge to Plastics Extrusion: £28,080 * 30% = £8,424
Now we can find the final total overheads for the production departments:
| Plastics Moulding (£) | Plastics Extrusion (£) | Maintenance (£) | |
|---|---|---|---|
| Total from Primary | 137,380 | 109,340 | 28,080 |
| Re-apportionment of Maintenance | +19,656 | +8,424 | (28,080) |
| Final Total Overheads | 157,036 | 117,764 | 0 |
After this process, all factory overheads now reside in the two production departments.
Conclusion
In this lesson, you've learned the essential mechanics of overhead allocation and apportionment, a fundamental process in management accounting. You now understand how to take a pool of general factory costs and systematically assign them to the departments that ultimately create the products.
Key Takeaways:
- Primary Distribution is the first step, assigning overheads to all departments.
- Allocation is used for costs directly traceable to a single department.
- Apportionment is used to share common costs across multiple departments using a fair and logical basis (e.g., rent by floor area).
- Secondary Distribution is the second step, where service department costs are re-apportioned to production departments. Key methods include the direct, step-down, and reciprocal (algebraic) methods.
We have now successfully collected all production overheads into the production cost centers. The logical next question is: how do we get these costs out of the departmental "pots" and into the cost of each individual product? This is achieved by calculating an Overhead Absorption Rate (OAR), which will be the entire focus of our next lesson.