Lesson 32 - Intermediate Accounting Course 

32. Overhead Allocation and Costing Methods

Understanding how businesses allocate and apply overhead costs is crucial for accurate financial reporting, pricing, and profitability analysis. Overhead costs are the indirect costs that cannot be directly traced to a single product or service but are essential for operations.

1️⃣ What Is Overhead?

Overhead refers to the ongoing business expenses that are not directly tied to production but are necessary for running a company. These costs can be:

✔ Types of Overhead Costs:

1. Fixed Overhead: Costs that do not change regardless of production levels.
   
   

   • Rent, insurance, salaries of administrative staff.
     
     

2. Variable Overhead: Costs that fluctuate with production volume.
   
   

   • Utilities, machine maintenance, packaging.
     
     

3. Semi-Variable Overhead: Costs that have both fixed and variable components.
   
   

   • Sales commissions, some utility bills (base charge + usage fee).
     
     

Properly allocating these costs ensures that pricing decisions, profitability analysis, and financial statements accurately reflect the company's cost structure.

2️⃣ Why Is Overhead Allocation Important?

✔ Accurate Product Pricing – Ensures products or services are priced to cover all costs.
✔ Profitability Analysis – Helps identify which products or services are truly profitable.
✔ Financial Reporting – Allocates costs correctly for tax and financial statements.
✔ Budgeting & Cost Control – Allows businesses to analyze and reduce unnecessary expenses.

3️⃣ Methods of Overhead Allocation

There are different ways to allocate overhead costs to products or services. The most suitable method depends on the nature of the business and its cost structure.

1. Traditional Overhead Allocation (Single Cost Driver)

This method applies overhead based on a single cost driver, such as:

• Direct Labor Hours (commonly used in labor-intensive industries).
  
  

• Machine Hours (suitable for automation-heavy industries).
  
  

• Direct Material Costs (used in businesses where materials are a major cost factor).
  
  

Formula:

Example:

A factory has $100,000 in overhead costs and operates 50,000 machine hours. 

If a product requires 5 machine hours, the overhead assigned to it is $10 (5 × $2).

✅ Pros: Simple and easy to apply.
❌ Cons: Can be inaccurate if a single cost driver does not reflect the actual consumption of overhead.

2. Activity-Based Costing (ABC Method)

ABC assigns overhead based on multiple activities and cost drivers rather than a single one.

How ABC Works:

1. Identify all activities that incur overhead costs (e.g., machine setup, inspections, order processing).
   
   

2. Assign a cost pool for each activity.
   
   

3. Determine a cost driver for each pool (e.g., number of machine setups, number of inspections).
   
   

4. Allocate costs based on actual usage of these activities.
   
   

Example of ABC Allocation:

A company has overhead costs related to:

• Machine Setup ($40,000) – based on number of setups.
  
  

• Quality Inspections ($30,000) – based on number of inspections.
  
  

• Packaging ($30,000) – based on units packaged.
  
  

If a product requires 10 setups, 20 inspections, and 50 packaging units, overhead is applied based on usage rather than a single rate.

✅ Pros: More accurate, improves decision-making.
❌ Cons: More complex, requires detailed data tracking.

3. Job-Order Costing vs. Process Costing

Companies allocate overhead differently depending on whether they produce custom or mass-produced goods.

Job-Order Costing (for custom products or services)

• Overhead is applied to specific jobs or projects.
  
  

• Used in construction, legal services, custom manufacturing.
  
  

• Costs are tracked separately for each order.
  
  

Process Costing (for mass production)

• Overhead is spread across a large volume of identical products.
  
  

• Used in industries like food processing, chemicals, textiles.
  
  

• Costs are divided per unit based on production volume.
  
  

✅ Pros: Tailored to specific production environments.
❌ Cons: Job costing requires tracking each project separately; process costing assumes uniform costs.

4. Predetermined Overhead Rates

Instead of waiting for actual overhead costs, businesses use a predetermined rate based on estimated costs.

Formula:

Example:

A factory estimates $200,000 in overhead and expects 80,000 labor hours. 

If a worker spends 10 hours on a project, overhead applied = $25.

✅ Pros: Helps with budgeting, prevents cost delays.
❌ Cons: Can lead to inaccurate allocations if estimates are incorrect.

4️⃣ Choosing the Right Overhead Allocation Method 

5️⃣ Impact of Overhead Allocation on Business Decisions

🔹 Pricing Strategy – Ensuring that overhead is properly allocated prevents underpricing and loss of profitability.
🔹 Cost Control – Identifying high overhead costs helps businesses cut unnecessary expenses.
🔹 Profitability Analysis – Helps determine which products or services generate the most profit.
🔹 Financial Reporting & Compliance – Ensures that financial statements accurately reflect cost structures.

6️⃣ Summary & Key Takeaways

✔ Overhead costs are indirect costs that must be allocated for accurate pricing and profitability.
✔ Traditional Overhead Allocation uses a single cost driver but may not reflect actual usage.
✔ Activity-Based Costing (ABC) provides a more accurate method by allocating costs based on multiple drivers.
✔ Job-Order Costing is used for custom projects, while Process Costing is for mass production.
✔ Predetermined Overhead Rates help companies estimate costs in advance for budgeting.

Choosing the right overhead allocation method is essential for accurate financial management and strategic decision-making.