Live Support
+1-802-778-9005Every organization incurs overhead costs associated with its business. These costs involve operating expenses such as rent, utilities, administrative salaries, etc.
Overhead allocation involves spreading externally incurred costs across different cost objects. These costs, also known as indirect costs, are incurred in support of various business activities but are not directly assignable to a particular product or service.
Proper overhead charging allows for a fair distribution of indirect costs among different products or services. This recognizes the cost of variation between the products or services offered and facilitates sound decision-making to support the continued existence of business entities in the current competitiveness.
Overhead allocation is the process of correctly distributing indirect costs among various cost objects, such as products, services, or departments. This is critical for small businesses, as it helps them achieve accurate pricing, budget, and profitability analyses.
There is the danger of firms setting wrong prices that fail to reflect the correct value and making wrong decisions on resource commitments that cost profits. For example, a café that sells a number of cups of coffee daily but does not incorporate other overhead charges, such as power bills and equipment repair, into the price may find itself pushed out of business because the overhead costs outweigh the sales.
Examples of overhead costs include:
Overhead allocation distributes all these expenses to relevant products, services, or departments reasonably based on some factor that appears reasonable.
The overhead allocation base is the measure, criterion, or standard that is used to spread overhead costs. The basis is a critical factor because it defines how accurately costs are allocated.
Common allocation bases include:
The decision of what basis to use to allocate depends on the type of business you are undertaking. For example, using machine hours is correct for a production company, while direct labor hours are correct for a service-oriented company.
The overhead allocation rate determines the extent of overhead cost absorbed for each activity base unit.
It is calculated using the formula:
Overhead allocation rate = Total overhead costs / Total Allocation Basis
Example:
The overhead cost of a business amounts to $30,000, while the direct labor hours recorded amount to 6,000. The overhead allocation rate is:
Respectively: Rate = 30,000/6,000 = $5 per labor hour.
The type of business can be used as a major determinant of how overhead costs are to be shared. Thus, there are different methods for cost allocation since different industries have their cost structures and operation models.
Overhead allocation is available in many methods, and each method meets various business requirements.
Here are the most commonly used methods, along with their applications:
All the overhead allocations have their strengths and weaknesses, which are discussed below, and should, therefore, undergo a suitability review before any business can adopt them.
Below is an analysis of the pros and cons of four common methods:
| Method | Pros | Cons |
| Direct Labor Hours Method | Simplicity: This is easy to apply because in service-based or more focused highly on human resource companies, this is usually easy to measure in terms of the number of labor hours worked. Relevance for Labor-Driven Businesses: This one links overhead costs to the major expense, the employees, through the use of activity-based costing. | Limited Applicability: This may not hold well for businesses whose cost structure involves much machinery or any factors of production other than labor, such as manufacturing companies. Overhead Variability Ignored: It makes a complete assumption that the rate between hours of work and overhead expenses is constant, while in practice, overhead expenses change from time to time. |
| Machine Hours Method | Ideal for Equipment-Intensive Businesses: Helps accurately estimate overhead costs for organizations whose operations depend on machinery such as factories or workshops. Precision: It prevents Imputing costs on machines to products that rarely, if at all, use the machines in the production process. | Not Suitable for Service Businesses: It does not take into consideration overhead costs, particularly the wage bill. Therefore, it is not suitable for organizations that do not sell physical products. Complexity in Tracking: Calls for tracking the usage of the machines may be difficult, especially for organizations that do not have efficient working tracking systems. |
| Activity Based Costing | High Accuracy: This is designed to point out overhead activities’ specific cost origin, achieving accurate allocation. Customizable: Good for industries whose processes are many and varied since it spearheads the assignment of expenses in relation to the activity. | Resource-Intensive: Costing In establishing and maintaining an ABC system, several costs may be incurred, such as time and money, which may prove difficult, especially for small businesses. Complexity: Stiff needs a lot of data compilation and analysis, a test that small businesses might find cumbersome. |
| Percentage of Direct Costs Method | Ease of Use: Very easy to organize as well as easy to set up for small firms, which have no time or adequate knowledge to do it. Effective for Stable Overheads: It proves effective when overhead cost is less changeable from one accounting period to the next. | Potential for Inaccuracy: It presumes a fixed proportion of direct costs and overhead costs, even if these costs might not be directly proportional to where they are most likely to occur. Limited Insight: Lacks specificity to some overhead costs. It may misallocate them, and it is also inflexible with changes. |
Depending on the approved overhead allocation method, cost sheets reflecting total expenses related to specific products or services are as accurate as the method itself. Overhead allocation in the right way means that the cost sheets point to the correct costs to help in accurate pricing, establishing budgets, and profitability analysis.
Choosing an appropriate method of allocation will provide cost sheets as a useful tool aiming at financial outcomes and strategic development.
The choice of the overhead allocation method is influenced by the nature of the business, industry type, volume of production, and cost behaviour patterns.
Below are key factors to consider:
Real-life Example:
An example of how overhead works is Direct Labor Hours; a graphic design firm allocates overheads to the time incurred on the project. On the other hand, a factory manufacturing automobiles faces total overheads regarding equipment by adopting the Machine Hours Method.
It should be noted that overhead allocation is complicated, and its implementation depends on the systematized approaches that are followed.
Below is a step-by-step guide tailored for small businesses:
Overhead allocation rate= Total overhead costs / Total allocation basis
There are a few challenges and solutions to give you a clear view of overhead allocation:
Overhead allocation requires sound data, and many companies have limited or out-of-date records.
Solution:
Automate the tracking of incorporated parameters such as labor hours and machines used. They need to schedule periodic audits to ensure a more accurate check of their data.
It explains how incorrect selection of allocation methods affects cost spread, hence product pricing and profitability.
Solution:
It is recommended that you use the basic approach to determining your cost, DLH, and then choose other, more rigorous methods for your growing business. Consult with professionals or analyze the cost-driven method to determine which one is most effective in achieving that procedure.
Overs and under-absorption of overhead cost lead to irregular distribution of overheads to cost units.
Solution:
You should update your allocation model from time to time, depending on the changing cost. To remove spikes or blips, rolling averages or seasonality techniques are applied.
Small businesses may not always have the time, skill, or resources necessary to allocate overhead correctly.
Solution:
Introduce efficient and easy-to-use software that will be used in calculation and report generation. Employee training should be given to check this daily, or it should be done by professionals at the time of setting it up and at least once every few months.
Conclusion
Consistent overhead allocation methods are core financial management principles in small businesses. As with any field, by mastering basic knowledge, selecting the proper method of allocation, and using sound plans and steps, indirect costs can be allocated precisely, prices can be set rationally, and therefore, the maximum potential profitability can be attained.
There are always some obstacles to such activities – intern data inaccuracy, pricing changes, etc.- but all these problems can be solved through effective planning, constant review, and the use of advanced technologies. In conclusion, an optimal overhead allocation approach enables organizations to obtain financial transparency and sustain their competitive position within industries.
