What are Overhead Costs?
Overhead costs are those expenses incurred in the course of running a business that cannot be connected to a specific product or service.
Apportionment of Overhead Expenses: Definition
Certain overhead expenses cannot be charged completely to a specific department or shop. Such expenses are apportioned in a suitable ratio over several departments or shops.
Apportionment is the process of distributing overhead items to cost centers on a fair and reasonable basis.
The principle is that if an overhead item cannot be fully allocated to one cost center, it should be apportioned over related cost centers.
This involves finding out a suitable basis of apportionment that enables the overhead item to be shared equitably across the cost centers.
Departmentalization: A Procedure for Apportionment of Overhead Expenses
For the apportionment of overhead expenses, the departments of a factory are divided into two categories: production and service departments.
Production departments are directly engaged in manufacturing products. For example, in a garment factory, production may be shared across the cutting, stitching, finishing, and packing departments.
Service departments do not perform operations on products to be manufactured. Instead, they provide auxiliary services to support the production departments. These services include repairs and maintenance, purchasing, storeroom, training, and payroll.
Principles of Apportionment of Overhead Expenses
The guidelines used to find a suitable basis for the apportionment of overheads expenses are explained below.
1. Derived Benefit
This principle states that the apportionment of common overhead items should be based on the actual benefit received by the respective cost centers. This method is applicable when the actual benefits are measurable.
For example, rent can be apportioned based on the floor area occupied by each department.
2. Potential Benefit
According to this principle, common overhead items should be apportioned based on potential benefits (i.e., benefits likely to be received). When the measurement of actual benefits is difficult, impossible, or uneconomical, this method is adopted.
For example, the cost of a canteen can be apportioned based on the number of employees in each department, which is a potential benefit.
3. Ability to Pay
According to this principle, overheads should be apportioned based on the saleability or income-generating ability of the respective departments. In other words, departments that contribute more profit should receive a higher proportion of overheads.
4. Efficiency Method
This principle states that the apportionment of overhead expenses should be made based on production targets. If the target is higher, the unit cost falls, indicating higher efficiency. By contrast, if the target is not achieved, the unit cost rises, indicating departmental inefficiency.
5. Specific Criteria Method
According to this principle, apportionment of overhead expenses is made based on criteria determined using a survey. Hence, the specific criteria method is also known as the survey method.
When it is difficult to choose a suitable basis in other methods, it is worthwhile to use the survey method.
For example, using the method when apportioning a foreman’s salary, a careful survey would be made to know how much time and attention the foreman gives to different departments. The apportionment is made based on the survey.
Stages of Apportionment of Overhead Expenses
The overhead apportionment process takes place in two stages: the primary and secondary apportionments.
1. Primary Apportionment
Many overhead expenses are incurred for the common benefit of several departments. Examples include the costs of fire insurance, repairs and maintenance, and rent.
To apportion expenses at the primary apportionment stage, such items are apportioned to benefiting departments. A useful process to apply to apportion overhead expenses is to understand the basis of apportionment of overhead expenses and then to use them.
There are various bases on which it is possible to apportion overhead items over different departments. The choice of an appropriate basis is really a matter of judgment.
By using the appropriate basis, all overhead items will be apportioned to the relevant production departments and service departments.
Suppose a company’s total rent is $5,000. The areas of three departments, A, B, and C, are as follows:
- Area of department A is 100 square feet
- Area of department B is 200 square feet
- Area of department C is 700 square feet
Now, the total ratio of A : B : C is 1 : 2 : 7. Therefore, the total rent expenses (TRE) for each department are:
- TRE department A = (5,000) x 1/10 = $500
- TRE department B = (5,000) x 2/10 = $1,000
- TRE department C = (5,000) x 7/10 = $3,500
This example shows that the total overhead cost will be apportioned across the departments on some basis. The basis for rent apportionment, in this case, is the area of the department.
2. Secondary Apportionment
The secondary apportionment stage reapportions service department overheads to the production departments. The objective of this stage is to ensure that only the production departments bear all overhead costs, which will eventually be charged to products.
Such reapportionment is needed to calculate predetermined overhead absorption rates for production departments, through which overheads are assigned to products. The basis for secondary apportionment is also the value of the benefit derived.
In a store department (i.e., a service department), the store service cost is $1,000.
Production department A has consumed 4000 units and production department B has consumed 6,000 units. Therefore, the store service department cost will be reapportioned on the basis of the material consumed by different departments.
Department A’s store service cost = 1,000 x 4/10 = $400 Department B’s store service cost = 1,000 x 6/10 = $600
In this example, the total materials consumed is 4,000 + 6,000 = 10,000. Therefore, the above ratio is calculated as:
Department A = 4,000 / 10,000 = 4/10 Department B = 6,000 / 10,000 = 6/10
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.