Overhead allocation rate is a crucial concept in cost accounting that involves spreading overhead costs to products or services produced by a business. Overhead costs are expenses not directly tied to a specific product or service, such as rent, utilities, administrative salaries, and insurance. Allocating these costs accurately is essential for determining the total cost of products and services, setting prices, evaluating profitability, and making informed resource allocation decisions.
Key Facts
- Definition: Overhead allocation, also known as overhead absorption, is a method used in cost accounting to spread overhead costs to the products or services that a business produces.
- Overhead Costs: Overhead costs are expenses that are not directly tied to a specific product or service, such as rent, utilities, administrative salaries, insurance, etc. These costs need to be allocated to the products or services to determine their total cost.
- Allocation Base: The method for allocating overhead costs depends on the chosen allocation base. Common bases used for allocation include direct labor hours, direct labor costs, or machine hours. The allocation base should ideally have a direct correlation with the overhead costs incurred.
- Calculation: To calculate the overhead rate, the total overhead costs are divided by the allocation measure. For example, if the allocation measure is machine hours, the overhead rate is calculated by dividing the total overhead costs by the total machine hours.
- Impact on Costs and Profitability: The method of overhead allocation can significantly impact reported costs and profitability of different products or services. Different methods may be appropriate for different purposes, such as pricing, performance evaluation, or decision making.
Definition of Overhead Allocation Rate
Overhead allocation rate is a method used in cost accounting to distribute overhead costs to products or services. This rate is calculated by dividing the total overhead costs by the chosen allocation measure, which is typically a factor that has a direct correlation with the overhead costs incurred. Common allocation bases include direct labor hours, direct labor costs, or machine hours.
Calculation of Overhead Allocation Rate
The formula for calculating the overhead allocation rate is as follows:
Overhead Allocation Rate = Total Overhead Costs / Allocation Measure
For instance, if a company has total overhead costs of $100,000 and uses direct labor hours as the allocation measure, with a total of 10,000 direct labor hours, the overhead allocation rate would be:
Overhead Allocation Rate = $100,000 / 10,000 hours = $10 per direct labor hour
This means that for every direct labor hour incurred in the production of a product or service, $10 of overhead costs are allocated to that product or service.
Impact of Overhead Allocation Rate
The method of overhead allocation can significantly impact the reported costs and profitability of different products or services. This is because the allocation rate directly affects the amount of overhead costs assigned to each product or service. Different allocation methods may be appropriate for different purposes, such as pricing, performance evaluation, or decision making.
Conclusion
Overhead allocation rate is a critical tool in cost accounting that helps businesses accurately determine the total cost of products and services, set prices, evaluate profitability, and make informed resource allocation decisions. The choice of allocation base and the method used for calculating the overhead allocation rate can have a significant impact on the reported costs and profitability of different products or services. Therefore, it is essential for businesses to carefully consider and select the most appropriate allocation method based on their specific circumstances and objectives.
References:
- FreshBooks. (2023, April 10). What Is Overhead Cost and How to Calculate It. FreshBooks. https://www.freshbooks.com/hub/accounting/overhead-cost
- Hayes, A. (2020, December 03). Overhead Rate Meaning, Formula, Calculations, Uses, Examples. Investopedia. https://www.investopedia.com/terms/o/overhead-rate.asp
- SuperfastCPA. (n.d.). What is Overhead Allocation? SuperfastCPA CPA Review. https://www.superfastcpa.com/what-is-overhead-allocation/
FAQs
What is overhead allocation rate?
Overhead allocation rate is a method used in cost accounting to spread overhead costs to the products or services that a business produces. Overhead costs are expenses that are not directly tied to a specific product or service, such as rent, utilities, administrative salaries, and insurance.
How is overhead allocation rate calculated?
Overhead allocation rate is calculated by dividing the total overhead costs by the chosen allocation measure. Common allocation measures include direct labor hours, direct labor costs, or machine hours.
What is the purpose of overhead allocation rate?
The purpose of overhead allocation rate is to accurately determine the total cost of products and services, set prices, evaluate profitability, and make informed resource allocation decisions.
How does overhead allocation rate impact the cost of products and services?
The overhead allocation rate directly affects the amount of overhead costs assigned to each product or service. Therefore, it can significantly impact the reported costs and profitability of different products or services.
What factors should be considered when choosing an allocation base for overhead allocation rate?
When choosing an allocation base for overhead allocation rate, businesses should consider factors such as the nature of the overhead costs, the relationship between the allocation base and the overhead costs, and the availability of data.
Can different allocation methods be used for different purposes?
Yes, different allocation methods may be appropriate for different purposes. For example, one method may be used for pricing, while another method may be used for performance evaluation or decision making.
How can businesses ensure that the overhead allocation rate is accurate and appropriate?
Businesses can ensure that the overhead allocation rate is accurate and appropriate by carefully selecting the allocation base and the allocation method, and by regularly reviewing and updating the overhead allocation rate as needed.
What are some common challenges associated with overhead allocation rate?
Some common challenges associated with overhead allocation rate include the difficulty in accurately identifying and classifying overhead costs, the selection of an appropriate allocation base, and the potential for the allocation method to distort the reported costs and profitability of different products or services.