How to Calculate Direct Method Overhead Allocation

All overhead costs must be included in direct overhead allocation to estimate the costs of production.

Allocating costs is an important part of making budgetary decisions, especially when it comes to the decisions involved in the manufacturing of existing or new product lines. While it's fairly simple to allocate the costs of production in raw materials or direct labor, allocating accurate overhead costs throughout a company based on actual usage can be difficult. For a quick and dirty method of applying overhead costs, the direct method of overhead allocation exists. In the direct method, accountants peg overhead costs to a single determinate, such as labor hours or square footage. You then use this overhead rate wherever you need to apply overhead costs, based on the amount of the pegged item used in the area.

Things You'll Need

• Company expense records

Instructions

1. Divide the costs for your company into three categories -- direct labor, direct materials and overhead. Go through a list of all of your organization's expenses throughout a month's operation and split every item into one of those three categories on a sheet of paper.

2. Examine the production process to determine every worker directly involved in the manufacture of your product. Add their pay expenses to the direct labor category. Place all costs of raw materials or any item purchased for use in the production process of your company's product into the direct materials category. Add all other costs related to the running of the company to the overhead category.

3. Determine a cost driver to which to peg your overhead allocation. Choose a cost driver based on a commonality shared throughout your company. For example, if you manufacture multiple products, you can use labor hours as the cost allocation.

4. Count the number of hours worked for the month by direct labor and then divide the total overhead by the number of hours worked. This will give you the predetermined overhead rate per labor hour used in production throughout your company. When determining the price of manufacturing a product, just add the variable costs of producing the item in an hour, which is the direct labor plus the direct materials cost for that item, to the predetermined overhead rate for that hour.

Tips & Warnings

• While not precise, direct method overhead allocation does give an estimate suitable for making rough comparisons between costs of separate production lines, or company division.

References

• University of Omaha: Overhead: Allocating Your Costs Efficiently