Departmentalisation and Six Methods of Overhead Absorption

## Departmentalisation and Overhead Absorption Methods

### Departmentalisation of Overhead

Definition: The process of allocating and apportioning overheads to the various departments of an organisation.

Step 1: Divide all departments into Production Departments (directly involved in making the product) and Service Departments (provide support services to production departments and each other — e.g., maintenance, stores, canteen).

Step 2: Allocate and apportion all overheads to both production and service departments.

Step 3: Re-apportion all service department costs to production departments (since service departments are not directly involved in output, all their costs must ultimately rest in production departments for product costing).

#### Advantages of Departmentalisation

1. Better cost estimation: Knowing each department's overheads enables more accurate budgets and better cost control.

2. Better control: Compare actual vs budgeted overhead for each department individually.

3. Accurate product cost: Each job/product is charged only with the overheads of the departments it actually passed through.

4. Accurate WIP valuation: WIP is charged with overheads of only those departments it has passed through, not the entire organisation's overheads.

---

### Six Methods of Overhead Absorption

#### Method 1 — Percentage of Direct Material Cost

$$\text{Rate} = \frac{\text{Total Production OH}}{\text{Budgeted Direct Material Cost}} \times 100$$

Suitable when: Material prices are stable (do not fluctuate widely).

---

#### Method 2 — Percentage of Prime Cost

$$\text{Rate} = \frac{\text{Total Production OH}}{\text{Prime Cost}} \times 100$$

Prime Cost = Direct Material + Direct Labour + Direct Expenses.

---

#### Method 3 — Percentage of Direct Labour Cost

$$\text{Rate} = \frac{\text{Total Production OH}}{\text{Direct Labour Cost}} \times 100$$

Suitable when: Labour rates are stable.

Disadvantages: Ignores distinction between skilled and unskilled labour; ignores distinction between machine work and manual work.

---

#### Method 4 — Direct Labour Hour Rate

$$\text{Rate} = \frac{\text{Total Production OH}}{\text{Direct Labour Hours}}$$

Suitable when: Manual labour is the dominant factor of production.

Disadvantage: Ignores distinction between machine-intensive and manual jobs.

---

#### Method 5 — Machine Hour Rate

$$\text{Rate} = \frac{\text{Total Production OH}}{\text{Number of Machine Hours}}$$

Suitable when: Major portion of production is performed by machines.

This is the most commonly used and preferred method in modern, capital-intensive factories.

---

#### Method 6 — Rate per Unit of Output

$$\text{Rate} = \frac{\text{Total OH}}{\text{Number of Units Produced}}$$

Suitable when: Output is uniform (all units identical).

Disadvantage: Ignores distinction between machine-done and manually-done work.

---

### Choosing the Right Method