Companies incur overhead costs as the result of existing in the business world. Overhead costs refer to all expenses paid to operate as a business that do not relate directly to the primary business. Examples of overhead costs include corporate staff salaries, licensing fees or office building rent. When the company calculates its costs, it allocates the overhead costs to products. Some companies allocate overhead costs based on revenue. Several reasons exist to support this allocation method.
Certain expenses maintain a direct relationship with revenue. These expenses exist because of revenue-producing activities, such as sales activities, engaged in by the company. Examples of these expenses include sales commissions, advertising and travel expenses to visit clients. Each of these expenses contributes to the revenue production associated with each product. The direct relationship provides a valid reason for allocating these costs to the products based on revenue.
Allocating overhead costs based on revenue also provides a simple calculation for the company. The company calculates the total revenue earned from the sale of each product and adds up the total revenues earned for the entire company. Each product’s revenue is divided by the total revenue earned to calculate a percentage. The company multiplies this percentage by the total overhead expenses to determine the amount of overhead to allocate to each product.
Products with higher revenue share an indirect relationship with the company’s overhead-producing functions. The overhead functions serve a necessary purpose in the business and allow the revenue production to continue. Management might assume there’s a correlation between the product lines that record higher revenues and the resources used to earn those revenues. For instance, management might assume that a product line that creates the majority of the revenue also uses most of the company’s technical resources. Based on this assumption, allocating expenses based on revenue makes logical sense.
Subsidize Necessary Functions
Each overhead function of the company exists for the greater good of maintaining and developing the business. For example, the payroll department exists to compensate the employees who work on the production floor. Payroll employees do not generate revenue, but serve a business purpose. Many managers consider allocation an arbitrary process. They choose an allocation method that best meets their needs, realizing that the allocation lacks a direct link to the revenue production.