How does overhead allocation work?

Definition

Overhead allocation is the rule a shop uses to split shared costs onto products, jobs, or departments. On the books, this is how much of the shared pool each job or department receives.

A machine shop can point bar stock and the machinist's hours at one run. The rent, the power, and the shop supervisor have to be split, and this method is that split.

Cash-basis and accrual books both still post the actual rent and power as they happen. The method is only how those shared dollars are assigned after they are collected.

This method is the split. It is not the rent bill, and it is not the finished part.

Where it shows up

Balance Sheet: Related to work in process that receives the allocated costs.

P&L: Related to how indirect costs land on jobs or departments.

See also: Manufacturing Overhead · Cost Center · Job Costing

When you look at your Balance Sheet, you will not see an allocation-method line. You see the shared cost after it has been applied, sitting in work in process inventory or in finished goods inventory.

When the method is current, each open job holds a fair share of the floor. When it is stale, a short job can carry last year's rate, or a long job can escape cost that belongs to it.

The Income Statement does not print the method. Related cost shows up as cost of goods sold when the finished parts sell, or as department expense when the split is by department.

On the Statement of Cash Flows, paying the shared bills is the cash event. The split itself does not move cash.

Inventory is where applied factory cost waits until the parts sell. Office costs split by department never enter inventory; they hit the P&L in the period they are assigned.

How it works

The shop first collects the shared costs in a pool, or in more than one pool. Factory rent and power might share a pool; the office might use another.

It then picks a base that explains how those costs are used. Machine hours, labor hours, and square feet are common bases.

The pool divided by the base is the rate for the period. Each job or department is then charged that rate times the base it actually used.

Stay with the split when you read this method. Direct materials already sit on the job; this step is only the shared layer.

A planned rate can be set at the start of the year from expected costs and expected hours. Actual bills still post as they come in, and the difference is explained later.

Do not treat the method as proof the bills have been paid. Accounts payable still holds an unpaid landlord bill until cash leaves.

After a job is finished, the assigned share rides with the rest of the unit cost into finished goods. Until the parts sell, those dollars are still an asset.

Keep the worksheet that shows the pool, the base, and the rate. Anyone tying a job to the floor should be able to see why that job received its share.

A quiet month with the same rent makes the rate higher. The same shared dollars spread over fewer hours, so each hour carries more.

Current assets hold the inventory that received the split. A department split that never touches inventory hits the P&L in the period of the assignment.

Example

A machine shop expects $6,000 of floor cost this month and 300 machine hours. The planned rate is $20 per machine hour.

Job 14 runs 40 hours on the mill. The method assigns 40 times $20, or $800, to that job.

There is no allocation-method account to post. The books still collect the actual $6,000 of floor cost, then apply $800 to Job 14's work in process using the shop's overhead account.

If the other jobs use the remaining 260 hours, they pick up $5,200. The full $6,000 has then been assigned if actual hours matched the plan.

The Income Statement does not change until Job 14's parts sell. Until then the $800 is still inventory on that job.

Common mix-ups

Overhead allocation is not the shared cost itself. The cost is the rent and power; this method is only how those dollars are split.

Overhead allocation is not a ledger account. You do not debit or credit the method when a job receives its share.

Overhead allocation is not the same thing as a departmental income statement. A department split can feed that report, but the method is the rule, not the report.

Related terms

• Manufacturing Overhead: Indirect production costs applied to units made.
• Cost Center: A part of the business tracked for its spending rather than its profit.
• Job Costing: Tracking revenue and cost for each individual job, project, or order.
• Departmental P&L: An income statement split by department, location, or product line.
• Standard Cost: A pre-set expected cost per unit used for planning and comparison.
• Fixed Costs: Costs that stay roughly the same regardless of sales volume.
• Contribution Margin: Revenue minus variable costs, showing what is left to cover fixed costs.
• Cost Variance: The gap between actual cost and the standard or budgeted cost.