Overhead Allocation is a crucial aspect of cost accounting that involves distributing indirect costs to the various operational segments that utilize these resources. Indirect costs, such as utilities, rent, and administrative expenses, are not directly attributable to a specific product or service but are necessary for the overall operation of a business. By allocating these costs accurately, businesses can better understand the true cost of their products or services and make more informed financial and operational decisions.
A common method of overhead allocation is using a predetermined overhead rate, which involves calculating an estimate based on a consistent metric, such as labor hours or machine usage. For example, if a business has $100,000 in overhead expenses and plans 10,000 direct labor hours, the overhead allocation rate would be $10 per labor hour. Each product or project would then be assigned overhead costs proportional to the labor or machine hours it requires.
For instance, if a project requires 200 labor hours, $2,000 of overhead costs would be allocated to this project. Understanding and updating overhead allocation methods are essential for maintaining accurate financial records and making informed business strategy decisions.