How much does it cost to create your product or deliver your service? Well, some costs are more apparent than others. If you’re a blue jean manufacturer, for example, your material costs and the labor costs you incur can be easily tracked. However, to determine the full cost of you product, you also need to allocate overhead costs.
Overhead costs are expenses that cannot be directly traced to a product or service. If you’re a manufacturer, for example, you may incur costs to lease your factory. You also incur utility costs to heat and cool your production facility.
These costs cannot be directly tied to a pair of blue jeans you produce. However, every cost you incur in your business must be tied to a product that you sell. To accomplish this, overhead costs are applied to a product using an overhead rate.
If you calculate your total costs, you can properly price your product. Management can then come up with a price that will generate a desired profit margin.
Peanut butter costing
Some companies don’t invest the time required to accurately allocate overhead costs. These businesses use a technique called peanut butter costing. Like spreading peanut butter, they simply spread the cost evenly over every product.
Well, the problem is some products generate more overhead costs than others. Say, for example, that you manage a catering company. You have 5 major clients. 2 of the 5 clients frequently change their orders at the last minute.
Last minute changes cause your firm to incur more costs. For one thing, you have to change the customer invoice. Your production area may need to stop and change their food production process to fill the order. If the order is really last minute, you may have to unload your delivery truck and load the new catering items.
To properly allocate overhead, you need to change your cost assignment process. The catering company should track the cost to take each order, generate an invoice, fill each order and load the truck. If 2 clients generate the most costs, they should be allocated more of the overhead.
Activity-based costing (ABC)
The solution for more precise overhead allocation is activity-based costing (ABC).
To compute a rate to allocate your costs, you need to think about an activity that relates to that cost. Many companies use machine hours or labor hours incurred for their overhead allocation rates.
Say, for example, that you want to allocate overhead for repair and maintenance expenses on your machines. Well, the more you use your machines, the more maintenance they will require. It makes sense to apply repair and maintenance costs to production using machine hours.
Cost allocation example
Assume that you manage Sturdy Jeans, a jean manufacturer. Your production has three departments: cutting, sewing and fabric coloring. Each of these three departments incurs material and labor costs that you can directly trace to production. All three areas also incur overhead costs.
You determine that the most effective way to allocate overhead costs is to use direct labor costs. That’s because you incur more overhead costs as incur more labor hours.
The cutting department
Say that the cutting department incurs overhead costs to repair and service their machinery. The department also pays wages and benefits to a production supervisor. This supervisor’s work cannot be directly traced to production. The total overhead for the department is $16,000 for the month.
You decide to allocate overhead based on labor hours. The total labor hours incurred for the month are 800 hours. So, ($16,000 overhead costs) / (800 hours) = $20 overhead applied per labor hour.
Sturdy produces batches of jeans. The cost to produce a particular batch is tracked on a job cost sheet. This sheet tracks the total material, labor and overhead cost incurred for a specific job or batch.
Assume that a job requires 12 hours of labor costs. The overhead assigned to that job would be ($20 overhead allocation rate) multiplied by (12 hours), or $240. That $240 is added to the material and labor costs. The total represents the entire cost to produce a batch of jeans.
The concept of overhead can be expanded to entire departments within a company. Sturdy Jeans can look at their organization and divide their departments into service departments and production departments.
A service department exists to support other departments that make the product or service. Two good examples are human resources (HR) and accounting functions. While these areas aren’t directly involved in making a product, they provide critical services. HR, for example, helps other departments write job descriptions, collect and review resumes and schedule interviews.
The goal of your cost accounting process is to make sure that all costs ultimately get assigned to a product or service. To accomplish that, you may use two-stage cost allocation.
The first step is to allocate the entire cost of the HR department to other areas that are involved in production. After that, you can allocate from each production area to your products. Two-stage costing helps you ensure that your service department costs eventually end up as part of your product’s cost.
Allocating the HR department’s cost
Let’s assume that the cost to operate your human resources department is $200,000 a year. Since this is an overhead cost, you need an activity level to allocate the cost to other departments. For HR, you decide to use a production department’s percentage of total production employees.
Assume that Sturdy’s cutting department has 30% of the total employees who work in production. That department would be allocated ($200,000 X 30%), or $60,000 for the year. The $60,000 is another overhead cost for the cutting department.
The cutting department may allocate HR costs by simply dividing $60,000 by the number of jeans they produce during the year. The same is true of the other production departments. They would get their HR overhead allocation and allocate the allocation based on the number of jeans they produce.
Your ultimate goal
Allocating overhead is something that you can automate. Most accounting software packages allow you to set up overhead allocations. As you put in the time to do this work, keep the ultimate goal in mind. Allocating overhead helps you to assign all of your company costs to a product or service. Overhead allocation will help you make better business decisions.