Overhead Cost Allocation: Three Bases and a Worked Example on 12 Products

Overhead cost allocation is the split of a month’s production overhead (shop rent, electricity, foremen’s pay, security) between products by a chosen base, for example units, cost of materials or labor hours. The base decides how much each product receives. In the example below a stool with €5 of materials takes €6.00, €1.50 or €1.20 of overhead, and a wardrobe with €97.50 of materials takes €6.00, €29.25 or €28.80.

The example is fictional: a 12-person furniture shop makes 12 kinds of products and has €2,400 of overhead in the month.

How does overhead allocation to product cost work?

Direct costs are known at the moment of production. Boards, hardware and the assembler’s piecework pay enter the product by specification. Shop rent, lighting, the pay of the production manager and foremen, lubricants, work clothes, security and waste removal do not work that way, because they belong to the shop as a whole. They are first accumulated over the month and then split between products. That second step is the allocation.

Common accounting frameworks (IAS 2 is one example) treat these as production overheads and separate a variable part from a fixed part. The variable part is allocated on actual output. The fixed part is allocated on the normal capacity of the shop, and the unallocated remainder of fixed overhead is expensed in the period. The company chooses the base (labor hours, wages, activity volume, direct costs) and records it in its accounting policy. This is the general scheme, and your accountant confirms the treatment for your company. In the example below the whole amount is allocated on actual output, with no split into fixed and variable parts.

Which overhead allocation bases are used in a shop?

Each base gives a coefficient by which you multiply a product’s indicator. Output for the month is 400 units, materials cost €8,000 and labor is 1,000 hours. By units, €2,400 is divided by 400 and gives €6 per product regardless of size. By cost of materials the rate is €0.30 of overhead per euro of materials (2,400 / 8,000), and by labor hours it is €2.40 per hour (2,400 / 1,000).

Units work for products close in size and labor content, for example chairs of one model. In a range from stools to wardrobes, units load small products the same as large ones. Cost of materials ties overhead to the price of the product, but an expensive material may need as much work as a cheap one. A veneer front costs more than chipboard, and the machines and people spend the same time on it. Labor hours are closer to what rent, electricity and foremen consume, which is the time a product spent in the shop. This needs records of hours by product. In shops with heavy equipment, machine hours play the same role.

What input data do you need to allocate shop rent across 12 products?

The month’s overhead has five items.

Output, materials and hours by product.

What do the three bases give?

Each product is multiplied by the coefficient of the base. For a stool that is €6.00 by units, 5 × 0.30 = €1.50 by materials and 0.5 × 2.40 = €1.20 by hours. For a wardrobe it is €6.00, 97.50 × 0.30 = €29.25 and 12 × 2.40 = €28.80.

The check is by total. By units 400 × 6 = €2,400. By materials 8,000 × 0.30 = €2,400. By hours 1,000 × 2.40 = €2,400. Every base returns the same €2,400, and only the recipient changes.

On the stool the difference is visible at once. By units it carries €6.00 of overhead against €5 of materials, so overhead is larger than materials. By materials it is €1.50 (30% of materials), by hours €1.20 (24%). On the wardrobe the same units base adds €6.00 to €97.50, about 6%, while materials and hours give 30% and 29.5%. Over the month 60 stools receive €360, €90 or €72, and 8 wardrobes receive €48, €234 or €230.40.

Which base distorts less in a shop like this?

In this range materials and hours give the same amount, or differ by less than 2%, for five products: both chairs, the cabinet, the bed and the wardrobe. They diverge on tables and small products. A dining table takes €12.00 by materials and €14.40 by hours, a desk €14.40 and €16.80. These products take longer to make than the value of their materials suggests.

Moving from units to hours takes €516 off stools and shelves. By units, stools and shelves carry 60 × 6 + 50 × 6 = €660, and by hours 60 × 1.20 + 50 × 1.44 = €144. The remaining €516 is spread between the ten other products. The conclusion applies to this shop, where the labor content of small products is far below average. In a shop with uniform output the three bases would come closer together.

How does the allocation base affect the price of a stool and a wardrobe?

Suppose the shop sets price as cost (materials plus overhead) plus 30%. Direct labor is left out to keep the calculation short. With the base “units”, the stool costs 5 + 6 = €11 and the price is 11 × 1.3 = €14.30. By hours the cost is 5 + 1.20 = €6.20 and the price €8.06. The price by units is €6.24 higher, which is 77% of the price by hours.

The wardrobe drifts the other way. By units its cost is 97.50 + 6 = €103.50 and the price €134.55. By hours the cost is 97.50 + 28.80 = €126.30. If the wardrobe is sold at the price from the “units” base, its markup over the hours-based cost is (134.55 − 126.30) / 126.30 = 6.5% instead of the planned 30%. A stool at the “units” price would earn 131% markup over its hours-based cost, (14.30 − 6.20) / 6.20.

The choice of base turns into a pricing decision. A stool priced by units loses against competitors on price, and a wardrobe sells almost at cost.

What changes when the shop runs below capacity?

Overhead does not depend on output: rent and security are paid in full in a quiet month too. Suppose 750 hours are worked instead of 1,000 and overhead stays at €2,400. At actual hours the rate becomes 2,400 / 750 = €3.20 per hour, and a stool gets 0.5 × 3.20 = €1.60 instead of €1.20. The unit cost rose because the shop stood idle.

For the fixed part of overhead, accounting frameworks such as IAS 2 allocate on normal capacity. If the normal capacity of the shop is 1,000 hours, the rate stays at €2.40 per hour. On 750 worked hours, 750 × 2.40 = €1,800 is allocated, and the unallocated 2,400 − 1,800 = €600 goes to period expense. A stool in such a month carries the same €1.20, and the idle time shows as a separate line. In the examples above the whole overhead was treated as allocated on actual output.

What does an overhead calculation sheet look like?

The sheet from which the accountant takes amounts for the document holds one table per month. The stool row on the hours base looks like this.

The rate is calculated once as total overhead divided by the total base. The remaining rows are filled in the same way, and the total must match the amount accumulated for the month.

How do you allocate overhead costs in Bimp?

First, costs are accumulated with no link to an order. In Finance → Other cash operations you create “Other expenses”, turn on the “To cost price” switch and choose an expense item of type “Cost price”, for example “Work in progress”. A landlord’s or utility’s invoice can also be posted through “Goods and services receipt” with the “Management accounting” switch. The amounts show up in the “Accumulated cost” report, and the ways to do it are described in Cost accumulation.

Then you create a document in Warehouse → Cost allocation. In the “Allocate to” field choose “Produced goods” and specify the “Period” and “Warehouse”. On the “Products” tab the Fill button loads the products, and on the “Costs” tab it loads the unallocated costs assigned to cost price. The Allocate button offers the base “By amount” or “By quantity”, fills the “Costs amount” column and shows “Allocated” and “Accrued” at the bottom of the window. In the example, a base of “cost of materials” is close in logic to “By amount”, because more expensive products receive a larger share.

If the allocated amount does not equal the amount of costs, the document will not post. After posting, Bimp moves the accumulated amounts from the accumulation accounts to the cost price of produced goods, and the result appears in the “Accumulated cost” and “Gross profit” reports. A step-by-step guide is in Cost allocation. How overhead fits into the overall formula is covered in the guide to manufacturing cost calculation and on the Bimp home page.

What does Bimp do and what does it leave out?

Bimp is a Ukrainian cloud ERP for manufacturers. It accumulates indirect costs, splits them with the “Cost allocation” document by amount or by quantity and requires the allocated amount to match the accumulated one. The document has no other bases, so allocation by labor hours or machine hours is calculated by the accountant in a sheet. The system does not suggest the split into fixed and variable costs, the normal capacity under your accounting framework or the choice of base. Those decisions belong to the cost accountant and the chief accountant.

What did the 12-product calculation show?

The same €2,400 of overhead fell on cost price differently depending on the base. On the stool the difference was fivefold, €6.00 by units against €1.20 by hours. On the wardrobe materials and hours nearly matched, €29.25 and €28.80, while units gave only €6.00. The stool price calculated by units is €6.24 higher than by hours.

Related reading on cost: landed cost of imported components, scrap accounting, by-product and scrap cost allocation.

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