Distribution of Overheads

Overheads refer to the indirect costs incurred during production that cannot be directly attributed to a specific product or service. The distribution of overheads is essential for ensuring accurate product costing and effective financial management. The process involves three key steps: Allocation, Apportionment, and Absorption of overhead costs across different cost centers and units.

Allocation of Overheads

Allocation refers to directly assigning specific overhead costs to a cost center. This is possible when the overheads are incurred for a particular department or activity.

For example:

• Factory rent is allocated to the production department.

• Salaries of departmental managers are assigned to their respective departments.

• Electricity costs of a machine are allocated to that machine’s operational cost center.

Proper allocation ensures that identifiable costs are assigned accurately, minimizing cost distortions in product pricing.

Apportionment of Overheads:

Apportionment is the process of dividing general overhead costs among multiple cost centers in a fair and logical manner. Overheads that benefit more than one department but cannot be directly assigned are apportioned based on relevant bases.

Some common bases for overhead apportionment include:

• Factory rent → Apportioned based on the floor area occupied by each department.

• Electricity expense → Distributed based on the number of units consumed by each department.

• Depreciation on machinery → Allocated according to the machine’s usage time in different departments.

The objective of apportionment is to ensure that shared costs are fairly distributed across departments, improving cost accuracy.

Absorption of Overheads:

Absorption refers to the process of charging overheads to individual products, services, or jobs. Once overheads are allocated and apportioned, they must be absorbed into the cost of production to determine total product costs.

There are several methods of overhead absorption, including:

• Percentage on Direct Material Cost → Suitable when material cost is a major production expense.

• Percentage on Direct Labor Cost → Applied when labor-intensive production methods are used.

• Machine Hour Rate → Used when machines are heavily involved in the production process.

• Direct Labor Hour Rate → Suitable when labor hours significantly impact production.

Proper absorption ensures that all indirect costs are covered and accurately reflected in product pricing, preventing financial losses.

Methods of Overhead Distribution:

Overhead distribution is carried out through two primary methods:

a) Primary Distribution

Primary distribution refers to the initial allocation and apportionment of overheads to different cost centers. This process divides expenses such as rent, power, depreciation, and administration costs among all departments (production and service departments).

b) Secondary Distribution

Secondary distribution involves reallocating the service department costs to production departments. Since service departments (e.g., maintenance, canteen, stores) do not directly contribute to production, their costs are transferred to production departments based on appropriate bases. Common methods of secondary distribution include:

• Direct Redistribution Method → Service department costs are directly assigned to production departments.

• Step Ladder Method → Service departments are ranked in order of importance, and costs are distributed step by step.

• Reciprocal Distribution Method → Used when service departments provide services to each other.

Proper secondary distribution ensures that all costs are included in the final product cost, leading to accurate pricing decisions.

Importance of Overhead Distribution:

• Ensures Accurate Product Costing → By distributing overheads properly, businesses can determine the true cost of production.

• Facilitates Budgeting & Cost Control → Helps in monitoring and controlling indirect expenses.

• Aids in Pricing Decisions → Correct cost distribution ensures competitive pricing.

• Improves Financial Performance → Reduces cost distortions and prevents underpricing or overpricing of products.