Overhead Allocation
Definition
Overhead allocation is the process of assigning indirect costs — such as rent, utilities, supervision, and equipment depreciation — to products, orders, or services using an allocation base like labor hours, machine hours, or activity drivers.
In Practice
Indirect costs can dwarf direct ones — a warehouse's rent, systems, and management may exceed its picking labor — and how they are spread determines which products look profitable. Traditional costing applies overhead via a single rate (say $40 per direct labor hour); activity-based costing refines this by tracing costs through drivers such as receipts, picks, or shipments, so a low-volume product needing many small orders absorbs the burden it actually creates.
Allocation choices distort real decisions: an overhead rate loaded onto labor hours makes automation look artificially attractive and low-touch products artificially cheap, while cost-to-serve models built on activity drivers routinely reveal that a quarter of customers are unprofitable once their true handling burden is applied.
Frequently Asked Questions
What allocation bases are used for overhead?
Traditional bases are direct labor hours, machine hours, or material cost, applied as a single plant-wide or departmental rate. Activity-based costing uses operational drivers — number of setups, receipts, picks, or shipments — that trace overhead to the products and customers actually consuming the activities.
How does poor overhead allocation distort supply chain decisions?
A single labor-based rate overcosts high-volume simple products and undercosts complex low-volume ones, misleading pricing, SKU rationalization, and make-or-buy choices. Cost-to-serve analyses using activity drivers frequently reveal customers or channels that are unprofitable once their real handling and order burden is allocated.
Related Terms
Break-even analysis is a calculation that finds the sales volume at which total revenue equals total cost, computed as fixed costs divided by the contribution margin per unit — the point beyond which each additional unit generates profit.
Life Cycle CostingLife cycle costing is the evaluation of an asset or product's total cost across its entire life — acquisition, operation, maintenance, and disposal — rather than purchase price alone, enabling comparisons on whole-life economics.
Cost-Volume-Profit AnalysisCost-volume-profit (CVP) analysis is a financial modeling technique that shows how profit responds to changes in sales volume, prices, variable costs, and fixed costs — extending break-even analysis into full what-if planning.
Standard TimeStandard time is the time a qualified worker needs to complete a task at a normal, sustainable pace using the prescribed method, including allowances for fatigue, personal needs, and unavoidable delays.