Overheads: apportionment, absorption and under- or over-absorption

In short

Overheads are all indirect costs - indirect material, indirect labour and indirect expenses - that cannot be traced directly to a single cost unit, so they must be collected, apportioned to departments and then absorbed into products through a rate. Apportionment spreads a shared cost over departments on an equitable basis; absorption charges departmental overhead into cost units; the difference between overhead absorbed at a pre-determined rate and overhead actually incurred is under- or over-absorption. This is the highest-scoring numerical block in CMA Intermediate Cost Accounting and in B.Com/BBA cost accounting papers, and it is tested in placement rounds for costing, FP&A and plant-finance roles. In practice it drives machine hour rates, job quotations, Cost Audit Report annexures and CAS-3 compliance in Indian manufacturing.

Explained

What overheads are, and how they are classified

• Overhead = indirect material + indirect labour + indirect expenses. CAS-3 (Cost Accounting Standard on Production and Operation Overheads, issued by ICMAI) defines and standardises treatment of production overheads for cost statements and cost audit.
• By element: indirect materials (lubricants, cotton waste, consumable tools), indirect labour (supervisor, storekeeper, sweeper salary), indirect expenses (rent, insurance, power, depreciation, repairs).
• By function: factory/works (production) overhead, administration overhead, selling overhead, distribution overhead, and in some syllabi research & development overhead.
• By behaviour: fixed (rent, salaries, straight-line depreciation), variable (power, consumable stores), semi-variable/semi-fixed (telephone, repairs, supervision) - split by least squares, high-low or level-of-activity method.
• By controllability: controllable at a given management level versus uncontrollable (apportioned head-office cost).
• Normality: normal overhead is part of cost; abnormal items (abnormal idle time, abnormal loss, penalty, loss on sale of asset) are charged to Costing Profit and Loss Account, not to product cost.
• Excluded from cost under CAS-3 / cost audit practice: finance cost/interest, income tax, donations, dividend, goodwill written off, voluntary retirement payments treated as per standard, and any imputed cost not actually incurred.

Step 1 - collection, codification, allocation and apportionment

• Collection: overheads are gathered through standing order numbers (factory overheads) and cost account numbers (administration, selling, distribution) from invoices, wage analysis sheets, stores requisitions and journal entries.
• Allocation = charging the *whole* of an overhead to one cost centre because it was incurred wholly for it (e.g., salary of the machine shop foreman, power metered separately to one department). No sharing, no basis needed.
• Apportionment = distributing a *common* overhead over two or more cost centres on an equitable basis (e.g., factory rent over departments on floor area).
• Absorption = charging the cost centre's total overhead to the cost units passing through it, using an absorption rate.
• Primary distribution: all overheads spread over all departments - production and service - in the Overhead Distribution Summary.
• Secondary distribution: service department totals re-distributed to production departments, because only production departments have output to absorb cost.

Common bases of apportionment (examinable list)

• Principles of apportionment: service rendered/benefit received, ability to pay, survey/analysis method, and efficiency (apportioning more to a department whose output rises).

Step 2 - methods of secondary distribution

1. Direct re-distribution: service department cost is given only to production departments; inter-service service is ignored. Simplest, least accurate.
2. Step ladder (non-reciprocal) method: service departments are arranged in order of the number of other service departments they serve; each is closed one by one and never reopened.
3. Reciprocal methods, used when service departments serve each other:
   • Repeated distribution (continuous distribution): keep re-distributing in the given percentages round after round until the service figures become negligible, then close the last small balance.
   • Simultaneous equation (algebraic) method: let x and y be the total costs of the two service departments including re-apportioned service; solve the two linear equations, then distribute x and y once.
   • Trial and error method: build up each service department's total by repeated substitution, then apportion to production departments only.
4. With exact arithmetic, all reciprocal methods give the same answer; the step and direct methods do not.

Step 3 - absorption of overheads and the choice of rate

• Pre-determined rate = budgeted overhead ÷ budgeted base, fixed before the period; needed for quotations, price fixation and prompt job costing. Actual rate is computed after the period and delays costing. Blanket (single) rate = one rate for the whole factory - valid only if the factory makes one product or all departments are alike; otherwise multiple (departmental) rates are used.
• Methods of absorption:
  • Percentage of direct material cost - crude; ignores time; distorts when material prices differ.
  • Percentage of direct wages - simple; wrong where wage rates differ widely or work is machine-paced.
  • Percentage of prime cost - carries both defects above.
  • Direct labour hour rate - suitable for labour-intensive work (tailoring, assembly, foundry fettling).
  • Machine hour rate - best for machine-intensive work; the preferred and most examined method.
  • Unit of output rate - only for a single homogeneous product (cement, sugar, bricks).
  • Sale price method - used for administration and selling overhead, and for joint products.
• Machine hour rate (MHR): total overhead chargeable to a machine ÷ effective machine hours. Simple/ordinary MHR excludes the operator's wages; comprehensive MHR includes the operator's wages and other direct-type charges.
• Fixed and running (standing and machine) charges: standing charges (rent, supervision, insurance, lighting) accrue with time; machine expenses (power, repairs, depreciation, consumables) vary with running - both may be converted to an hourly rate.
• Effective/productive machine hours = available hours − normal idle time for maintenance, tool changing and similar unavoidable stoppages. Normal setting-up time is conventionally treated as productive time (so it is not deducted) unless the question says otherwise; abnormal idle time is excluded and charged to P&L.
• Capacity concepts: installed/rated capacity, practical capacity (installed less normal unavoidable loss), normal capacity (average of practical capacity over 3-5 years, used by CAS-3 and cost audit to absorb fixed overhead), budgeted capacity, actual capacity utilised, idle capacity. Normal idle capacity cost is absorbed in cost; abnormal idle capacity cost goes to the Costing P&L.

Step 4 - under- and over-absorption and its treatment

• Under-absorption (under-recovery): absorbed overhead < actual overhead; cost is understated, profit overstated in cost books. Over-absorption: absorbed > actual.
• Causes: wrong estimate of overhead; wrong estimate of the base (hours, output, wages); change in method or capacity utilisation; seasonality; price changes in power, rent or stores; major repair not budgeted; abnormal items wrongly included; clerical error.
• Treatment (three recognised routes):
  1. Supplementary rate - used when the amount is large and arises from a faulty estimate. A positive/plus supplementary rate recovers under-absorption; a negative/minus rate refunds over-absorption. It is applied to finished goods, WIP and cost of sales in proportion to units or hours, so inventory carries its due share.
  2. Write off to Costing Profit and Loss Account - when the amount is small, or arises from abnormal causes (abnormal idle capacity, strike, abnormal wastage) or from abnormal items not chargeable to product cost.
  3. Carry forward to the next period (to an Overhead Reserve/Suspense Account) - defensible only for seasonal businesses or when the period is part of a longer normal cycle; generally criticised because it carries one period's cost into another and is not acceptable for annual accounts.
• Indian practice: for cost audit and the Cost Audit Report annexures under section 148 of the Companies Act, 2013 read with the Companies (Cost Records and Audit) Rules, 2014, fixed production overhead is absorbed on normal capacity, and the under-absorbed portion attributable to abnormal idle capacity is not loaded on product cost. Under AS-2 / Ind AS 2 for financial statements, the same principle applies - fixed production overhead is allocated on normal capacity, unallocated overhead is expensed in the period, and in a period of abnormally high production the per-unit allocation is reduced so inventory is not measured above cost.
• Administration overhead is either transferred to production and selling, or treated as a separate charge to the cost of sales; selling and distribution overhead is absorbed only on goods sold, never on closing finished stock.

Advantages and limitations

• Advantages of pre-determined departmental rates: quick job costing and quotation, inter-period comparability, basis for budgetary control and variance analysis, fair inter-departmental charging.
• Limitations: every basis of apportionment is an approximation; volume-based absorption over-costs high-volume simple products and under-costs low-volume complex ones (the gap that activity-based costing addresses); blanket rates distort multi-product costing; under/over-absorption adjustments disturb comparability; fixed overhead per unit is a function of volume, so it is not valid for marginal decisions.

Key points

• Overhead - aggregate of indirect material, indirect labour and indirect expenses; it cannot be traced to one cost unit.
• Allocation - whole item charged to one cost centre; apportionment - common item shared on a basis.
• Primary distribution - all overheads over all departments; secondary distribution - service departments into production departments.
• Repeated distribution and simultaneous equation - both handle reciprocal services and give the same result; the step ladder and direct methods do not.
• Absorption rate = overhead of cost centre ÷ base (hours, wages, units); pre-determined rates are used for prompt costing and pricing.
• Machine hour rate - overhead per productive machine hour; the right choice where machines dominate; comprehensive MHR adds operator wages.
• Blanket rate - a single factory-wide rate; acceptable only for one product or uniform departments.
• Under-absorption - actual > absorbed, so cost understated; over-absorption - absorbed > actual, cost overstated.
• Supplementary rate - recovers or refunds a large under/over-absorption across cost of sales, finished goods and WIP; plus rate for under, minus rate for over.
• Abnormal causes - under/over-absorption from strike, abnormal idle capacity or abnormal wastage goes straight to Costing P&L.
• Normal capacity - practical capacity averaged over a cycle of years; the CAS-3, cost-audit and Ind AS 2 base for absorbing fixed overhead.
• Idle capacity cost = fixed overhead rate per hour × idle hours; normal portion absorbed, abnormal portion written off.
• Semi-variable overhead - split into fixed and variable by high-low, least squares or level-of-activity method.
• Excluded from cost - interest and finance cost, income tax, donations, dividend, goodwill written off, and all purely financial charges.
• Selling and distribution overhead - absorbed only on units sold; never loaded on closing finished goods stock.
• Over-absorption inflates reported cost, so in reconciliation with financial accounts it is added to costing profit, and under-absorption is deducted.
• CAS-3 - ICMAI standard governing production and operation overheads; CAS-11 covers administrative overheads and CAS-12 repairs and maintenance.

Formulas and examples

Example 1 - Primary distribution. Overheads: rent ₹60,000; plant depreciation ₹45,000; supervision ₹36,000. Departments A, B (production) and S (service): floor area 1,500 : 900 : 600 sq m; plant value ₹5,00,000 : ₹3,00,000 : ₹1,00,000; employees 30 : 18 : 12.

Check: 73,000 + 43,800 + 24,200 = 1,41,000. ✔ (Depreciation 5:3:1 of 45,000 → 45,000/9 = 5,000 per part.)

Example 2 - Secondary distribution, simultaneous equation method. Production departments P1, P2; service departments S1 (₹9,000) and S2 (₹6,000) after primary distribution. S1 serves P1 40%, P2 40%, S2 20%. S2 serves P1 30%, P2 50%, S1 20%.

Let x = total S1, y = total S2.

• x = 9,000 + 0.20y; y = 6,000 + 0.20x
• x = 9,000 + 0.20(6,000 + 0.20x) = 10,200 + 0.04x → 0.96x = 10,200 → x = ₹10,625
• y = 6,000 + 0.20 × 10,625 = ₹8,125

Distributed to production = 6,687.50 + 8,312.50 = ₹15,000 = 9,000 + 6,000. ✔

Example 3 - Machine hour rate. A machine cost ₹4,80,000, scrap value ₹30,000, life 10 years, runs 2,000 hours a year (after deducting 200 hours of normal maintenance from 2,200 available hours). Annual charges: rent apportioned ₹24,000; supervision ₹30,000; insurance ₹9,000; repairs ₹20,000; power 10 kWh per hour at ₹8 per kWh; consumable stores ₹12,000; operator's wages ₹1,80,000 (one operator per machine).

• Depreciation = (4,80,000 − 30,000)/10 = ₹45,000 → ₹22.50/hour
• Standing charges = 24,000 + 30,000 + 9,000 = ₹63,000 → ₹31.50/hour
• Repairs ₹20,000 → ₹10.00/hour; consumable stores ₹12,000 → ₹6.00/hour
• Power = 10 × 8 = ₹80.00/hour
• Simple machine hour rate = 22.50 + 31.50 + 10 + 6 + 80 = ₹150.00 per hour
• Operator's wages ₹1,80,000 ÷ 2,000 = ₹90.00/hour → Comprehensive MHR = ₹240.00 per hour

Example 4 - Under-absorption and supplementary rate. Budget: factory overhead ₹15,00,000; budgeted machine hours 50,000 → pre-determined rate ₹30 per hour. Actual: overhead ₹17,28,000; machine hours worked 48,000; in addition 1,500 hours were lost as abnormal idle time arising from a power failure.

• Overhead absorbed = 30 × 48,000 = ₹14,40,000
• Under-absorption = 17,28,000 − 14,40,000 = ₹2,88,000 (under-absorbed, so cost understated)
• Abnormal portion = 1,500 h × ₹30 = ₹45,000 → written off to Costing P&L
• Balance to be recovered by supplementary rate = 2,88,000 − 45,000 = ₹2,43,000
• Output units in the period: cost of sales 40,000; finished goods 8,000; WIP equivalent 2,000 → 50,000 units
• Supplementary rate = 2,43,000 ÷ 50,000 = ₹4.86 per unit (a plus rate)
• Charge: cost of sales 40,000 × 4.86 = ₹1,94,400; finished goods ₹38,880; WIP ₹9,720. Total ₹2,43,000. ✔

Example 5 - Idle capacity and comparison of absorption bases. A department budgets fixed overhead ₹6,00,000 at practical capacity 20,000 machine hours; it actually works 17,000 hours.

• Fixed overhead per hour = 6,00,000 ÷ 20,000 = ₹30
• Idle hours = 3,000 → idle capacity ratio = 3,000/20,000 = 15%; idle capacity cost = 3,000 × 30 = ₹90,000 (the normal part absorbed, the abnormal part written off)

Same department, overhead ₹6,00,000, direct wages ₹8,00,000, direct material ₹10,00,000, labour hours 40,000, machine hours 20,000, output 25,000 units:

The bases coincide only because this job happens to consume each resource in the departmental average proportion; a machine-heavy job (say 25 machine hours on the same wages) would attract ₹750 on the machine hour rate but still ₹300 on the wages basis - which is exactly why the base must match the dominant resource.

Where it is used

• Engineering and auto-component plants (Bosch, Sundram Fasteners, Bharat Forge tiers): departmental machine hour rates for CNC, heat treatment and plating cost centres, and quotations to OEMs built on pre-determined rates.
• Cost audit and cost records under the Companies (Cost Records and Audit) Rules, 2014 for regulated and specified industries - cement, steel, fertiliser, drugs, sugar, electricity, telecom - where overhead apportionment and normal-capacity absorption are reported in the CRA-3 annexures.
• Pharmaceutical and FMCG costing: absorption of block/plant overhead on batch hours for product costing and transfer pricing between units.
• Power, railways and large infrastructure contracts: apportionment of common workshop and site overhead over projects, feeding tariff petitions before CERC/SERCs and contract claims.
• Job roles: cost accountant, plant/management accountant, FP&A analyst, pricing analyst, SAP CO consultant configuring cost centres, activity types, assessment and distribution cycles and cost splitting.
• Inventory valuation and audit: fixed overhead allocation on normal capacity under AS-2/Ind AS 2, checked by statutory auditors and by GST/Income-tax authorities when valuing stock.

Interview questions

• Q: Difference between allocation and apportionment? A: Allocation charges an entire overhead to one cost centre that wholly caused it; apportionment splits a common overhead over several cost centres on an equitable basis.
• Q: Why is secondary distribution needed at all? A: Service departments have no saleable output, so their cost must be pushed into production departments where cost units pass and can absorb it.
• Q: When would you use the simultaneous equation method rather than the step ladder method? A: When service departments serve each other reciprocally; the step ladder closes a department once and cannot reflect service received back from a later department.
• Q: Why are pre-determined rates preferred to actual rates? A: They allow jobs to be costed and quoted immediately, smooth seasonal fluctuations and give a yardstick for control; the price is some under- or over-absorption.
• Q: When is a blanket overhead rate acceptable? A: Only when the factory produces a single product, or when all departments use roughly the same mix of resources per unit; otherwise it cross-subsidises between products.
• Q: How do you treat a large under-absorption caused by a wrong budget estimate? A: Apply a plus supplementary rate over cost of sales, finished goods and equivalent WIP, so inventory and sold units each carry their share.
• Q: And if the under-absorption arose from a two-month lockout? A: That is abnormal - write it off to the Costing Profit and Loss Account; abnormal idle capacity cost must not be loaded on product cost.
• Q: Over-absorption of ₹2 lakh - what happens in reconciliation with financial accounts? A: Costing profit was understated by the excess charge, so ₹2 lakh is added to costing profit to reach financial profit (under-absorption is deducted).
• Q: Why does CAS-3 and Ind AS 2 insist on normal capacity for fixed overhead? A: So that the per-unit fixed overhead is independent of short-term volume swings, preventing inventory from being inflated in a slack period.
• Q: Simple versus comprehensive machine hour rate? A: The simple rate carries only machine-related overhead; the comprehensive rate also includes the operator's wages and allied direct charges, giving a single all-in hourly cost.
• Q: Should selling overhead be absorbed into closing finished goods stock? A: No - selling and distribution overhead is incurred on goods sold, so it is charged only to units sold and excluded from inventory valuation.
• Q: Why does traditional absorption distort costs, and what fixes it? A: Volume-based bases load overhead on high-volume simple products while complex low-volume products escape; activity-based costing uses cause-and-effect drivers instead.
• Q: Is interest on capital an overhead? A: No - finance cost is excluded from cost accounts; only in some decision studies is a notional interest imputed, and never in cost statements for cost audit.

Common mistakes

• Confusing apportionment with absorption - apportionment ends at the department, absorption ends at the cost unit.
• Using total available machine hours instead of effective productive hours in the machine hour rate, which understates the rate.
• Forgetting the 20% inter-service percentage in reciprocal problems, or not re-checking that the amount distributed to production departments equals the original service totals.
• Writing off the whole under-absorption to Costing P&L when it is large and normal (a supplementary rate is required), or using a supplementary rate for an abnormal cause.
• Getting the reconciliation sign wrong - over-absorption is added to costing profit, under-absorption deducted.
• Applying the supplementary rate only to cost of sales and ignoring finished goods and WIP, so inventory stays understated.
• Loading abnormal items, interest, income tax or donations into overhead, and absorbing fixed overhead on actual rather than normal capacity.
• Choosing a wages-based percentage for a machine-paced department, which hides the real cost of machine-heavy jobs.

Related topics

Cost accounting: elements of cost · Activity-based costing · Job, batch and contract costing · Cost bookkeeping: integrated accounts and reconciliation with financial accounts · Cost Accounting Standards (CAS) · Service and operating costing