How Do You Allocating Overhead Costs to Products?

Job costing assigns overhead costs to a job based upon a predetermined rate, which is calculated as a ratio of total overhead (or a specific pool of overhead) to a specific type of activity (allocation base). 

Process costing requires assigning a percentage of overhead to the types of products produced by a given department. 

There are several approaches to determine the percentage of overhead to attribute to a particular product. 

Companies allocate overhead costs using either:  

• plantwide rate, 
• department rates, or 
• activity-based costing.

Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool.

What is a Cost Pool?

Groups of overhead costs are called cost pools. 

The plantwide allocation approach uses one cost pool to collect and apply overhead costs and therefore uses one predetermined overhead rate for the entire company. 

The department allocation approach uses several cost pools (one for each department) and therefore uses several predetermined overhead rates.

The activity-based costing approach uses several cost pools (one for each major activity) and therefore uses several predetermined overhead rates.

The choice of an allocation method depends on how managers decide to group overhead costs and the desired accuracy of product cost information. 

In general, the more cost pools used, the more accurate the allocation process.

Why Allocate Overhead Costs?

Three important reasons that managers allocate overhead costs to products are described in the following:

Provide information for decision making. Setting prices for products is one example of a decision that must be made by management. Prices are often established based on the cost of products. It is not enough to simply include direct materials and direct labor. Overhead must be considered as well.

Promote efficient use of resources. Several different activities are performed to produce a product, such as purchasing raw materials, setting up production machinery, inspecting the final product, and repairing defective products. All of these activities consume resources (consuming resources is another way of stating that a cost is associated with each of these activities). If products are charged for the use of these activities, managers will have an incentive to be efficient in utilizing the activities.

Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. GAAP requires that all manufacturing costs—direct materials, direct labor, and overhead—be assigned to products for inventory costing purposes. This requires the allocation of overhead costs to products.

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing