** Understanding Overhead Allocation in Cost Accounting**

1. Overheads • Overhead includes a large number of types of indirect costs • Direct cost are identifiable to cost units, but overhead which are often considerable, cannot be related directly to cost units

2. Two-stage method to allocate overhead to products • Overheads are assigned to the cost centres such as department • An allocation base is selected for allocating production centre expenses to products

3. Procedures of overhead allocation to product • Assign all factory overheads to cost centres • Reallocate service-centre overheads to production cost centres • Calculate separate overhead absorption rate for each cost centre • Assign cost-centre overhead to products

4. Assign all factory overhead to cost centres • Cost allocation • Cost apportionment

5. Cost allocation • Where a cost can be clearly identified with a cost center or cost unit, then it can be allocated to that cost center or cost unit

6. Cost apportionment • It is not possible to identify a discrete item of cost with a cost center and it is necessary to split a cost over several cost centers on some agreed basis

7. Bases of apportionment • Apportionment of indirect expenses to cost centers must be made on fair and reasonable bases • Different types of expense require different bases according to their individual characteristics

8. Exampletextbook P.183

9. Calculate separate overhead absorption rate for each cost centre • To determine the overheads to be absorbed by a cost centre, it is necessary to establish an overhead absorption rate (OAR) Total overhead of cost centre OAR = Total number of units of absorption base applicable to cost centre

10. An appropriate OAR should reflect the effort or time taken to produce the products • Some commonly used absorption bases are listed as follows:

11. Example textbook P.183

12. Predetermined overhead absorption rates (POAR) • The overhead absorption rates are usually computed in advance of operations • In practice, most absorption rates are only predetermined because the actual overheads are not known until the end of the period • If the actual overheads are used to compute the OAR, the product cost can only be obtained at the end of the accounting period • A delay in product cost calculation will also affect the pricing setting, the profit calculation and stock valuation As identified by the IMA

13. The formula of POAR The formula are as follows: Budgeted total overheads POAR = Budgeted total number of units of absorption base

14. Under-absorption and over-absorption base • Since the POAR are based on the estimated production and estimated overheads, the overheads absorbed seldom agree with the actual overheads incurred for the period • Under-absorption occur when overhead absorbed are small than the actual overheads • Over-absorption occurs when the overhead absorbed are greater than actual overheads

15. For financial accounting, under- or over-absorption of overheads should be treated as period cost and written off against the profit and loss account in the current accounting period • The under- or over-absorption of overheads should be debited or credited to the profit and loss account • The under-absorbed overheads should be deducted from profit and vice versa