Overhead allocation

Overhead Allocation Overview

The allocation of certain overhead costs to produced goods is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.

There are two types of overhead, which are administrative overhead and manufacturing overhead. Administrative overhead includes those costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing overhead. Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

You need to allocate the costs of manufacturing overhead to any inventory items that are classified as work-in-process or finished goods. Overhead is not allocated to raw materials inventory, since the operations giving rise to overhead costs only impact work-in-process and finished goods inventory.

The following items are usually included in manufacturing overhead:

Depreciation of factory equipment Quality control and inspection
Factory administration expenses Rent, facility and equipment
Indirect labor and production supervisory wages Repair expenses
Indirect materials and supplies Rework labor, scrap and spoilage
Maintenance, factory and production equipment Taxes related to production assets
Officer salaries related to production Uncapitalized tools and equipment
Production employees’ benefits Utilities

Overhead Calculation

The typical procedure for allocating overhead is to accumulate all manufacturing overhead costs into one or more cost pools, and to then use an activity measure to apportion the overhead costs in the cost pools to inventory. Thus, the overhead allocation formula is:

Cost pool ÷ Total activity measure = Overhead allocation per unit

You can allocate overhead costs by any reasonable measure, as long as it is consistently applied across reporting periods. Common bases of allocation are direct labor hours charged against a product, or the amount of machine hours used during the production of a product. The amount of allocation charged per unit is known as the overhead rate.

The overhead rate can be expressed as a proportion, if both the numerator and denominator are in dollars. For example, ABC Company has total indirect costs of $100,000 and it decides to use the cost of its direct labor as the allocation measure. ABC incurs $50,000 of direct labor costs, so the overhead rate is calculated as:

$100,000 Indirect costs ÷ $50,000 Direct labor

The result is an overhead rate of 2.0.

Alternatively, if the denominator is not in dollars, then the overhead rate is expressed as a cost per allocation unit. For example, ABC Company decides to change its allocation measure to hours of machine time used. ABC has 10,000 hours of machine time usage, so the overhead rate is now calculated as:

$100,000 Indirect costs ÷ 10,000 Machine hours

The result is an overhead rate of $10.00 per machine hour.

If the basis of allocation does not appear correct for certain types of overhead costs, it may make more sense to split the overhead into two or more overhead cost pools, and allocate each cost pool using a different basis of allocation. For example, if warehouse costs are more appropriately allocated based on the square footage consumed by various products, then store warehouse costs in a warehouse overhead cost pool, and allocate these costs based on square footage used.

Thus, far we have assumed that only actual overhead costs incurred are allocated. However, it is also possible to set up a standard overhead rate that you continue to use for multiple reporting periods, based on long-term expectations regarding how much overhead will be incurred and how many units will be produced. If the difference between actual overhead costs incurred and overhead allocated is small, you can charge the difference to the cost of goods sold. If the amount is material, then allocate the difference to both the cost of goods sold and inventory.

Overhead Allocation Examples

Mulligan Imports has a small golf shaft production line, which manufactures a titanium shaft and an aluminum shaft. Considerable machining is required for both shafts, so Mulligan concludes that it should allocate overhead to these products based on the total hours of machine time used. In May, production of the titanium shaft requires 5,400 hours of machine time, while the aluminum shaft needs 2,600 hours. Thus, 67.5% of the overhead cost pool is allocated to the titanium shafts and 32.5% to the aluminum shafts.

As another example, Mulligan Imports incurs overhead of $93,000, which it stores in an overhead cost pool. Mulligan uses a standard overhead rate of $20 per unit, which approximates its long-term experience with the relationship between overhead costs and production volumes. In September, it produces 4,500 golf club shafts, to which it allocates $90,000 (allocate rate of $20 x 4,500 units). This leaves a difference between overhead incurred and overhead absorbed of $3,000. Given the small size of the variance, Mulligan charges the $3,000 difference to the cost of goods sold, thereby clearing out the overhead cost pool.