Definition of Overhead Allocation
Overhead Allocation refers to the process of assigning indirect costs (such as rent, utilities, depreciation, and administrative expenses) to different cost objects like products, departments, or services. Since overheads cannot be directly traced to a single unit, they are distributed using rational and systematic allocation methods.
Detailed Explanation of Overhead Allocation
In business and accounting, not all costs can be directly linked to a single product or service. For example, electricity bills, factory rent, or salaries of supervisors benefit multiple production lines. These indirect costs, known as overheads, must be allocated fairly across different cost centers.
The purpose of overhead allocation is to ensure accurate product costing, better pricing decisions, and profitability analysis. Without allocation, businesses might understate or overstate the true cost of production, leading to wrong decisions.
Sub-Sections for Clarity
Types of Overheads
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Fixed Overheads – Costs that remain constant regardless of production (e.g., factory rent).
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Variable Overheads – Costs that vary with production volume (e.g., power consumption).
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Semi-variable Overheads – Costs that have both fixed and variable components (e.g., telephone bills).
Cost Objects for Allocation
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Products (different items manufactured)
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Departments (production vs. administrative departments)
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Projects/Contracts (construction or service industries)
Methods of Allocation
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Direct Allocation – Assigning costs directly to departments.
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Step-Down Method – Allocating service department costs sequentially.
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Activity-Based Costing (ABC) – Allocating based on activities driving overhead.
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Predetermined Overhead Rate – Using estimated rates based on labor hours, machine hours, or units.
Formula for Overhead Allocation
The most common formula is:
Example Calculation
Suppose a company estimates annual factory overheads of ₹500,000 and expects to use 25,000 labor hours.
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Overhead Rate = ₹500,000 ÷ 25,000 hours = ₹20 per labor hour
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If a job requires 1,000 labor hours → Overhead Allocated = 1,000 × ₹20 = ₹20,000
Journal Entry for Overhead Allocation
When overheads are applied:
Example: Allocating ₹20,000 overhead to Job A.
If actual overhead differs, adjustment is made at year-end.
Detailed Illustration Calculation
Assume:
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Estimated Overheads = ₹1,000,000
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Machine Hours = 50,000
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Rate = ₹20 per machine hour
For three products:
| Product | Machine Hours Used | Allocated Overhead (₹) |
|---|---|---|
| A | 10,000 | 200,000 |
| B | 20,000 | 400,000 |
| C | 20,000 | 400,000 |
This ensures each product bears its fair share of overheads.
Key Features / Components of Overhead Allocation
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Systematic and rational distribution
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Based on measurable cost drivers
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Helps in fair cost determination
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Requires estimates and adjustments
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Used in both manufacturing and service industries
Importance of Overhead Allocation in Business
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Ensures accurate product costing
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Assists in pricing strategies
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Improves departmental performance evaluation
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Helps in budgeting and cost control
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Required for financial reporting compliance
Advantages and Disadvantages
Advantages
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Ensures fairness in cost distribution
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Aids in profitability analysis
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Provides insight into efficiency of departments
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Improves decision-making
Disadvantages
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Based on estimates, can lead to inaccuracies
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Time-consuming and complex
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May not reflect real usage without ABC method
Usage of Overhead Allocation
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Manufacturing companies for product costing
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Service industries like IT and consulting
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Construction projects for contract costing
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Hospitals, schools, and non-profits for fund management
Case Study Example
Case Study: Toyota Manufacturing
Toyota uses Activity-Based Costing to allocate overhead costs like maintenance, quality control, and energy consumption. This has allowed them to reduce unnecessary expenses and enhance lean manufacturing efficiency.
Case Study: Infosys
In the IT sector, Infosys allocates overhead costs such as software licenses, office rent, and HR expenses across projects. This ensures accurate client billing and profitability measurement.
Practical Example
A bakery produces cakes and cookies. Monthly overhead = ₹100,000.
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Cakes consume 70% of labor hours.
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Cookies consume 30%.
Overhead allocation:
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Cakes = ₹70,000
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Cookies = ₹30,000
This ensures proper pricing for each product.
Common Mistakes in Overhead Allocation
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Using outdated cost drivers
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Ignoring service departments
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Allocating equally instead of proportionately
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Not adjusting for under/over absorption
Real-Life Applications
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Manufacturing – Allocating machine maintenance and factory rent
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Retail – Distributing store rent and advertising across departments
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Healthcare – Allocating nurse salaries, utilities, and admin costs per patient service
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Legal Implications – Proper overhead allocation ensures compliance with accounting standards (GAAP, IFRS) and tax laws
FAQs on Overhead Allocation
Q1: What is the difference between overhead absorption and overhead allocation?
Overhead allocation assigns costs directly, while absorption applies them using a predetermined rate.
Q2: Which industries rely heavily on overhead allocation?
Manufacturing, construction, IT, healthcare, and hospitality industries.
Q3: What is under-absorption of overhead?
When allocated overheads are less than actual overheads incurred.
Q4: Is overhead allocation mandatory in accounting?
Yes, for accurate cost accounting, financial reporting, and compliance.
Expert Tip from Learn with Manika
“Always choose cost drivers that best represent actual resource consumption. Inaccurate allocation can distort product costing and profitability analysis.”
Related Terms
- Overhead Absorption
- Cost Allocation
- Activity-Based Costing (ABC)
- Cost Centers
- Indirect Costs