Overhead allocation, also known as overhead absorption, is a method used in cost accounting to spread overhead costs to the products or services that the business produces. Overhead costs are expenses that are not directly tied to a specific product or service, such as rent, utilities, administrative salaries, insurance, etc.
The goal of overhead allocation is to accurately reflect the total cost of producing a product or providing a service, beyond just the direct costs. This helps businesses to set prices that cover all costs, evaluate the profitability of different products or services, and make informed decisions about resource allocation.
The method for allocating overhead costs depends on the chosen allocation base. This base should ideally have a direct correlation with the overhead costs incurred. Common bases used for allocation include direct labor hours, direct labor costs, or machine hours.
For instance, if a company uses machine hours as the base for allocation, it would first calculate an overhead rate by dividing the total overhead costs by the total machine hours. This overhead rate would then be applied to the machine hours used for each product or service to determine the overhead costs to be allocated to that product or service.
It’s important to note that the method of overhead allocation can significantly impact reported costs and profitability of different products or services, and thus should be chosen and applied carefully. Different methods can also be appropriate for different purposes (e.g., pricing, performance evaluation, decision making).
Example of Overhead Allocation
Suppose there’s a company named XYZ Manufacturing that produces two types of widgets: Widget A and Widget B. The company incurs $100,000 per month in overhead costs, which includes expenses like rent, utilities, and administrative salaries.
XYZ Manufacturing decides to allocate overhead costs based on machine hours, as it believes this provides the most accurate reflection of the resources consumed by each type of widget.
Over a month, the company uses 10,000 machine hours. So, the overhead rate is calculated as $100,000 divided by 10,000 machine hours, which equals $10 per machine hour.
Now, let’s say it takes 2 machine hours to produce one Widget A and 1 machine hour to produce one Widget B. Therefore, the allocated overhead cost per widget would be:
- Widget A: $10 per machine hour * 2 hours = $20
- Widget B: $10 per machine hour * 1 hour = $10
So, according to this allocation method, Widget A carries a higher portion of the overhead cost ($20) compared to Widget B ($10) due to it requiring more machine hours for production.
XYZ Manufacturing would then add this overhead cost to the direct costs of materials and labor for each widget to determine the total cost of producing each type of widget. This would help the company in setting prices, assessing profitability, and making other key business decisions.
Remember that the choice of allocation base (in this case, machine hours) can significantly impact the calculated overhead cost per product, and different methods may be appropriate for different purposes.