Overhead Allocation

Definition

Overhead allocation is the process of assigning indirect costs, or overhead, to the products or services produced by a business. It is a critical component in determining the full cost of a product or service and is essential for both activity-based costing and the analysis of overhead variances.

5 Must Know Facts For Your Next Test

1. Overhead allocation is essential for determining the full cost of a product or service, which is necessary for accurate pricing, profitability analysis, and decision-making.
2. In activity-based costing (ABC), overhead costs are allocated to products or services based on the activities required to produce them, rather than using a single, company-wide overhead rate.
3. Overhead variances compare the actual overhead costs incurred to the budgeted or expected overhead costs, allowing managers to identify and address inefficiencies in overhead management.
4. The choice of overhead allocation method can significantly impact the reported costs of individual products or services, which can influence strategic decisions such as product mix, pricing, and outsourcing.
5. Accurate overhead allocation is particularly important in industries with high overhead costs, such as manufacturing, where overhead can represent a significant portion of the total cost of production.

Review Questions

• Explain how overhead allocation is used in the calculation of activity-based product costs.
  • In activity-based costing (ABC), overhead costs are allocated to products or services based on the specific activities required to produce them, rather than using a single, company-wide overhead rate. This allows for a more accurate representation of the full cost of a product or service, as it takes into account the varying levels of overhead resources consumed by different activities. By understanding the drivers of overhead costs and assigning them to products based on the activities they require, ABC provides a more precise and informative cost structure for decision-making.
• Describe how overhead variances are computed and used to evaluate the efficiency of overhead management.
  • Overhead variances compare the actual overhead costs incurred to the budgeted or expected overhead costs. This allows managers to identify and address inefficiencies in overhead management. The overhead variance is calculated by subtracting the budgeted overhead from the actual overhead, and can be further broken down into spending and efficiency variances. The spending variance reflects differences between actual and budgeted overhead costs, while the efficiency variance reflects differences between the actual and expected overhead usage. By analyzing these variances, managers can pinpoint areas where overhead costs are being managed inefficiently and implement corrective actions to improve overall overhead performance.
• Evaluate the importance of accurate overhead allocation in the context of strategic decision-making, such as product mix, pricing, and outsourcing decisions.
  • The choice of overhead allocation method can significantly impact the reported costs of individual products or services, which can in turn influence strategic decisions. If overhead costs are not accurately allocated, the reported costs of some products may be artificially inflated or deflated, leading to suboptimal decisions regarding product mix, pricing, and outsourcing. For example, if overhead is not properly allocated, a company may mistakenly believe that a particular product is unprofitable and decide to discontinue it, when in reality, the product may be a valuable contributor to the overall business. Accurate overhead allocation is particularly important in industries with high overhead costs, where overhead can represent a significant portion of the total cost of production. By ensuring that overhead is allocated correctly, companies can make more informed strategic decisions that maximize profitability and competitive advantage.

Related terms

Indirect Costs:

Costs that cannot be directly attributed to the production of a specific product or service, such as rent, utilities, and administrative salaries.

Activity-Based Costing (ABC): A costing methodology that assigns overhead costs to products and services based on the activities required to produce them.

Overhead Variance: The difference between the actual overhead costs incurred and the budgeted or expected overhead costs, which can be used to evaluate the efficiency of overhead management.