Overhead Allocation Overview
In many businesses, the cost of overhead is substantially greater than direct costs, so the cost accountant must expend considerable attention on the proper method of allocating overhead to inventory. 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 |
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...