Allocation and inproportion of overheads

Overhead allocation is the apportionment of indirect costs to produced goods. It is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.

There are two types of overhead, which are administrative overhead and manufacturing overhead. Administrative overhead includes those costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing overhead. Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

You need to allocate the costs of manufacturing overhead to any inventory items that are classified as work-in-process or finished goods. Overhead is not allocated to raw materials inventory, since the operations giving rise to overhead costs only impact work-in-process and finished goods inventory.

Method 1. Distribution in Proportion to Prime Cost:

According to this method, the rate of overhead equals the total overhead cost of the enterprise expressed as a fraction of the prime costs. Thus we get,

Rate of overhead = Total overhead costs/Total prime cost

This rate of overhead multiplied by the prime costs on the item of manufacture, gives the part of total overhead costs allocated to that item of manufacture. Evidently this method of distribution of overhead costs ignores the fact that in the manufacture of two different items, labour and material employed may be of different rates and the machines used may also be of different capacities and efficiencies.

Method 2. Distribution in Proportion Direct Labour Cost:

According to this method, the rate of overhead equals the total overhead cost of the enterprise expressed as a fraction of the direct labour costs.

Thus we have:

Rate of overhead = Total overhead costs/Total direct labour cost

This rate of overhead multiplied by the direct labour costs on the item of manufacture gives the part of total overhead costs allocated to that item of manufacture. This method suffers from the drawback that no difference has been made in the cost of manual labour and the cost of machine labour.

Method 3. Distribution in to Direct Material Costs:

According to this method, the rate of overhead equals the total costs of the enterprise expressed as a fraction of the direct material costs. Thus we have.

Rate of overhead = Total overhead costs/Total direct material cost

This rate of overhead multiplied by the direct material costs on the item of manufacture gives the overhead costs allocated to that item of manufacture. This method has the serious drawback that values of materials used in different items of manufacture may vary widely.

Method 4. Distribution on Man-Hour Rate:

According to this method, the rate of overhead equals the total overhead costs of the enterprise divided by the total productive man-hour utilised during the period. Thus we have,

Rate of overhead = Total overhead costs/Total productive hours worked

The rate of overhead multiplied by the productive man-hours used in the manufacture of the item under consideration, gives overhead costs allocated to that item of manufacture.

This method considers only the man-hours and ignores the efficiency of machines that may be used. On different items of manufacture, the machines used may have widely.

Method 5. Distribution on Machine-Hour Rate:

This method assumes that the production overhead expenses are proportional to the operating hours of the machines. Accordingly we have, the rate of overhead costs or machine-hour = total overhead costs on machines divided by the number of machine-hours.

This rate of overhead costs multiplied by the number of machine hours gives the overhead costs allocated to the item of manufacture under consideration.

Method 6. Distribution on Unit Output Rate:

This method assumes that the total, overhead costs are proportional to the total output. Thus we have, the Rate of overhead costs per unit production

Rate to overhead costs per unit production = Total overhead costs/Number of units produced

This rate of overhead costs multiplied by the number of units of the item manufactured gives the overhead costs allocated to that item of manufacture. This method is, however, applicable to such shops only which produce one type of products. This method has the advantage that it provides a standard rate of overhead costs for all items of manufacture.