Managing overhead costs is a critical aspect of financial management for companies in a variety of industries. When it comes to allocating and accounting for overhead costs, three key concepts often come into play: allocation, apportionment, and absorption. While these terms may sound similar, they represent different approaches to dealing with overhead. In this article, we will explore the differences between allocating, apportioning, and absorbing overhead costs, as well as their unique characteristics and applications.
Allocation of Overhead Costs
Allocation refers to the process of distributing overhead costs to different cost centers or departments within an organization. This method involves assigning a portion of the total overhead costs to specific departments based on a predetermined basis or allocation key. The allocation key can be determined by factors such as labor hours, machine hours, or square footage. The purpose of apportionment is to allocate a fair share of overhead costs to each department, allowing for better cost tracking, performance evaluation, and decision making.
Apportionment of Overhead Costs
Apportionment, on the other hand, is the process of dividing or distributing overhead costs among different cost centers or departments when the costs cannot be directly attributed to a specific department. Unlike allocation, apportionment is used when overhead costs are shared by multiple cost centers or cannot be accurately attributed to a single department. Apportionment is typically based on a predetermined basis that reflects the proportional use or benefit received by each cost center. Common apportionment bases include direct labor costs, machine usage, or sales revenue. By using apportionment, organizations can ensure a more equitable distribution of shared overhead costs among relevant departments.
Absorption of Overhead Costs
Absorption refers to the process of including overhead costs as part of the cost of producing goods or services. It involves absorbing overhead costs into the cost of units produced by including them in the cost per unit or overhead absorption rate. The overhead absorption rate is calculated by dividing the total overhead costs by an appropriate allocation base, such as direct labor hours or machine hours. By absorbing overhead costs, organizations can accurately determine the total cost of production, which is critical for pricing decisions, profit analysis, and inventory valuation. Overhead absorption also helps align costs with the goods or services produced, providing a more complete picture of the true cost of production.
Challenges in implementing Allocation, Apportionment, and Absorption methods
Implementing allocation, apportionment, and absorption methods for overhead costs in business operations can present several challenges. It’s important to be aware of these challenges in order to effectively address them and ensure accurate financial management. Here are some common challenges that organizations may face:
- Identifying appropriate allocation bases: Selecting appropriate allocation bases that accurately reflect the use or benefit received by different departments or cost centers can be challenging. Determining the right factors, such as labor hours, machine hours, or square footage, requires careful analysis and consideration of the specific operations and cost drivers within the organization.
- Data availability and accuracy: Accurate and reliable data is critical to effective allocation, apportionment, and absorption. Organizations may face challenges related to the availability, completeness, and accuracy of data needed to calculate overhead costs and determine appropriate allocation bases. Incomplete or inaccurate data can lead to distorted cost allocations and inaccurate financial reporting.
- Cost distortion: Allocation, apportionment, and absorption methods have the potential to distort the true cost of products or services. Overhead costs may not be distributed evenly or allocated proportionally, resulting in cost discrepancies between departments or products. This can affect pricing decisions, profitability analysis, and overall cost control.
- Changing cost structures: Overhead costs can vary over time due to changes in business operations, technology, or market conditions. Implementing allocation, apportionment, and absorption methodologies can be challenging as the cost structure evolves because the existing allocation bases and rates may no longer accurately reflect the cost drivers. Periodic review and adjustment of allocation methods is necessary to adapt to changing circumstances.
- Complex organizational structures: Large organizations with complex organizational structures, multiple departments, and interdepartmental dependencies may face challenges in accurately allocating and assessing overhead costs. Determining the appropriate basis for cost allocation and ensuring a fair distribution to various cost centers can be complicated and time-consuming.
- Cost visibility and transparency: Implementing allocation, apportionment, and absorption methodologies can sometimes make it difficult to achieve complete cost visibility and transparency. It can be challenging to track and analyze individual overhead costs and their impact on specific departments or products. Companies should strive to maintain transparency and ensure that the allocation methods used provide meaningful insight into cost structures.
- Compliance with accounting standards: Compliance with relevant accounting standards and regulations is essential when implementing allocation, apportionment and absorption methods. Companies need to ensure that the methods they choose comply with accounting standards such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
To address these challenges, companies should establish robust data collection and reporting systems, regularly review and update allocation methods, and seek professional guidance when needed. By proactively addressing these challenges, companies can increase the accuracy of their cost allocations, improve decision making, and achieve better financial management.
Conclusion
Allocating, apportioning, and absorbing overhead costs are different approaches to managing and accounting for indirect costs in organizations. Allocation involves the distribution of overhead costs to specific departments, assessment involves the distribution of shared costs to relevant cost centers, and absorption involves the inclusion of overhead costs in the cost of goods or services produced. Understanding these differences is critical for accurate cost tracking, performance evaluation, and informed decision making. By effectively implementing these methods, organizations can gain greater control over overhead costs, optimize resource allocation, and improve overall financial management.
FAQ
What are the difference between allocation apportionment and absorption of overhead?
Allocation, apportionment, and absorption are three different approaches to managing overhead costs within an organization.
Allocation is the process of distributing overhead costs to specific departments based on a predetermined basis, such as labor hours or square footage. It ensures a fair distribution of costs and enables better cost tracking and performance evaluation within each department.
apportionment on the other hand, is used when overhead costs cannot be directly attributed to a single department. It involves allocating shared costs to multiple cost centers on a predetermined basis that reflects the proportionate use or benefit received by each center.
Absorption refers to the inclusion of overhead costs in the cost of goods or services produced. It involves calculating an overhead absorption rate and including overhead costs in the cost per unit. Absorption allows companies to accurately determine the total cost of production, which aids in pricing decisions and profit analysis.
Cost allocation for management profit analysis
Any company with several types of activity faces the need for management evaluation of the financial result of each of them. The main issue in solving such a problem is correct determination of expenses related to separate lines of work.
Basic principles of managerial accounting of expenses for analysis of profit of separate lines of work of the company
In order to get reliable information about financial results of different activities of the company, it is necessary to define income and expenses related to each of them objectively and as precisely as possible. Determination of income part in most cases does not cause difficulties. The main volume of analytical work falls on the calculation of costs. From all possible classifications of expenses for an estimation of profitability of separate business directions (as well as separate goods and services) classification of expenses on direct and indirect is actual.
What are the difference between allocation apportionment and absorption of overhead?
Allocation of Overheads refers to the allocation of whole item of cost into Cost Centre and Cost Unit. In this, it allocates to the particular cost centre in which they relate. Apportionment of Overheads refers to the allocation of proportion of item to the Cost Centre and Cost Unit among different departments.
What is the difference between apportionment of overhead and absorption of overhead?
The distribution of such overhead to several departments or cost centres proportionately on some equitable basis is known as apportionment of overheads. The process of the overhead of a cost centre or department to different cost units or product is called absorption of overhead.
What is the difference between allocation and apportionment?
Allocation of cost means a process in which the entire amount of overhead is charged to a specific cost center. On the contrary, Apportionment of cost can be understood as the distribution of proportions of cost items to the cost unit, i.e. product or service or the cost center.
What is meant by absorption of overheads and allocation of overheads?
Overhead absorption is the amount of indirect costs assigned to cost objects. Indirect costs are costs that are not directly traceable to an activity or product. Cost objects are items for which costs are compiled, such as products, product lines, customers, retail stores, and distribution channels.
What are the objectives of overhead apportionment and absorption?
Allocate or apportion the overheads among the various departments on suitable basis. The ultimate aim of Overhead Accounting is to absorb them in the product units produced by the firm. Thus, the indirect costs or overhead will have to be distributed over the final products so that the charge is complete.
What is mean by allocation of overheads?
Overhead allocation is the apportionment of indirect costs to produced goods. It is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.
Which is the process of allocation and apportionment of overhead to different department?
Primary distribution of overhead involves allocation or apportionment of different items of overhead to all departments of a factory. This is also known as departmentalization of overheads.
What is absorption of overhead with example?
Absorption of overhead cost. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. read more is a set requirement by both GAAP and IFRS.
What are the different methods of absorption of overheads?
Methods of Overhead Absorption
- Direct Material Cost Method.
- Direct Labour Cost Method.
- Prime Cost Method.
- Direct Labour Hour Method.
- Rate Per Unit of Production Method.
- Sales Price Method.
What is cost absorption?
What Is Absorbed Cost? Absorbed cost, also known as absorption cost, is a managerial accounting method that includes both the variable and fixed overhead costs of producing a particular product. Knowing the full cost of producing each unit enables manufacturers to price their products.
What is meant by cost absorption and cost apportionment?
Cost apportionment means the allotment of proportions of items of cost of cost centers or cost units. Cost Absorption: Cost absorption means allotment of overhead expenses to cost units. Overhead absorption is usually achieved by the use of one or a combination of overhead recovery rates.
How do you apportion allocate and overhead?
Quote from video: Cost between cost centers or products that we’re creating on a fair basis. And we do this in three steps. So what we do is known as allocation apportionment. And absorption.
What is the difference between absorption costing and variable costing?
Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period. Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
What is the basic difference between direct costing and absorption costing?
The fundamental difference between the two systems is one of timing. The direct costing model takes all the fixed cost to the income statement immediately. The absorption costing model assigns the fixed cost to units produced during the period.
What are the basis of apportionment of overheads?
Basis for Apportionment
The basis used for apportionment of costs is the number of cost centres when the expenses are to be shared equitably between them. This happens when an overhead can not be assigned directly to one specific cost centre.
What is overhead reapportionment?
It means re-distribution of service cost centres’ overheads to production cost centres on some suitable basis/method because, the overheads are finally recovered through the production cost centres only.
What is difference between cost control and cost reduction?
Cost Control focuses on decreasing the total cost of production while cost reduction focuses on decreasing per unit cost of a product. Cost Control is a temporary process in nature. Unlike Cost Reduction which is a permanent process. The process of cost control will be completed when the specified target is achieved.
What are the principles of apportionment of overheads?
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.
What is cost absorption?
What Is Absorbed Cost? Absorbed cost, also known as absorption cost, is a managerial accounting method that includes both the variable and fixed overhead costs of producing a particular product. Knowing the full cost of producing each unit enables manufacturers to price their products.
What is cost absorption and cost apportionment?
Cost apportionment means the allotment of proportions of items of cost of cost centers or cost units. Cost Absorption: Cost absorption means allotment of overhead expenses to cost units. Overhead absorption is usually achieved by the use of one or a combination of overhead recovery rates.
Cost definition and allocation
Cost allocations move costs and revenues between cost types, cost centers and cost objects. You can define as many allocations as you need. Each assignment consists of:
- An allocation source.
- One or more allocation destinations.
The allocation source determines which costs are to be allocated, and the allocation destinations determine where the costs are to be allocated. For example, an allocation source may be the costs of cost type Electricity and Heating. Allocate all electricity and heating costs to three cost centers: Workshop, Production and Sales. These cost centers are the allocation destinations.
For each allocation source, you can define an allocation level, a validity period and a variant as group identifier. You can use a batch job to define filters to select allocation definitions and then execute cost allocations automatically.
For each allocation target, you define an allocation base. The allocation base can be static or dynamic.
- Static allocation bases are based on a defined value, for example square meters or a set allocation ratio, such as 5:2:4.
- Dynamic allocation bases are based on changeable values, such as the number of employees of a cost center or the sales revenue of a cost object in a certain period of time.
The following table describes a sequence of assignments, with links to topics that describe them.