# Dealing with overhead costs on a departmental basis

In previous posts we’ve addressed what full costing is and how overheads can be applied in different ways. Now it’s time to talk about how the overheads can be sorted into departments.

Think about a medium to large sized business. They are often separated into departments, for example, sales, customer service, manufacturing etc. So what if, when a product’s cost is calculated, the overheads were allocated depending on how long the product spends in a certain department?

Instead of departments, we’ll refer to the different business areas as cost centres. There can be two types of these:

## Product cost centres

The main thing here is that they incur direct costs. So if direct workers worked on the product using direct materials, this would be a product cost centre. Manufacturing is a good example of a product cost centre.

## Service cost centres

Basically the opposite of product cost centres, so no direct costs are involved here. You can probably think of lots of examples of service cost centres as they are basically any part of the company that provides a service to other cost centres, for example catering (provides food to manufacturing), accounting and so on.

There are 7 steps to follow to implement full costing on a departmental basis:

## The 7 step approach

1. Allocate the specific departmental overheads to the correct department
2. Apportion the general overheads between the departments
3. Sum up each department so far to get the total for each department
4. Apportion the service department costs to product cost centres
5. Sum up the product cost centre overheads
6. Calculate an overhead absorption rate for each department
7. The cost units absorb the overheads as they pass through the product cost centres

Also, a distinction: Allocate is when you assign cost to a particular department. Apportion is when the cost is spread across two or more departments.

## Apportioning

There are a few different criteria we might use to apportion cost across departments:

• We could apportion rent across departments based on the floor area of each cost centre
• We could do the same for heat and light
• We could apportion electricity by looking at which departments have the most machines
• Canteen costs could be apportioned depending on how many employees are in each cost centre
• Depreciation and insurance could be apportioned by looking at the value of the machinery in each cost centre

There are plenty more you could come up with. Now let’s work through an example.

## Example

• Indirect materials: £36,000
• Indirect labour: £40,000
• Rent: £1,000
• Insurance: £1,600
• Depreciation: £2,000

Now here’s some information about the 3 departments in the company:

The first thing for us to do is apportion the general overheads across the departments, so first let’s look at the above table, but instead of including the full figures, we put the proportion each department is using. For example, there is (300 + 600 + 300) = 1200 sq ft of floor area in total, and assembly uses 25% of it, cutting uses 50% and maintenance uses 25%.

The next step is to apportion the overheads from earlier based on these proportions: (Click for bigger view)

Next, as maintenance is a service cost centre, we need to apportion the £5,970 of overheads it incurs to the other 2 departments, which are product cost centres. As maintenance deals with machines we base this on value of machinery. This is quite a straightforward calculation:

We continue to use value of machinery as the basis (as that is what maintenance deals with). From the table earlier, that means assembly counts for 30% of the value of machinery, cutting is 50% and maintenance is 20%. As we are eliminating maintenance from the calculation, these ratios change.

Summing the assembly and cutting figures gives a total of 80%. Therefore assembly counts for 30/80 of that, and cutting counts for 50/80 of it.

Now we just apply these new proportions to the £5,970 that was earlier apportioned to maintenance.

• Assembly: (30/80 × £5970) = £2239
• Cutting: (50/80 × £5970) = £3731

Now it’s simply a case of adding these figures to the overheads that were allocated to the assembly and cutting departments earlier

• Assembly: £29,569
• Cutting: £51,031

The next step is to work out the overhead absorption rate for each department. This is really easy and it’s just like when we worked out the absorption rate in previous posts.

• Assembly: £29,569 ÷ 55,000 direct labour hours = £0.5376 per direct labour hour
• Cutting: £51,031 ÷ 64,000 direct labour hours = £0.7974 per direct labour hour

Adding those figures together brings the total overhead cost of a job (assuming it spends one hour in each department) to £1.34.

## Pros and cons of full costing

Note: This is talking about full costing in general, not just full costs separated into departments.

• Pro: Is has a broader consideration than marginal costs
• Pro: Shows the relevant cost in the long run
• Con: Uses past costs
• Con: Restricts future costs to outlays only (not opportunities)