Examining options for allocating overhead costs

Overhead cost is an ongoing expense of operating a business and is also usually used to group bills that are necessary to the ongoing functioning of the business, but cannot be immediately associated with the products/services being offered as in the expenses do in a roundabout way become profitable.

Overhead cost includes indirect product cost or indirect cost of responsibility centre. Indirect product cost is recognized as manufacturing overhead whereas indirect cost of responsibility centre is known as non-manufacturing cost. Manufacturing overhead is those making costs that are incurred to a variety of products. It can't be traced to specific products like depreciation and insurance of production equipment, cost of occupying, handling and preserving a production center. Manufacturing over head is the cost that could be traced to individual product but it is not worth the trouble to like cost of lubricants and glue used. Making overhead likewise incorporate cost that is more appropriately to be treated as cost of all outputs like overtime premium, cost of idle time, resources cost.

Non-manufacturing cost includes customer support, marketing and research & development cost.


Normally, only developing overhead is assigned to products. However, with regards to the industry the business enterprise is in and obtain more complete quotes of product cost, management accountant may allocate non-manufacturing cost to products. One of these is Apple Co. with high research & development cost, to acquire accurate product priced at, they allocate area of the research & development cost to product cost.


Production overhead, or usually make reference to as manufacturing over head, is recovered by absorbing them into the price tag on a product. This process is known as absorption costing. Absorption costing means that of the production costs are utilized by the models produced. Quite simply, the price of a finished device in inventory will include direct materials, direct labor, and both adjustable and fixed manufacturing overhead. Because of this, absorption costing is generally known as full costing or the entire absorption method.

Absorption costing is often contrasted with adjustable costing or direct costing. The fixed manufacturing overhead costs aren't allocated or given to (not absorbed by) the products manufactured under changing or immediate costing. Varying costing is often ideal for management's decision-making. However, absorption costing is often required for external financial reporting and then for tax reporting.

Absorption costing includes 3 stages, specifically apportionment of overheads, reapportionment or allocation of service (non-production) cost centre overheads and also absorption of overhead.

For apportionment of overheads, there are no hard and fast rules that basis of apportionment to utilize except that whichever method is employed to apportion overheads, it must be good. Unlike immediate cost, indirect cost is usually assigned to cost objects which is not directly followed to cost items. Cost subject is thought as item that is designated separate way of measuring cost. To assist in allocation of over head cost, over head cost which have common allocation foundation is pooled mutually and is known as cost pool. For each cost pool, bases of apportionment are chosen. Bases of apportionment are some factors or parameters that allow us to allocate costs in a cost pool to cost things. Selecting the base of apportionment should be on causal-and-effects grounds, which mean it ought to be a cost driver. Some examples of bases of apportionment include floor area, net reserve value of set assets and volume of employees. Floor area is usually used for lease and rates overhead. It is assumed that the greater the floor space occupied by the creation centers, the greater lease, cleaning and electricity consumption are consumed. World wide web book value of set assets can be used for depreciation and insurance of machinery. It is based on the assumption that - Variety of employees is employed for canteen cost. The assumption is when the amount of employees increases, the canteen cost will increase.


ABC Ltd has two creation departments (Assemblage and Finishing) and two service departments (Maintenance and Canteen). The following are budgeted costs for the next period:

The second level of absorption costing is reapportionment or allocation of service cost centre costs overhead to creation cost centers. Service cost centers (departments) are not directly involved with making products. Therefore the fixed production overheads of service cost centers must be distributed out between the creation cost centers using suitable basis. Examples of service cost centers or generally known as support team cost centers include maintenance section, payroll office, stores and canteen. As opposed to operating or creation department which engages in production of the products and directly provides value to something or service, support or service section supplies the service that assist and matches the smooth working of the production departments in the company.

Methods of allocating support or service section cost to production department include direct method, step-down method and reciprocal method.


The immediate method is the most widely-used method where it allocates each service department's total costs directly to the creation departments. It ignores the fact that service departments may also provide services to other service departments. Under this method, there is absolutely no relationship between service departments prior to allocation.


Machining and Assemblage are the only production departments that used the services of the RECRUITING Division in March. Costs from RECRUITING are allocated predicated on the amount of new hires. Machining hired seven employees in March and Set up employed three employees. Human Resources incurred total costs of RM93, 000 in March.

Allocation of H. R. Office costs to Machining:70% of RM 93, 000 = RM 65, 100

Allocation of H. R. Section costs to Assembly:30% of RM 93, 000 = RM 27, 900

No information is essential about whether any service departments utilised services of the RECRUITING Division is the characteristic feature of the direct method. It generally does not take bill whether no other service division employed anybody, or whether three other service departments each employed five employees (implying that more than 50% of the hiring happened in the service departments). Service office to service section services are ignored, no costs are allocated in one service department to some other when using the direct method.


Thestep-down methodor known as sequential method allocates the costs of some service departments to other service departments. However, once something department's costs have been allocated, no subsequent costs are allocated back again to it.

The selection of which department to begin with is very important. The sequence in which the service departments are allocated usually effects the best allocation of costs to the production departments, in that some creation departments gain plus some lose when the collection is improved. Hence, production team managers usually favor over the collection. The most defensible collection is to begin with the service department that provides the best ratio of its total services to other service departments, or the service division with the highest costs, or the service section that delivers services to the most number of service departments, or some similar criterion.


Human Resources (H. R. ), Data Handling (D. P. ), and Risk Management (R. M. ) provide services to the Machining and Assembly production departments, and perhaps, the service departments provide services to each other:


The amounts in the considerably left column will be the costs incurred by each service section. Any services a team provides to itself are dismissed, so the intersection of the row and column for every single service office shows zero. The rows amount to 100%, so that services provided by each service section are recharged out.

The company decides to allocate the expenses of RECRUITING first, since it provides services to two other service departments, and a greater ratio of its services to other service departments. However, a case could be made to allocate Data Handling first, since it has better total costs than either of the other two service departments. In any case, the company decides to allocate Data Handling second.

In the desk below, the row for every service section allocates the total costs for the reason that department (the initial costs incurred by the division plus any costs assigned to it from the previous allocation of other service departments) to the creation departments as well as to any service departments which have not yet been allocated.

After the first service team has been allocated, to be able to derive the percentages to apply to the creation departments and any staying service departments, it is necessary to "normalize" these percentages in order that they amount to 100%. For example, after H. R. has been allocated, no costs from D. P. can be allocated back again to H. R. The percentages for the remaining service and creation departments amount to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows:

For example, in the stand above, 59. 78% of RM136, 000 (= RM 81, 304) is assigned to Assemblage, not 55%.

The quality feature of the step-down method is that once the costs of something department have been allocated, no costs are allocated back to that service section. As can be seen by adding RM 105, 522 and RM 134, 478, all RM 240, 000 incurred by the service departments are eventually allocated to the two creation departments. The intermediate allocations from service section to service section improve the precision of those last allocations.


Thereciprocal method is the most correct among the list of three options for allocating service department costs. For the reason that it recognizes reciprocal services among service departments. However, it is also the most complicated method, since it requires solving a couple of simultaneous linear equations.

Using the info from the step-down method example, the simultaneous equations are:

H. R. =RM80, 000 + (0. 08 x D. P. )

D. P. =RM 120, 000 + (0. 20 x H. R. )

R. M. = RM40, 000 + (0. 10 x H. R. ) + (0. 07 x D. P. )

Where the parameters H. R. , D. P. and R. M. stand for the total costs to allocate from each of these service departments. For instance, Human Resources get services from Data Processing, but not from Risk Management. 8% of the services that Data Control provides, it provides to Human Resources. Therefore, the full total costs allocated from RECRUITING should include not only the RM 80, 000 incurred for the reason that department, but also 8% of the expenses incurred by Data Handling. Handling for the three unknowns (which can be performed using spreadsheet software):

To illustrate the derivation of the amounts in this desk, the RM36, 423 that is allocated from RECRUITING to Machining is 40% of H. R. 's total cost of RM 91, 057.


Direct method allocates support cost only to operational departments and there in no interaction between support departments prior to allocation. On the other hand, step down method allocates support costs to other support departments also to functioning departments that partially recognizes the mutual services provided among all support departments. Under this method, there may be one-way connection between support departments prior to allocation. Reciprocal method allocates support office costs to functioning departments by completely recognizing the common services provided among all support departments. It is full two-way Connection between support departments prior to allocation.

Direct, step-down and reciprocal methods of support team cost allocation provided slightly different total overhead cost and over head rates for every single production department. It is because of the different recognition that each method gives to aid relationships. The immediate method will not recognize any interactions that exist between support departments whereas step-down method gives only partial acknowledgement to these romantic relationships.

Reciprocal method provides most correct results when allocating of multiple service departments' costs to working departments. The energy of reciprocal method over other methods (immediate method, step-down method) is based on its considering the mutual services provided among all service departments which means the costs of service departments are assigned to each service section (except the company) besides working departments.

However the application of this more powerful method is exceptional. For the reason that it is more complicated than other methods and it requires sophisticated computer help. Some firms that use ERP software since this technique requires additional changes in coding. Therefore most of the companies prefer using either of immediate or step down methods. Reciprocal method considers shared services provided among all service departments, direct method and step-down method ignore this point. Moreover service team cost used by other service departments are also disregarded in direct method. The drawback of direct method is partly reduced by step-down method by following a hierarchy among service departments while considering cost allocation.

There is a standing among service departments concerning which division to commence allocation corresponding to different rules which yields different allocation statistics. The disadvantage of step-down solution to reciprocal method is that once the cost accumulated in the first in positioning service department is allocated, that section will not take any talk about from other service departments. Two main guidelines determine the raking. The first approach considers the number of departments served by the service departments to guage on which service team to commence allocation and those to move on. The service department that functions to the best quantity of departments is the first section to start allocation. In case of several department serve the best volume of departments, the team with highest accumulated costs is the first in the ranking etc.

The second procedure adopts the ratio of service in identifying the rank of service department to begin with also to carry on. The service division with highest ratio of service to other departments is the first in the rating and so forth. In case there is several department with identical the best service percentage, the one with higher accumulated costs is defined as the first and so on.

Lastly reciprocal method or algebraic allocation method (REC) considers all offered departments including service departments and working departments by something department except the main one whose costs are allocated. There's a two way discussion among service departments unlike step-down method. The technique yields equations with multiple unknowns which can be equal to the amount of service departments because the method considers all the expenses of the service departments to be allocated. As the amount of service departments raise the number of equations with multiple unknowns increase and hence a computer help must solve the equations all together.


Out of the 3 allocation methods to allocate service/ support division cost to development section cost, reciprocal method is said to be the most exact method. It is also the most complicated method as it needs solving a couple of simultaneous linear equations. However, immediate and step-down methods are simple to compute and easy to comprehend. Nonetheless, immediate method is the most widely used in industry. Immediate method allocates each service department's total costs directly to the creation departments, and ignores the actual fact that service departments may also provide services to other service departments. The direct method and step-down method have no advantages in the reciprocal method except for their simpleness, and the step-down method may also be not so simple. Nevertheless, the reciprocal method is not widely used. Given developments in computing electric power, the reciprocal method would appear to be accessible to numerous companies that are not using it. Presumably, these companies believe that the benefits obtained from more appropriate service department cost allocations do not justify the expenses required to use the reciprocal method.

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