Allocating overhead

Overhead allocation decides how much of the shared cost of running a business each job, product or customer carries. Done badly, it makes some work look more profitable than it is and other work look worse, and prices drift in the wrong direction.

The predetermined rate

Overhead is applied with a rate set before the year begins:

Predetermined overhead rate = Budgeted overhead ÷ Budgeted activity

Using a budgeted rate, instead of waiting for actual costs, means jobs can be costed and quoted as they happen, and that a job done in a quiet month isn't charged more than the same job done in a busy one.

Choose the activity base with care. It should be the thing that drives the overhead. Labour hours suit a business whose overhead grows with the hours its people work. Machine hours suit a workshop. Number of jobs or calls suits costs that arise once per job, such as dispatching and invoicing.

Normal capacity and idle time

What should the denominator be: the hours the business could work, the hours it expects to work, or the hours it actually works? IAS 2, the IFRS standard for inventories, requires fixed production overhead to be allocated on the basis of normal capacity, the output expected on average over several periods under normal circumstances. Overhead that is not absorbed because output was low is expensed in the period instead of loaded onto the units produced.

Hartley doesn't hold inventory, so IAS 2 doesn't govern its job costing. The reasoning still applies to pricing: if the rate is set on a year of unusually low activity, each job carries an unusually high share of overhead, quotes rise, more work is lost, and activity falls further.

Hartley treats the unbilled time of its salaried plumbers as overhead. That choice keeps the cost of a billable hour honest: if a third of paid hours go unbilled, someone has to pay for them, and the only source is the billed hours.

Under- and over-applied overhead

At year end, overhead applied to jobs (actual activity times the predetermined rate) rarely equals overhead actually incurred.

Under-applied overhead = Actual overhead − Applied overhead

If the difference is small, close it to cost of goods sold or cost of services. If it is large, investigate. It usually means activity was below plan, spending was above plan, or the activity base doesn't drive the costs.

More than one pool

A single plant-wide rate is easy but treats every hour as consuming overhead in the same way. If a large part of overhead arises per job instead of per hour, short jobs will be under-costed and long jobs over-costed. Splitting overhead into two or more pools, each with its own driver, fixes this. Activity-based costing extends the idea to many pools. For a small business, two or three well-chosen pools capture most of the benefit.