The allocation of overhead costs to products or services necessitates a method to estimate these expenses before actual costs are known. This calculation involves dividing the estimated total overhead costs by the estimated total amount of the allocation base. The allocation base is a cost driver, such as direct labor hours, machine hours, or direct material cost, used to assign overhead to products or jobs. For example, if a company anticipates $500,000 in total overhead costs and expects to use 25,000 direct labor hours, the calculation yields a rate of $20 per direct labor hour.
Employing this methodology provides several advantages. It enables businesses to determine product costs more accurately, facilitating better pricing decisions and inventory valuation. It also allows for timely cost estimation, supporting informed management decisions throughout the production cycle. Historically, this approach evolved as manufacturing processes became more complex, demanding a more refined way to distribute indirect costs than simply allocating them at the end of an accounting period.
