Cost Classification Overhead Costs Alloc

Cost and Management Accounting
Fundamentals
Textbook
(Management Accounting 1)
Chapter 2
Cost classification, overhead costs
allocation and apportionment
Ibrahim Amoo Ganiyu

Cost and Management Accounting Fundamentals Management Accounting 1
AIMS OF THE TEXT

The fundamental functions of the management team of any organisation include strategic
planning, controlling and decision making, among other functions. Managers do need basic
elementary calculations and interpretations as provided by the study of cost and management
accounting. Costing and Management accounting play a vital role in carrying out these basic
functions, which is the reason why the cost and management accounting course is important to
both accounting and non-accounting students of all universities and professional examination
bodies. My experience as a university lecturer in multi-cultural environment, shows that most
students always dread this area of their study before the classes’ start, which actually surprises
me because I found this area of study interesting during my study days and as a lecturer. But
quite remarkably, at the end of the semester, with my systematic analysis, my students end up
liking the course and it becomes a favourite course to them in all institutions where I have worked,
hence I decided to publish my lecture notes in the form of a textbook. The ultimate aim of this
book is to:
“Provide students with knowledge, skills and confidence required in
understanding cost and management accounting for both accounting and
non-accounting students at the university degree and professional
examination levels”.
The main focus is to discuss fundamentals of costing to form a solid foundation to management
accounting courses at undergraduate, post-graduate and professional examination levels. The
areas covered are presented in clear English language with clear and helpful layouts and formats
on how to solve questions on a systematic and consistent basis.
Accounting students hoping to progress to professional examinations after university often faced
a daunting challenge. From my experience of delivering lectures on ACCA/CIMA/AAT
professional studies, graduates do struggle with and are even afraid to start the professional
exams. Some good and confident graduates that start their professional exam are often
disappointed to know that they are short of knowledge required at that level and always have to
do extra work.
This situation is due to the gap that exists between the methods of studies and gathering of
information by the academic and professionals. The academicians explain fundamental
knowledge, rules and principles based on historical studies with application to the environment,
unlike the professional textbooks, academic textbooks are not regularly updated and may not
take into account the current changes in the environment.
The professional exams are based on historical knowledge and its application to the most current
scenarios and continuous interpretation of rules and principles. Most professional examination
questions require very deep knowledge and understanding in each area of studies, and unlike
academic work, in professional exams there are no portfolios, assignments or coursework and
Article/Textbook extract 1
no room for laziness. This provide a gap between academic studies and professional exams,
leading to lack of confidence and fear of starting the professional exams. The accounting
graduates are also given exemptions by most professional bodies which seem not to be of help
in some instances. I am of the opinion that students should claim their exemptions if deemed
necessary, but bearing in mind the consequence of doing so, i.e. extra work is required
It is also the aim of this textbook to bridge the gap between academic and professional
studies by explaining fundamental rules and principles in a more practical manner using
professional examination questions to illustrate all the fundamental knowledge
discussed, hereby exposing students to professional exams and linking their academic
knowledge to the professional environment.
Complete textbook available on:
https://www.amazon.co.uk/Cost-Management-Accounting-
Fundamentals/dp/1515264831/ref=sr_1_fkmrnull_1?keywords=ibrahim+ganiyu&qid=
1555958607&s=gateway&sr=8-1-fkmrnull
Type Ibrahim Ganiyu on the search bar of “www.amazon.co.uk”
Contents
Pages
1 Introduction to cost and management accounting information 8
Data and information, classification and differences between financial and
management accounting, sources of information, sampling, management
information need for planning, controlling, decision making and performance
management and cost coding system
2 Cost classification, overhead costs allocation and apportionment 30
Classification by element, function, decision-making, behaviour and nature.
Calculation of total cost of production
3 Traditional costing methods 60
Marginal costing, overhead absorption rate (OAR) and absorption costing,
over and under absorption of overhead, calculation of total cost of
production, preparation of marginal and absorption profit or loss statements
and reconciliations of both statements
4 Activities based costing (ABC) method 128
Calculation of ABC total cost of production and preparation of profit or loss
statements and suitability of ABC method
5 Cost behaviour and statistical techniques 148
High-low method, regression analysis technique and calculation of cost of
production
6 Accounting for materials 172
Material documentation and procedure, Order levels, economic order
quantity (EOQ), calculation of total cost of material, economic batch quantity
(EBQ), valuation of purchased materials using FIFO, LIFO and WA)
7 Accounting for labour 214
Remuneration methods, analysis of labour cost, treatment of overtime
payments, controlling and monitoring of labour cost – turnover rate,
efficiency rate, idle time rate, capacity rate and production volume ratio
8 Job and batch costing 242
Calculation of total cost of a job and batch, margin and mark-up discussion
9 Process costing, joint-products and by-product costing 255
Process costing of a single production process, multi-production process
with and without opening and closing work-in-process, preparation of
process account, losses accounts and scrap account. Accounting treatment
of joint products and by-products.
Contents
Pages
10 Short-term decision making: relevant costing technique 335

Analysis of costs for decision-making, identification of relevant costs,
analysis of relevant costs of material, labour, overheads and assets.
11 Short-term decision making: limiting factor 368

Ranking method – decision on maximisation contribution and minimisation
of cost (outsourcing and make or buy decision) and linear programming
method – graphical method (trial and error and Iso-line contribution

solutions
12 Cost-volume-analysis (CVP analysis) 418

Calculation of break-even point – contribution formula and C/S ratio, margin
of safety and treatment of target profit requirements.
13 Pricing decision 457

Demand-based and cost-based pricing approaches and limitation of cost-
plus pricing. Pricing strategies: (skimming, penetration, and price-

discrimination, product-line, volume-discounting and complimentary
product) pricing strategies.
14 Long-term decision-making techniques 495

Analysis of project relevant cash flows, compounding and discounting
methods, long-term decision-making tools - payback periods, accounting

rate of return, net present value and internal rate of return.
15 Budgeting 532
Purpose of budgets and budget preparation process, types of budgets –
functional/operating budgets – sales budget, production budget, material
usage budget, material purchase budget, labour budget, overhead budget

and cash budget. Budgetary control – fixed, flexible and flexed budgets
16 Standard costing and basic variance analysis 564

Standard cost and types of standards, calculation and interpretation of
direct material, direct labour, variable overhead variances, production
overhead – expenditure, volume, capacity and efficiency variances. Sales

variance – price and volume variances. Reconciliation of budgeted cost
information and actual cost information.
Be a prepared candidate
Passing exams and Ingredients compiled based on
getting ready for
experience in preparing students for
work environment
without fear Important ingredients professional exams, lecturing at
requires for passing your
undergraduate and post-graduate
examinations
levels over the years
Knowledge + Understanding + Planning +

Attention to detail
=
Solid background, no fear & Exam Success
Practice many questions with understanding not cramming, as each question will pose
different challenges but the basic principles behind each topic are always examined.
Understanding is crucial
 All areas covered in this book are presented in a systematic and consistent manner including
solutions to the professional questions, all the introduced methods of answering questions can
be applied to any related topic of any examination both at university and professional exam
levels, hence students should practice, practice and keep on practicing until you can solve
questions comfortably, quickly and easily
 The study of cost and management accounting involves the scientific art of skilfully applying a
set of rules and principles to various situations in different environments. The scientific aspect
is in the form of the rules and principles that can be learned in the classroom or other methods
of learning such as textbooks, journals etc., but the art of accounting can be developed by
critical thinking and application of knowledge gained and practising many questions
 Develop your critical thinking by applying related rules and principles to many related questions
from different sources such as textbook questions and various professional exam questions.
Most of the professional examination bodies do publish their past questions and solutions on
their websites or in textbooks recommended by the body.
 Don’t be lazy, practise many questions with understanding to develop your scientific art on
cost and management accounting.
Lecture Note
Chapter 1
Introduction to cost and management accounting information
Learning outcome: it is the aim of this chapter
 To explain data and information for accounting purpose.
 To explain cost and management accounting and financial accounting including

comparison
 To explain internal, external and sampling sources of data and information
 To discuss information for planning, controlling and decision making at different level of
management
 To discuss coding system and the use of information in performance evaluation and
responsibility accounting
Lecture Note
Chapter 2
Costs classification and production overhead cost allocation and

apportionment
Learning outcome: it is the aim of this chapter
 To explain cost, cost classifications with associated calculation of total cost
 To explain cost allocation and apportionment, calculation of overhead absorption rate
 To discuss and calculate unit cost of production under the traditional marginal costing
methods and to discuss/highlight the uses and criticism of the method
 To discuss and calculate units cost of production under the traditional absorption costing
methods and to discuss/highlight the uses and criticism of the method
 To calculate the profit or loss by preparing the income statement or profit/(loss) statement
under the marginal and absorption costing methods
 To explain the over and under absorption of the overhead cost
 To prepare the reconciliation statement between the marginal and absorption costing
traditional methods
Costs, Cost classification and production overhead cost allocation and

apportionment
Cost is simply an amount that has to be incurred by an organisation in the production and selling
of its goods and services.
The production of goods involves the process of converting the raw materials into finished goods,
such process always includes incurring cost on raw materials, worker’s time, machines to carry
out the actual conversion and other costs such as factory rent, maintenance costs etc.
In cost accounting, cost is an amount incurred or to be incurred on:
 the purchase of materials (often referred to as material costs),
 payment of workers (often referred to as labour costs) and
 payments for other services necessary to carry out the production activities (often
referred to as production overhead costs)
The above costs are referred to as total production cost and also known as total cost if other
non-production costs such as administrative, selling and distribution costs, are added.
The costs are analysed in many ways due to various names ascribed to the cost components
and noticeable common characteristics exhibited by the cost components e.g. material and labour
costs are known as direct costs because they are directly linked to the units produced and are
also known as variable costs because they vary in direct proportion to the units produced, hence
it is always possible to classify costs in many logical ways.
Cost classification is the analysis and grouping of costs into logical groups, summarised into
meaningful information for management or intended users, for intended purpose.
Costs can be classified in many ways depending on the situation of use, the following cost
classification are commonly used:
 Classification by element
 Classification by function
 Classification for decision making
 Classification by behaviour
 Classification by nature
Classification by element
This is the classification of costs based on components of the production activities as follows:
Classification by elements
Material costs Labour costs Overheads
Direct Indirect Direct labour Indirect Variable Fixed

Material cost material cost cost labour cost overhead overhead
Materials costs are all costs of material purchased for production and non-productive activities;
e.g. raw materials, cleaning material and stationary etc. It is further divided into:
 Direct material cost e.g. raw material
 Indirect material cost e.g. cleaning material
Labour costs are the amount paid to the workers that are involved in production and non-
production activities. It is further divided into:
 Direct labour cost: amount paid to the production line staff, also known as skilled labour cost
 Indirect labour cost: amount paid to non-production line staff, known as unskilled workers
cost e.g. factory cleaners wages, factory supervisor etc.
Overhead costs are all other production costs other than direct material and direct labour costs
e.g. factory rent, storage cost etc. It is further divided into:
 Variable overhead costs: these are all other costs, other than direct material and direct labour
cost, paid to the production line staff or skilled labour that are involved in production activities.
 Fixed overhead costs are all other non-production related costs, they are also referred to as
indirect production cost
The above cost classification can be used to calculate the total production cost as follows:
£
Direct material xx
Add direct labour xx
Add variable overhead xx
xx
Add all indirect costs xx
Total production cost xx
Classification by function
This is the classification of costs based on the organisation’s functional activities. The
classification is as follows:
Classification by nature
Production costs Non-production costs
Direct production Indirect

costs production costs
Production costs are all costs incurred directly and indirectly during the production activities.
They are further divided into:
1. Direct production costs: these are costs incurred directly on units produced, they vary in
direct proportion with the units produced i.e. the more the production units, the more these
costs are incurred, e.g. direct material and direct labour costs
 The costs are cumulatively known as prime cost
2. Indirect production costs: these are cost incurred indirectly on the production units, e.g.
machine cleaning cost
 The costs are cumulatively known as overhead cost or fixed production overhead
cost or simply production overheads
The above cost classification can be used to calculate total production cost as follows:
£
Direct material xx
Add direct expenses xx

Prime cost xx
Add production overhead costs xx
Non-production costs are costs that are not associated with the production activities within an
organisation, i.e. costs that are not incurred in the production process e.g. general office
expenses, office rent, manager’s salaries etc.
 Non-production costs are often referred to as period costs and are not always included in
the calculation of the production cost, but are included in the statement of profit or loss when
calculating profit or loss for the period.
 Non-production costs include the following:
 Administration cost e.g. office rent, account department or administrative staff salaries
and other costs incurred in the department such as stationery cost, general office
expenses etc.
 Note that office rent is different from factory rent, office rent is classified as part of
administrative cost while factory rent is classified as part of production overheads
 Selling and distribution costs e.g. sales team or department costs, marketing cost,
delivery cost, warehouse or storage cost etc.
 Finance cost this is the interest cost on loan arrangements
 Others: such as research and development cost
The non-production costs are not included in the calculation of total production cost, however, it
is common to refer to the “total production cost” as “total cost” in the early part of cost and
management accounting studies, even though it doesn’t include the non-production costs.
The non-production costs are incorporated later in other areas of studies such as the study of
target costing and production-life cycle costing (see later)
Classification for decision making

This is a classification based on critical evaluation of costs in terms of minimum costs required
for an organisation’s production activities to support the decision-making process, especially in
the short run.
The classification is as follows:
Classification for decision making
Relevant cost Irrelevant cost
Relevant costs: are costs arising as a direct consequence of production activities e.g. direct
material cost, direct labor cost and all other variable cost of production.
 Relevant costs are also known as incremental cost, opportunity cost (benefit foregone),
variable cost, specific or directly attributable fixed production overhead cost.
 Direct material, direct labour and other variable costs are also known as relevant cost
Irrelevant costs: are costs either already incurred or must be incurred regardless of production
activities
 Irrelevant cost also known as unavoidable cost, sunk cost (already incurred cost), general
fixed production overhead, notional cost (e.g. factory machine depreciation)
 The only irrelevant cost considered when calculating production cost is fixed production
overhead cost
The above cost classification can be used to calculate total production cost as follows:
£
Relevant costs:
 Direct material xx
 Direct labour xx
 Direct expenses xx
Prime cost xx
Add irrelevant costs i.e. overhead cost xx
The classification is used in the study of relevant costing method, cost-volume profit (CVP)
analysis and decision-making process (see later).
Classification by behaviour
This is cost classification based on how cost react to changes in the level of activities. This
classification is based on the behavioural observation of costs.
It has been observed that:
 some costs change in direct proportion to the changes in the level of activities
 some costs change when the level of activities changes but not in direct proportion
 And some costs remain unchanged when the level of activities changes, but within certain
changes in the level of activities.
Based on the above observations, costs are classified as follows:
Classification by behaviour
Variable Costs Fixed costs Stepped fixed cost Semi-variable cost
Variable Costs: these are cost incurred on core-production activities and change in direct
proportion to changes in the level of activities i.e. costs that increase or decrease when production
units increase or decrease. Direct material and direct labour are referred to as variable costs and
total variable costs is referred to as prime cost of production.
Fixed costs: are costs incurred on non-core production activities and tend to be unaffected by
the fluctuation in the changes in the level of activities especially in the short run e.g. cleaners
wages, factory rent, factory supervisor salary etc.
 These are also referred to as production overheads, fixed production cost, many writers
simply called fixed cost “overheads”
 In general terms, they are defined as costs incurred over a period of time
Stepped fixed cost: These are costs which are constant for a range of level of activities and
then changed to another level and remain constant for another range of activities or period e.g.
changes in salary
Semi-variable cost: these are costs that contain both fixed and variable components and are
partly affected by the changes in the level of activities. It is also called mixed cost e.g. electricity
cost which consist of a fixed charge irrespective of consumption, known as an administrative
charge by the provider of the electricity meter and a variable charge based on consumption
 During the calculation of production cost, the semi-variable cost is separated into the
variable and fixed components using separation techniques such as high-low method
(discussed later), regression analysis and scattered graph.
The above costs classification is discussed in more details under cost behaviour
Calculation of production cost based on cost classification by behaviour

Variable costs: £
Direct material xx
Add other variable costs including variable
xx
cost component of a semi-variable cost
Prime cost xx
Add all fixed production costs (including fixed
xx
cost component of a semi-variable cost)
This is the classification of costs based on basic or inherent characteristics of costs. It is regarded
as a default classification of costs and it is a further analysis or regrouping of classification of cost
by element as follows:
Direct costs Indirect costs
Direct costs are costs that are traceable to the units of good produced e.g. raw material cost,
labour cost paid to the production-line staff and any other variable costs of production.
 It can simply be described as traceable costs to the units produced e.g. the cost of
materials used during the production process, labour cost for workers involved in the
production process and any other direct costs, which are required during the actual
production process.
 Direct costs are generally costs that have direct implication on the production units, without
direct costs, production activities are not possible.
 Direct costs are also called relevant costs of production in the study of decision making, and
they are also generally known as variable costs in many areas of management accounting
studies.
 The cumulative total of direct costs is called prime cost of production
Indirect costs
Indirect costs are routine and general expenses costs that cannot be traced directly to the units
produced e.g. indirect material such as cleaning materials, indirect labour such as supervisor
cost, general costs such as general maintenance cost, storage, etc.
 The indirect costs are generally referred to as production overhead costs, fixed
production cost and it is also known as irrelevant cost in the study of decision making
 Indirect costs are always costs that must be incurred with or without production activities,
the costs are often shared between production and non-production departments and always
require further analysis.
Calculation of total cost of production
From the discussion on cost classification, it can be concluded that the total cost of a product
can simply be calculated as follows:
Total cost
£
These costs are
known as: Direct material xx
 Direct Costs Add direct labour xx
 Variable costs
Add direct expenses xx
 All these costs is
 Relevant costs
Prime cost xx
known as total
Add overhead costs i.e. production costs
indirect materials, labour &
These costs are xx
known as: expenses, collectively called
 Indirect Costs overheads cost
 Fixed costs Total production cost xx
 Overhead Non-production overheads
 All these costs is
cost Administration cost xx
known as non-
Selling and distribution cost xx production costs
Total cost xxx
Summary of cost classification

Production costs Non-production cost
Direct costs: Indirect costs: Administrative Selling and Finance
also known as: also known as: cost distribution cost cost
 Production
 Variable costs
overhead cost
 Relevant costs  Irrelevant cost
 Prime cost  Fixed cost
Types of costs
Raw material ✔
Carriage inward of
raw material i.e. ✔
transportation cost
Royalty payment per
✔
unit produced
Carriage outward ✔
Production line staff
wages also known as
✔
factory wages or
direct labour cost
Machine cleaning &
✔
maintenance costs
Factory canteen
✔
wages
Factory supervisor
✔
salaries
Office supervisor
✔
salary
Factory rent and rate ✔
Office rent and rate ✔
Advertisement cost ✔
Salesperson’s
✔
wages/salaries
Loan interest ✔
Direct costs: all costs that vary in direct proportion to the level of activities i.e. the
Summary of
basic
costs that increase or decrease with increase or decrease in production activities
identification
principle Indirect costs: all costs that do not vary in direct proportion to the level of activities
i.e. the costs that do not fluctuate or change due to increase or decrease in
production activities in the short-run
Production overhead costs (Indirect costs of production)
Production overhead costs are routine, on-going and general expenses incurred during the
production process, the costs cannot be traced directly to the units of product produced.
The overhead costs are always incurred on cost items shared by all departments or cost centres
e.g. rent of premises used for production operations and administrative purpose.
Overhead costs are mostly paid on a monthly or annual basis and are not generally based on
level of activities e.g. rent is paid even if there are no production activities.
Hence, production overhead can be described as necessary production expenses that cannot
be traced directly to the products produced e.g. general machine cleaning or maintenance cost.
In the service industry, overhead costs are general business expenses that cannot be traced
directly to the services provided.
 The production overhead cost is generally known as fixed production cost and is sometimes
referred to as expenses; however, not all expenses are production overhead costs
Expenses are usually regular money incurred by an organisation for general purpose, but some
expenses are also incurred during the production process e.g. machine maintenance cost after
every ten thousand units, hence, expenses can be categorised as direct expenses and indirect
expenses
Direct expenses
These are monies incurred during the production process that are traceable to the units of goods
produced. If a particular expense must be incurred after producing a certain number of products,
such expense is treated as a direct cost, e.g. the general cleaning cost of production machines
is an indirect expenses because it cannot be traced to a specific product but if the machines must
be (compulsorily) cleaned, with a particular chemical or any other substance after producing
certain number of products, say 1,000 units, such cleaning cost is categorised as direct cost and
will be added to other variable costs as part of prime costs
 It should be noted that direct material and direct labour costs are also referred to as direct
expenses but in the real analysis of production costs, direct expenses are all other expenses
other than direct material and direct labour costs, which can be identified to the unit of goods
produced.
 The direct expenses form part of the prime cost of production.
£
Direct material xx Direct expenses is
Add direct labour xx also referred to as

Add direct expenses xx other variable cost
Prime cost xx
Indirect expenses
These are general and necessary expenses incurred during the production process but cannot
be traced directly to the units of products produced.
 Examples:
 Indirect material cost for general cleaning of production machines
 Indirect labour e.g. cleaners cost, supervisor cost etc.
 Any other indirect expenses e.g. factory rent, general lighting and heating, routine repairs
and maintenance cost etc.
 It is the indirect expenses that are referred to as production overhead costs, it is also called
fixed overhead cost or simply called fixed production costs
Conclusion and further discussion

It can be concluded that expenses are general costs incurred by an organisation on an on-going
basis but can be categorised as direct expenses and indirect expenses.
 Expenses linked or traceable to the production units are called direct expenses and form
part of the prime cost
 All other general expenses that are not traceable to the production units are called indirect
expenses and form part of the production overhead cost.
However, other overhead costs do exist in an organisation and hence, the indirect expenses are
generally categorised into three headings as follows:
 Production overheads e.g. factory rent, cleaning materials, factory cleaners
 Selling and distribution overheads e.g. transportation cost, delivery van depreciation
 Administration overheads e.g. office rent, supervisor salaries etc.
The above category of indirect expenses is as explained under the classification of cost by
function on page 33-34 and is further discussed from on the page.
Classification of overhead costs

Overheads are generally classified by function as follows:
1. Production overhead costs e.g. factory rent, cleaning materials, factory cleaners. It is also
known as manufacturing overhead costs
2. Selling and distribution overheads e.g. transportation cost, delivery van depreciation
3. Administration overheads e.g. office rent, supervisor salaries etc.
All of the above costs are necessary in an organisation that engages in production and selling
activities and have to be accounted for or included in the calculation of total costs and profit or
loss calculation as follows:
 The production overheads are accounted for, or recovered by absorbing the costs into the total
cost of production through a logical process of allocation and apportionment discuss later.
 The selling/distribution and administration overheads are not absorbed into the calculation of
total production cost, the total amount incurred are always deducted when calculating the profit
or loss for the period. These overhead costs do not need any further explanation.
The production overhead costs are much more complicated than other overheads and are further
discussed. There are two main departments or cost centres where overheads are incurred in the
production of products, namely, the main production departments and supporting departments
which are standalone departments necessary to support the main production departments e.g.
canteen department, maintenance department etc. These are referred to as service centres.
Hence, products-related overhead costs can be incurred in two cost centres in an organisation
as follows:
Production cost Centres: These are departments where production of products take place, the
overhead costs incurred in such centres are simply regarded as production overhead costs e.g.
factory rent, factory supervisor cost, factory lighting and heating
Service cost Centres: These are centres that exist to provide support to the main production
centres, i.e. the centres do not produce any products but incur costs by providing services to the
main production centres e.g. canteen department, quality control department etc.
Overhead costs are incurred in two ways in the above cost centres:
 Individually incurred overhead costs e.g. supervisor salary incurred in the production cost
centre or store manager salary incurred in the maintenance service cost centre or department.
 Shared or jointly incurred overhead costs e.g. payment of rent for the floor areas occupied by
the organisation as a whole which include production and service centres.
The individual overhead cost incurred are accounted for under each cost centre accordingly but
all overhead costs jointly incurred are allocated between the production and service cost centres
through a logical process of allocation, which is discussed next
Allocation overhead costs
In an organisation, there may be more than one production centre with one or two service centres,
and all the centres can be sharing the same overheads e.g. rent. The organisation will pay one
lump sum for rent, but the building is shared by the production centres and service centres.
All overhead costs incurred in production departments are indirect costs of production without
doubt, and need to be included in the cost of production as an overhead production cost, but
costs incurred in the service centres do not relate to the production activities directly but have to
be accounted for, because such costs are also incurred in supporting the main production
activities e.g. storage department to store products produced.
During the calculation of the total production cost, all jointly or shared overhead costs are logically
allocated or shared by both the production and service cost centres, and all overhead costs
allocated to the service cost centres are then re-allocated to the production cost centres before
the production overhead costs are finally absorbed into the calculation of the total cost of
production. This process is known as “allocation and apportionment” of overheads
Cost allocation: is the collection of all individual and shared overhead costs incurred in a
particular department or identification of overhead costs to a specific cost centre.
Cost centre is a location where activities take place and cost incurred or a location where costs
have accumulated.
 Cost allocation includes sharing of jointly incurred overhead costs by production and service
centres based on a logical but arbitrary basis of allocation, for example total rent amount
shared by production and service centres according to the square metres occupied.
 The overhead cost incurred will be given together with the agreed or logical basis of allocation
to construct an allocation table. The following is an example of a logical basis of allocation:
Cost items Basis of allocation
Rent and rate Floor area
Light and heating Cubic capacity
Insurance cost Number of machines
Welfare cost Number of employees
Depreciation Machine hours
Note: the above basis of allocation is not absolute; it is arbitrary but must be logical
Format of a cost allocation table

Overheads Amount to Production centres Service Centres
Basis of allocation
item be allocated 1 2 Store Maintenance
Rent As given Floor space xx xx xx xx
Heat and light As given Cubic capacity xx xx xx xx
Welfare As given Number of employees xx xx xx xx
Total xxx xxx xxx xxx
Formula: how to allocate overhead cost to specific cost centre
Specific cost centre Basis of allocation of a cost centre Overhead cost

= x = £xxx
overhead allocation cost Total basis of allocation to be allocated
Example: allocation of rent to production centre 1:
Floor area occupied by production centre Total rent

Production
= 1 x amount = £xxx
centre 1: Rent
Total floor area given
2.1 Illustrative example (ACCA paper 1.2 Financial Information for Management, Pilot Paper)
Warninglid has two production centres and two service centres to which the following applies:
Production departments Service centres
1 2 Stores Maintenance Total
Floor area (m2) 5,900 1,400 400 300 8,000
Cubic capacity (m3) 18,000 5,000 1,000 1,000 25,000
Number of employees 14 6 3 2 25
Direct labour hours 2,400 1,040
Machine hours 1,500 4,570

The following overheads were recorded for the month just ended:
Rent $12,000
Heat and light $6,000
Welfare costs $2,000
Supervisors
Department 1 $1,500
Department 2 $1,000
Required:
What will be overheads allocated to each department or cost centre?
2.1 Model solution
Cost allocation table

Production
Overheads Amount to Service Centres
Basis of allocation centres
item be allocated
1 2 Store Maintenance
Rent 12,000 Floor space (wk. 1) 8,850 2,100 600 450
Heat and light 6,000 Cubic capacity (wk. 2) 4,320 1,200 240 240
Number of employees (wk.

Welfare 2,000 1,120 480 240 160
3)
Supervisor Direct (see below) 1,500 1,000 - -
Total 15,790 4,780 1,080 850
Workings (using previous page formula)
1. Allocation of rent amount of £12,000 3. Allocation of heat & light amount of £6,000
Production 5,900 Production 18,000
= x 12,000 = 8,850 = x 6,000 = 4,320
Department 1 8,000 Department 1 25,000
Production 1,400 Production 5,000

= x 12,000 = 2,100 = x 6,000 = 1,200
Department 2 8,000 Department 2 25,000
400 1,000
Store = x 12,000 = 600 Store = x 6,000 = 240
8,000 25,000
300 1,000
Maintenance = x 12,000 = 450 Maintenance = x 6,000 = 240
8,000 25,000
2. Allocation of welfare amount of £2,000

Production 14
= x 2,000 = 1,120
Department 1 25
Production 6
= x 2,000 = 480
Department 2 25
3
Store = x 2,000 = 240
25
2
Maintenance = x 2,000 = 160
25
Basis of allocation
 The overheads amounts incurred are given and are allocated on a logical and arbitrary basis
 It should be noted that if overheads are specifically traceable to a cost centre, such overhead
is recognised directly under the associated cost centre. The basis of allocation is known as
“direct” e.g. supervisor cost above.
Overhead cost apportionment/re-apportionments

The overhead costs incurred in the production centres represent production overhead costs as
all products pass through the production centres but all costs incurred in the service cost centres do
not represent overhead production cost, as products do not pass through the service centres.
However, service centres do exist to serve the production centres in most circumstances, e.g.
canteen for production centre workers, storage centre to store goods produced, hence, overhead
costs incurred or allocated to the service centres are due to the production activities indirectly
and such costs are re-allocated to the production centres based on suitable criteria or percentage
of usefulness of the service centres to the production centres.
 The sharing of the services centre costs between the main production centres is called
apportionment. It is also called re-apportionment or re-allocation
Cost apportionment or re-apportionment or re-allocation is the sharing of the costs incurred

in the service centres to the main production cost centres based on suitable criteria i.e. benefits
enjoyed or percentage of usage as calculated or agreed between all managers.
 For the purpose of re-apportionment, the cost allocation table is extended.
Overhead apportionment table is the extension of the cost allocation table where the overhead
costs allocated to service centres are shared between the production centres.
Format of a cost allocation and apportionment table
Amount to Production
Overheads Service Centres
be Basis of allocation departments
item
allocated 1 2 Store Maintenance
Rent As given Floor space xx xx xx xx
Heat and light As given Cubic capacity xx xx xx xx
Welfare As given Number of employees xx xx xx xx
Total xx xx xx xx
Apportionment of store based on percentage of

xx xx (xx) xx
usage or benefits enjoyed
Apportionment of maintenance based on

xx xx xx (xx)
percentage of usage or benefits enjoyed
Total production overheads xxxx xxxx 0 0
Methods of apportionments
The sharing of the cost allocated to the services centre between the main production centres can
be straight forward, when one service centre provides services to two or more production
departments only but in a situation where there is more than one service centre providing
services to the production departments and also the service centres provides reciprocal services
to each other, e.g. storage department providing service to two production departments and
canteen department, the canteen centre also provides services to the storage centre.
 The method of apportionment that recognises such services is called “reciprocal
apportionment”.
 In such situation, the apportionment could be carried out based on percentage given
repetitively until the overhead costs of all service centres become zero or insignificant or by
first applying a mathematical equation to each of the service centres allocated amount
inclusive of the percentage of the reciprocal service between the service centres then use the
mathematics equation to carry out the appointments, hence, there are two techniques of the
reciprocal method as follows:
Reciprocal Methods of apportioning service centres
Repetitive distribution method

This is the application of percentage given repetitively until all total cost of service centres
becomes zero or insignificant.
Substitution (equation) method
This method makes use of mathematical derivation to formulate the “total service centre cost”
for each service centre inclusive of the percentage of the reciprocal service rendered by other
service cost centres.
Under this method, the total service centre overhead cost:
= total allocated overheads + percentage of cost rendered by other service cost centres
Example:
Maintenance department provide 12% service to the store department and also store department
provide 15% service to the maintenance department, the mathematical equation is formulated for
the service centres as follows:
Let
S represent store
M represent maintenance
Store = overhead cost allocated + 0.12M
Maintenance = overhead cost + 0.15S
The total overhead cost of each service centres inclusive of the reciprocal service rendered, are
derived by substitution.
The total amounts derived from the above equations are apportion or reallocated to the main
production centres based on percentage given.
The equation substitution method is used throughout the book, however, either of the 2 methods
can be used
2.2 Illustrative example (ACCA paper 1.2 Financial Information for Management, Pilot Paper)
Warninglid has two production centres and two service centres to which the following applies:
Production departments Service centres

1 2 Stores Maintenance Total
Floor area (m2) 5,900 1,400 400 300 8,000
Cubic capacity (m3) 18,000 5,000 1,000 1,000 25,000
Direct labour hours 2,400 1,040
Machine hours 1,500 4,570
The following overheads were recorded for the month just ended:
Rent $12,000
Heat and light $6,000
Welfare costs $2,000
Supervisors
Department 1 $1,500
Department 2 $1,000
The service centres work for the other centres as follows:

1 2 Stores Maintenance
Work done by:
Stores 50% 40% - 10%
Maintenance 45% 50% 5% -
Required:
Calculate the total overheads included in the production departments after apportionment
of the service centres using the reciprocal method
2.2 Model solution
Cost allocation table will be constructed first, and then extended to include the appointment of
the service department to the production centres as follows:
Amount Production
Overheads Service Centres
to be Basis of allocation departments
item
allocated 1 2 Store Maintenance
Rent 12,000 Floor space (wk. 1) 8,850 2,100 600 450
Heat and Cubic capacity (wk.

6,000 4,320 1,200 240 240
light 2)
Number of
Welfare 2,000 employees 1,120 480 240 160
(wk. 3)
Supervisor Direct 1,500 1,000 - -
Total 15,790 4,780 1,080 850
Apportionment of store (wk. 4) next page 564 451 (1,128) 113
Apportionment of maintenance (wk. 4) 433 482 48 (963)
Total production overhead 16,787 5,713 0 0
These amounts are referred to as the production overhead costs or fixed production costs
and are absorbed into the total cost of production depending
Workings (using previous page formula)
1. Allocation of rent amount of £12,000 (as previously calculated on page 47)
2. Allocation of heat & light amount of £6,000 (as previously calculated on page 47)
3. Allocation of welfare amount of £2,000 (as previously calculated on page 47)
4. Formulate total overhead cost equation for both store and maintenance service centres
to derive total overhead cost including the amount of work done for each other based on
percentages given as follows:
Total service centre cost equations:
S = 1,080 + 0·05M
M = 850 + 0·1S
Deriving total overhead amount in

the store department:
Deriving total overhead amount in the
Substitute ‘M’ in formula of ‘S’ maintenance department:
S = 1,080 + 0·05 (850 + 0·1S) M = 850 + 0·1S

S = 1,080 + 42·5 + 0·005S Substitute the value of ‘S’ in the above
S - 0.005s =1,080 + 42.5 formula of ‘M’ as follows:
S(1 - 0.005) =1,080 + 42.5 M = 850 + (0·1 x 1,128) = 963
Total amount incurred by maintenance

1,080 + 42.5
S = = 1,128 department = 963. This amount will be
1 - 0.005
Total amount incurred by store reapportioned to other centres based on
department = 1,128. This amount will be percentages given as follows:

Department 1 = 45% x 963 = 433
reapportioned to other centres based on
Department 2 = 50% x 963 = 482
percentages given as follows:
Store department = 5% x 963 = 48
Department 1 = 50% x 1,128 = 564
Department 2 = 40% x 1,128 = 451
Maintenance = 10% x 1,128 = 113
Basic mathematics skill is required
2.3 (ACCA CAT Paper T4 Accounting for Costs J10)
A company has two production cost centres (PC1 and PC2) and two service cost centres (SC1
and SC2). Overhead allocation and apportionment is as follows for a period:
PC1 PC2 SC1 SC2

Overheads $460,200 $520,800 $122,000 $96,600
Reapportionment of SC1 35% 45% 20%
Reapportionment of SC2 30% 70%
What are the total overheads in PC2 after reapportionment of the service cost centre
overheads?
A. $605,500
B. $643,320
C. $660,400
D. $667,720
2.4 (ACCA Paper 1.2 Financial Information for Management)
A business operates with two production centres and three service centres. Costs have been
allocated and apportioned to these centres as follows:
Production Centres Service Centres

1 2 A B C
£2,000 £3,500 £300 £500 £700
Information regarding how the service centres work for each other and for the production centres
is given as:
Work done for:
1 2 A B C
By A 45% 45% - 10% -
By B 50% 20% 20% - 10%
By C 60% 40% - - -
Required:
Using the reciprocal method calculate the total overheads in production centres 1 and 2
after reapportionment of the service centre costs. (7 marks)
2.3 Model Solution
Apportionment of service cost centre to the production cost centres

PC1 PC2 SC1 SC2
$ $ $ $
Overhead allocated 460,200 520,800 122,000 96,600
Reapportionment of SC1
(Sharing of 122,000 in ratio 42,700 54,900 (122,000) 24,400
35%: 45%: and 20%)
121,000
Reapportionment of SC2
(Sharing of 121,000 in ratio 36,300 84,700 (121,000)
30%: 70%)
Total overheads in PC2 660,400 - -
Option C is correct
2.4 Model Solution

1 2 A B C
£ £ £ £ £
Allocated amounts as given: 2,000 3,500 300 500 700
Reapportionment of:
A (see next page working) 183.6 183.6 (408) 40.8
B (see next page working) 270.4 108.16 108.16 (540.8) 54.08
C (see next page working) 452.45 301.63 - - (754.08)
Overhead amounts 2,906 4,093 0 0 0
Workings
Total service centre cost formulae:

Equation 1: A = 300 + 0.20B
Equation 2: B = 500 + 0.10A
Equation 3: C = 700 + 0.10B
Deriving the total overhead amount incurred in Deriving the total overhead amount in
the service centre A: using equation 1 and 2 service centre B
Equation 1: A = 300 + 0.20B B = 500 + 0.10A
Equation 2: B = 500 + 0.10A Substitute the value of ‘A’ in the above
Substitute ‘B’ in equation ‘A’ to derive the total equation as follows:
overhead in service centre A B = 500 + 0.10(408)
A = 300 + 0.20 (500 + 0·10A) B = 500 + 40.8 = 540.8
A = 300 + 100 + 0·02A This amount (i.e. 540.8) will be reapportioned to
A - 0.002A = 300 + 100 other centres based on percentages given as
A (1 - 0.02) = 300 + 100 follows:

Production centre 1 = 50% x 540.8 = 270.4
300 + 100
A = = 408 Production centre 2 = 20% x 540.8 = 108.16
1 - 0.02 Service centre A = 20% x 540.8 = 108.16
This amount (i.e. £408) will be reapportioned to Service centre C = 10% x 540.8 = 54.08
other centres based on percentages given as
follows:
Production centre 1 = 45% x 408 = 183.6
Deriving the total overhead amount in service centre C
C = 700 + 0.10B
Substitute the value of ‘B’ in the above equation as follows:
C = 700 + 0.10(540.8)
C = 700 + 54.08 = 754.08
This amount (i.e. 754.08) will be reapportioned to other centres based on percentages given as
follows:
Production centre 1 = 60% x 754.08 = 452.45
Production centre 2 = 40% x 754.08= 301.63
2.5 ACCA CAT Paper T4 Accounting for Costs J06
There are two production cost centres (P1 and P2) and two service cost centres (Materials Store
and Employee Facilities) in a factory. Estimated overhead costs for the factory for a period,
requiring apportionment to cost centres, are:
£
Buildings depreciation and
42,000
insurance
Management salaries 27,000
Power to operate machinery 12,600
Other utilities 9,400
In addition, the following overheads have been allocated to cost centres:
Cost centre
Materials Employee
P1 P2
store facilities
£107,000 £89,000 £68,000 £84,000
Further information:
Cost Centre
Materials Employee
P1 P2 Total
store facilities
Floor area (m2) 4,560 5,640 720 1,080 12,000
Share of other utilities overhead 35% 45% 10% 10% 100%
Machine hours 6,200 5,800 12,000
Share of materials store overheads 40% 60% 100%
Required:
(i) Prepare a schedule showing the allocated and apportioned factory overhead costs for
each cost centre; (7 marks)
(ii) Re-apportion the service cost centre overheads. (4 marks)
2.5 Model solution
i. Schedule of allocated and apportioned factory overhead costs for each cost centre
Amount Production cost Service cost

to be centres Centres
Overheads item Basis of allocation
allocated Employee
(£) P1 P2 Store facilities
Buildings depreciation
42,000 Floor area (wk. 1) 15,960 19,740 2,520 3,780
and insurance
Number of employees
Management salaries 27,000 9,000 12,000 3,000 3,000
(wk. 2)
Power to operate
12,600 Machine hours (wk. 3) 6,510 6,090 - -
machinery
Percentages given
Other utilities 9,400 3,290 4,230 940 940
(wk. 4)
141,760 131,060 74,460 91,720
ii. Re-apportion the service cost centre overheads
Total allocated overhead (as above) 141,760 131,060 74,460 91,720
Apportionment of employee facilities (wk. 5) 34,395 45,860 11,465 (91,720)
85,925
Apportionment of materials store (wk. 6) 34,370 51,555 (85,925)
Note:
The apportionment of the service centres is tricky in this question; firstly, it is important to
recognise that the total materials store amount is apportioned last because it is only
apportioned between the production centres.
The employee facilities total overhead is apportioned first and the only reasonable basis to
apportion the employee facilities is the number of employees, but the centre also has number of
employee i.e. 6 employees in the employees facilities cost centre, this will be eliminated from the
total number of employees to be used for the apportionment i.e. 54 – 6 = 48. See working 5
Workings
1. Allocation of Buildings depreciation and insurance amount of £42,000 using floor areas as
the basis of allocation
4,560
Production cost centre 1 (P1) = x 42,000 = 15,960
12,000
5,640
12,000
720
Materials store = x 42,000 = 2,520
12,000
1,080
Employee facilities = x 42,000 = 3,780
12,000
2. Allocation of Management salaries of £27,000 using number of employees as the basis of

allocation
18
54
24
54
6
54
6
Employee facilities = x 27,000 = 3,000
54
3. Allocation of Power to operate machinery amount of £12,600 using machine hours as the
basis of allocation
6,200
12,000
5,800
12,000
4. Allocation of Other utilities amount of £9,400 using percentages given
 Production cost centre 1 (P1): 35% x 9,400 = 3,290
 Materials store: 10% x 9,400 = 940
 Employee facilities: 10% x 9,400 = 940
5. Apportionment of employee facilities based on number of employees after eliminating the

number of employees in the employees facilities cost centre.
18
48
24
48
6
48
6. Apportionment of material store overheads bases on percentages given:
2.6 ACCA CAT Paper B2 Cost Accounting Systems J02
Pride Ceramics Limited has two production departments A and B and two service departments X
and Y.
Some of the budgeted overheads for the year ending 30 June 2003 have already been allocated
to the departments as shown below:
Production Production Service Service

Total
Dept. A Dept. B Dept. X Dept. Y
£ £ £ £ £
Allocated overheads 280,000 141,345 82,655 32,000 24,000
However, the remaining overheads, as detailed below still have to be apportioned to each of the
departments:
Electricity £24,000
Indirect labour £36,000
Rent £64,000
Machine maintenance £12,000
The following information is also available:
Machine operating hours 12,000 10,000 1,500 500
No of indirect employees 2 2 1 1
Floor area (m2) 21,000 19,500 4,500 3,000
The service departments are expected to spend their time as follows:
Department X 40% 60% Nil
Department Y 50% 30% 20%
Required:
(a) Prepare an overhead apportionment schedule. The schedule should include the
overheads already allocated and the overheads that still require apportionment.
(8 marks)
(b) Re-apportion the service department overheads to the other departments. (7 marks)
2.6 Model solution
a. Overhead apportionment schedule
Amount to Production Service

Overheads Basis of departments departments
be allocated
item allocation
(£) A B X Y
Overheads allocated As given 141,345 82,655 32,000 24,000

Allocation of the remaining
overheads
Machine
Electricity 24,000 operating hours 12,000 10,000 1,500 500
(wk. 1)
No. of indirect
Indirect labour 36,000 12,000 12,000 6,000 6,000
employee (wk. 2)
Floor area (m2)

Rent 64,000 28,000 26,000 6,000 4,000
(wk. 3)
Machine
Machine
12,000 operating hours 6,000 5,000 750 250
maintenance
(wk. 4)
199,345 135,655 46,250 34,750
Note:
The examiner recognised that it will be acceptable if the floor area is used to allocate the electricity
overhead of £24,000 but the solution will give slightly different calculations.
b. Re-apportion the service cost centre overheads
Total allocated overhead (as above) 199,345 135,655 46,250 34,750
Apportionment of service centre Y (wk. 5) 17,375 10,425 6,950 (34,750)
53,200
Apportionment of service centre X (wk. 6) 21,280 31,920 (53,200)
Workings
1. Allocation of Electricity amount of £24,000 using Machine operating hours as the basis of
allocation
12,000
Production department A = x 24,000 = 12,000
24,000
10,000
Production department B = x 24,000 = 10,000
24,000
1,500
Service department X = x 24,000 = 1,500
24,000
500
Service department Y = x 24,000 = 500
24,000
2. Allocation of Indirect labour of £36,000 using No. of indirect employee as the basis of allocation
2
Production department A = x 36000 = 12,000
6
2
6
1
6
1
Service department Y = x 36,000 = 6,000
6
3. Allocation of Rent of £64,000 using Floor area (m2) as the basis of allocation
21,000
48,000
19,500
48,000
4,500
48,000
3,000
Service department Y = x 64,000 = 4,000
48,000
4. Allocation of Electricity amount of £12,000 using machine operating hours as the basis of
allocation
12,000
24,000
10,000
24,000
1,500
Service department X = x 12,000 = 750
24,000
500
Service department Y = x 12,000 = 250
24,000
5. Apportionment of service centre Y based on the percentages given
 Production department A: 50% x 34,750 = 17,375
 Production department B: 30% x 34,750 = 10,425
 Service department X: 20% x 34,750 = 6,950
6. Apportionment of service centre X based on the percentages given
 Production department A: 40% x 53,200 = 21,280
 Production department B: 60% x 53,200 = 31,920
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Cost and Management Accounting

Ibrahim Amoo Ganiyu

AIMS OF THE TEXT

Complete textbook available on:

Type Ibrahim Ganiyu on the search bar of “www.amazon.co.uk”

10 Short-term decision making: relevant costing technique 335

11 Short-term decision making: limiting factor 368

of cost (outsourcing and make or buy decision) and linear programming

method – graphical method (trial and error and Iso-line contribution

12 Cost-volume-analysis (CVP analysis) 418

of safety and treatment of target profit requirements.

13 Pricing decision 457

plus pricing. Pricing strategies: (skimming, penetration, and price-

product) pricing strategies.

14 Long-term decision-making techniques 495

methods, long-term decision-making tools - payback periods, accounting

functional/operating budgets – sales budget, production budget, material

usage budget, material purchase budget, labour budget, overhead budget

16 Standard costing and basic variance analysis 564

direct material, direct labour, variable overhead variances, production

overhead – expenditure, volume, capacity and efficiency variances. Sales

information and actual cost information.

Knowledge + Understanding + Planning +

Introduction to cost and management accounting information

Learning outcome: it is the aim of this chapter

 To explain data and information for accounting purpose.

 To explain cost and management accounting and financial accounting including

 To explain internal, external and sampling sources of data and information

Costs classification and production overhead cost allocation and

Learning outcome: it is the aim of this chapter

 To explain cost, cost classifications with associated calculation of total cost

 To explain cost allocation and apportionment, calculation of overhead absorption rate

 To explain the over and under absorption of the overhead cost

Costs, Cost classification and production overhead cost allocation and

In cost accounting, cost is an amount incurred or to be incurred on:

 the purchase of materials (often referred to as material costs),

 payment of workers (often referred to as labour costs) and

it is always possible to classify costs in many logical ways.

 Classification for decision making

Material costs Labour costs Overheads

Direct Indirect Direct labour Indirect Variable Fixed

Production costs Non-production costs

Direct production Indirect

 The costs are cumulatively known as prime cost

Add direct labour xx

Add direct expenses xx

 Non-production costs include the following:

 Finance cost this is the interest cost on loan arrangements

 Others: such as research and development cost

Classification for decision making

The classification is as follows:

Classification for decision making

Relevant cost Irrelevant cost

Variable Costs Fixed costs Stepped fixed cost Semi-variable cost

Calculation of production cost based on cost classification by behaviour

Direct costs Indirect costs

Calculation of total cost of production

can simply be calculated as follows:

Summary of cost classification

Production overhead costs (Indirect costs of production)

Add direct labour xx also referred to as

 Indirect material cost for general cleaning of production machines