Overhead Cost Allocation

Costs incurred by cost centers are classified into two types

a) Direct Costs
b) Indirect Costs
Costs which can be traced to the finished products manufactured are called ‘direct costs’. In other words a relationship between costs and finished products manufactured can be established.
Costs which cannot be traced to the finished products manufactured are called ‘indirect costs’. They are also known as ‘Overheads’. This implies overheads can only be apportioned to the finished products.
Example: A unit manufactures two products – Leather shoes & Leather wallets
Material (Leather) used for both the products is traceable to them individually. However, expenditure of a common machine used in making both the products cannot be traceable to them.
Therefore in the above case ‘Material’ would be a direct cost and ‘Machine expenses’ would be indirect cost.
Importance of overhead allocation
Total cost of product constitutes Direct Material, Direct Labor & Overheads. Direct Material and Direct Labor are directly traceable to the products manufactured. Accuracy of product cost computation depends on accurate distribution of overheads to products. Inaccuracies would lead to incorrect decisions – especially the pricing decisions.
However, the method of overhead distribution should be chosen by considering time and cost factors in addition to accuracy.
Traditional Distribution
Traditionally overhead apportionment to products was made in the following three step approach
I) Primary Distribution (Allocation & Apportionment)
II) Secondary Distribution (Re-apportionment)
III) Absorption

If you own a manufacturing company, your small business incurs a number of expenses other than direct labor. You must allocate those expenses to the product you make, so you know the true cost of manufacturing the item. How you allocate those expenses depends on how you categorize them. You must also decide whether you want to create a report for external purposes, such as reporting to the IRS, or for internal purposes, such as a budget meeting.

Variable Costs

List all the amounts for your variable costs in manufacturing your product. Variable costs include direct labor, raw materials, supplies, shipping expenses and production bonuses. These are called variable because they rise or fall with the number of products you produce. Always include variable expenses as part of your product costs.

Fixed Costs

You incur fixed costs no matter how many products you produce. Fixed costs include rent or mortgage payments for production facilities, insurance, property taxes, equipment lease payments and depreciation on equipment you own.

Absorption Costing Method

Under the absorption costing method, you can allocate your fixed overhead costs to products by determining how many of those products you sold. For example, you may find that you sold 80 percent of the products you manufactured. Assign 80 percent of your fixed overhead expenses to the cost of making those products. Use this method when making external reports to the IRS or any other entity outside of your business. The IRS will not accept any costing method other than the absorption costing method.

Variable Costing Method

Use the variable costing method for your internal reports. This method allocates all fixed overhead costs as part of your product expense, no matter how many products you sold. If you sold 80 percent of your products in any given time period, allocate 100 percent of your fixed overhead expenses to those products. This gives you a clear picture of which expenses you must keep up with no matter how much you sell. Your variable costing figure can be useful for budget and sales meetings.

Per Unit Cost

If you want to find out the total expense you have in each individual product, add your variable and fixed costs together and divide by the number of products you manufactured. For example, if your total expenses were $250,000 and you made 1 million products, divide 250,000 by 1,000,000 and you get .25. This means your products cost 25 cents each to make.

References (4)

About the Author

Kevin Johnston writes for Ameriprise Financial and Rant Finance. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP and Bank of America.