6.1 Overheads: Collection, Allocation and Apportionment (Background)

6.1 Overheads: Collection, Allocation and Apportionment (Background)

Key Concept: Overheads are indirect operating costs that cannot be traced directly or economically to an individual cost unit. Under absorption costing, overheads must be collected, allocated directly where whole costs attach to a specific department, and apportioned across cost centres using equitable, causal bases such as floor area, employee headcount, machine values, or power consumption. This initial distribution is recorded on an Overhead Analysis Sheet (OAS).

PCTN scope: PCTN examines overhead absorption (Section 6.2): calculating rates per unit, per labour hour and per machine hour from budgeted overheads that the task gives you. AAT's specification says the unit gives students "the basic tools for studies in overhead apportionment, reapportionment and absorption in later units", so apportionment and reapportionment calculations belong to Level 3. This section explains where a cost centre's overhead total comes from, so that absorption makes sense. Treat the apportionment example as background.

The Nature and Classification of Overheads

In financial and management accounting, total operational expenditure is bifurcated into direct costs and indirect costs:

• Direct Costs (Prime Cost): Expenditures that can be directly, unambiguously, and cost-effectively traced to a specific unit of product, service, or job. These consist of direct materials, direct labour, and direct expenses.
• Indirect Costs (Overheads): Costs incurred in operating the business that cannot be traced directly to a single cost unit. They represent expenditures that support production and commercial activities collectively.

A standard textbook definition of overheads is:

"The total cost of indirect materials, indirect labour and indirect expenses."

Overheads are classified by element and function:

1. Indirect Materials: Material items consumed in operations that do not form a primary, measurable component of the finished good. Examples include machine lubricants, cleaning rags, cutting fluids, maintenance drill bits, and low-value consumables like packing glue.
2. Indirect Labour: Remuneration paid to employees who support operations but do not work directly on the product. Examples include factory production supervisors, maintenance mechanics, material storekeepers, quality control inspectors, and forklift truck operators.
3. Indirect Expenses: Operating expenses that cannot be assigned to an individual cost unit, including factory rent, municipal business rates, building insurance, electricity, machine depreciation, and welfare costs.

Functional Classification of Overheads

From a functional perspective, modern enterprises segment overheads into:

• Production (Manufacturing) Overheads: All indirect costs incurred within the factory gates from the point raw materials are received to the completion of finished goods. Under UK GAAP (FRS 102) and International Accounting Standard (IAS) 2, production overheads must be absorbed into product inventory valuations.
• Non-Production Overheads: Indirect costs incurred outside manufacturing, comprising administrative overheads (executive salaries, legal retainers, head office audit fees), selling overheads (sales force commissions, national advertising), and distribution overheads (warehouse dispatch costs, haulage fleet fuel). Under financial reporting standards, non-production overheads are treated as period costs and expensed directly in the Statement of Profit or Loss in the period incurred.

---

The Three Stages of Overhead Accounting

To ensure that products and services carry an equitable share of the factory resources consumed in making them, cost accounting uses a structured three-stage framework:

1. Stage 1: Collection, Allocation, and Apportionment (Analysis):
   • Indirect expenditures are collected from source documents (purchase invoices, stores requisitions, payroll summaries, depreciation schedules).
   • Whole costs identifiable with a specific department are allocated directly.
   • Joint costs shared across multiple departments are apportioned using equitable operational bases.
   • At the end of Stage 1, all production and service cost centres have an initial overhead total recorded on an Overhead Analysis Sheet (OAS).
2. Stage 2: Reapportionment of Service Cost Centres:
   • Service cost centres (such as the maintenance workshop, stores, and canteen) do not produce saleable goods.
   • Their accumulated overheads must be transferred (reapportioned) to the production cost centres (e.g. Machining, Assembly) through which customer products physically pass.
3. Stage 3: Absorption into Cost Units:
   • The final accumulated overheads in each production cost centre are charged into individual products or jobs using a Predetermined Overhead Absorption Rate (OAR), typically based on direct labour hours or machine hours.

---

Allocation versus Apportionment: The Crucial Distinction

Two terms describe how overheads reach cost centres.

Cost Allocation

Cost allocation is the process of charging an entire cost item directly to a single cost centre. It applies whenever an expenditure can be identified 100% with a specific department, without the need for estimation, sharing, or arbitrary mathematical apportionment formulas.

• Identifiability: The cost is incurred exclusively for that department.
• Examples:
  • Salary of the Machining Department supervisor -> allocated 100% to Machining.
  • Specialized lubricants purchased solely for maintenance workshop machinery -> allocated 100% to Maintenance.
  • Stores requisition for packing boxes used exclusively by the Finished Goods Packing bay -> allocated 100% to Packing.

Cost Apportionment

Cost apportionment is the process of sharing a common, indirect cost across two or more cost centres on an equitable, fair, and rational basis. Apportionment is necessary when a single expenditure benefits multiple departments and cannot be physically isolated to any one department.

• Identifiability: The cost is shared or joint across several operational areas.
• Examples:
  • Factory building rent and local business rates (benefiting all departments housed within the premises).
  • Factory electricity for general lighting and heating.
  • Factory building insurance and fire alarm monitoring contracts.

---

Selecting Equitable Apportionment Bases

When apportioning overheads, the management accountant must choose a base that satisfies the cause-and-effect principle (the cost centre that causes the expenditure should bear the cost) or the benefit-received principle (costs are shared according to the operational benefit derived by each department). Choosing an arbitrary base distorts product costs and undermines departmental performance evaluation.

Standard Overheads and Apportionment Bases

The following table shows the apportionment bases commonly used in practice (you will apply these calculations at Level 3):

---

Step-by-Step Preparation of an Overhead Analysis Sheet (OAS)

An Overhead Analysis Sheet (OAS)—also referred to as an Overhead Allocation and Apportionment Schedule—is the formal spreadsheet schedule used to accumulate Stage 1 overheads.

Comprehensive Worked Example: Apex Precision Engineering Ltd

Apex Precision Engineering Ltd, based in Sheffield, operates two Production Cost Centres (Machining and Assembly) and two Service Cost Centres (Stores and Maintenance). The company is preparing its Overhead Analysis Sheet for the upcoming month.

Step 1: Departmental Operating Parameters

The costing department gathers the following operational data for the four cost centres:

Step 2: Directly Allocated Indirect Costs

The nominal ledger shows the following departmental indirect costs to be allocated directly:

• Indirect Materials: Total £8,500 (Machining £3,200; Assembly £1,800; Stores £2,100; Maintenance £1,400).
• Indirect Wages: Total £26,000 (Machining £10,500; Assembly £7,500; Stores £3,500; Maintenance £4,500).

Step 3: Shared Overhead Costs to Apportion

The general overhead expenses to be apportioned among the departments are:

• Factory Rent and Business Rates: £36,000 (Apportioned on Floor Area: 10,000 m² total).
  • Rate per m² = £36,000 / 10,000 m² = £3.60 per m².
  • Machining: 5,000 m² × £3.60 = £18,000
  • Assembly: 3,000 m² × £3.60 = £10,800
  • Stores: 1,000 m² × £3.60 = £3,600
  • Maintenance: 1,000 m² × £3.60 = £3,600
• Factory Heat and Light: £12,000 (Apportioned on Floor Area: 10,000 m² total).
  • Rate per m² = £12,000 / 10,000 m² = £1.20 per m².
  • Machining: 5,000 m² × £1.20 = £6,000
  • Assembly: 3,000 m² × £1.20 = £3,600
  • Stores: 1,000 m² × £1.20 = £1,200
  • Maintenance: 1,000 m² × £1.20 = £1,200
• Plant Machinery Depreciation: £24,000 (Apportioned on Machinery Carrying Value: £200,000 total).
  • Depreciation rate = £24,000 / £200,000 = 12% of asset value.
  • Machining: £150,000 × 12% = £18,000
  • Assembly: £30,000 × 12% = £3,600
  • Stores: £10,000 × 12% = £1,200
  • Maintenance: £10,000 × 12% = £1,200
• Machinery Insurance: £6,000 (Apportioned on Machinery Carrying Value: £200,000 total).
  • Insurance rate = £6,000 / £200,000 = 3% of asset value.
  • Machining: £150,000 × 3% = £4,500
  • Assembly: £30,000 × 3% = £900
  • Stores: £10,000 × 3% = £300
  • Maintenance: £10,000 × 3% = £300
• Electric Power: £18,000 (Apportioned on kWh: 60,000 kWh total).
  • Power cost per kWh = £18,000 / 60,000 kWh = £0.30 per kWh.
  • Machining: 36,000 kWh × £0.30 = £10,800
  • Assembly: 12,000 kWh × £0.30 = £3,600
  • Stores: 4,000 kWh × £0.30 = £1,200
  • Maintenance: 8,000 kWh × £0.30 = £2,400
• Staff Canteen and Welfare: £10,000 (Apportioned on Number of Employees: 80 staff total).
  • Welfare cost per employee = £10,000 / 80 = £125 per employee.
  • Machining: 20 employees × £125 = £2,500
  • Assembly: 40 employees × £125 = £5,000
  • Stores: 10 employees × £125 = £1,250
  • Maintenance: 10 employees × £125 = £1,250

Step 4: The Completed Overhead Analysis Sheet

All allocated items and apportioned lines are consolidated into the Overhead Analysis Sheet table:

Cross-Cast Verification: $\text{Total Overheads} = £73,500 + £36,800 + £14,350 + £15,850 = £140,500$ The horizontal and vertical totals balance to the penny, confirming the arithmetic integrity of the analysis sheet.

---

Common Pitfalls When You Meet Apportionment

When you meet apportionment calculations at the next level, avoid these missteps:

• Trap 1: Confusing Cost Allocation with Cost Apportionment. Remember that allocation deals with whole, dedicated costs where no basis of sharing is needed. Apportionment requires selecting a fair proportion or operational driver because the expense is shared.
• Trap 2: Selecting an Inappropriate Base for Machinery Costs. Apportioning machinery insurance or depreciation by floor area is incorrect. A small CNC cutting machine bay occupying 50 m² may house equipment worth £500,000, while a 500 m² manual assembly bench may contain tools worth only £5,000. Machinery depreciation and insurance must always follow machinery carrying value or replacement cost.
• Trap 3: Omitting Directly Allocated Costs from the Overhead Analysis Sheet. Examination tasks often give students a list of general expenses to apportion and separate figures for departmental indirect labour or indirect materials. Many candidates forget to add the directly allocated indirect costs, resulting in understated departmental totals.
• Trap 4: Rounding Intermediate Calculations. Always calculate exact fractions or cost rates (e.g. £3.60 per m²) before multiplying across departments. Rounding intermediate percentages to whole numbers can cause the sum of departmental apportionments to deviate from the nominal ledger control total.