What Is Overhead Cost Allocation?

Overhead cost allocation determines how much money is routed to cover expenses incurred in the course of doing business. This may be useful for budgeting and planning, where it is important to know how much a company spends on various business activities. Determining the source of costs can help companies decide how to price products and services. It can also provide information about where expenses could be cut to increase profits. Departments could be eliminated, moved, or rearranged, for example, to limit their overhead.

Costs like rents, utilities, labor, and supply purchases are examples of overhead costs. Without incurring these expenses, a business cannot operate. Overhead is not, however, necessarily efficient, and companies may waste funds as a result. Two departments might repeat each other, for instance, or a company might not have an efficient phone service plan. In overhead cost allocation, businesses determine where their expenses come from, and how to compensate for or address them.

Some businesses look at overall overhead costs and divide by departments and processes. This rough approach to overhead cost allocation can provide an estimate, but may conceal inefficiencies. For example, one department might be eating up more overhead than others. Averaged out, its excesses would not be apparent. The company might not know that it should be pricing products from that department higher, or that it should be conducting an audit to determine if it’s possible to cut costs.

In another approach to overhead cost allocation, businesses break down expenses by individual departments and production activities, like making different car models. This can allow them to identify products and services with high overhead costs. It may be necessary to price them higher to compensate and ensure that the company still meets profit goals. The company could also cut costs with options like changing suppliers, eliminating unnecessary personnel, or combining departments with similar functions to allow them to pool resources. Breakdowns of this nature can sometimes help a company target specific areas of concern.

A number of tools are used in overhead cost allocation. Accounting statements can be useful, especially if they are annotated to provide information about the nature of the expenses and the departments that incurred specific costs. It may also be necessary to look at department records to find out more about how they handle overhead expenses. This can also provide insights that may help companies cut costs. For example, a department may be paying for a subscription it doesn’t use simply because no one has taken the time to cancel it.