Allocation Rate
An allocation rate is the percentage or rate used to allocate indirect costs, also known as overhead costs, to different cost objects or activities. It is derived by dividing the total overhead costs by the total units of an appropriate allocation base. The allocation rate helps businesses accurately distribute costs that are not directly linked to a specific product, service, or activity.
Example of an Allocation Rate
Let’s consider a fictional company, XYZ Corporation, which produces two types of widgets: Widget A and Widget B. XYZ Corporation incurs $50,000 in indirect overhead costs for a specific month. The company chooses machine hours as the allocation base for distributing these overhead costs.
During the month, Widget A production uses 3,000 machine hours, and Widget B production uses 2,000 machine hours. The total machine hours for both products are 5,000 hours.
First, calculate the allocation rate by dividing the total overhead costs by the total machine hours:
Allocation Rate = (Total Overhead Costs) ÷ (Total Machine Hours)
= $50,000 ÷ 5,000
= $10 per machine hour
Now that we have the allocation rate of $10 per machine hour, we can allocate the overhead costs to each product based on their machine hours.
Overhead Cost for Widget A = Allocation Rate × Machine Hours for Widget A
= $10 × 3,000
= $30,000
Overhead Cost for Widget B = Allocation Rate × Machine Hours for Widget B
= $10 × 2,000
= $20,000
In this example, $30,000 of overhead costs are allocated to Widget A, and $20,000 of overhead costs are allocated to Widget B. This allocation helps the company to determine the true cost of producing each widget and make informed decisions about pricing, production, and resource allocation.
