Assigning Costs: The Importance of Allocating Overhead

by Greg DePersio

3 min read

Allocating manufacturing overhead directly impacts the balance sheet and income statement. The costs allocated to different products flow through multiple accounts during the products’ lifecycle. Therefore, management has the responsibility of assigning costs in a responsible and reasonable manner to not distort records.

What Is Manufacturing Overhead?

Manufacturing overhead is a collection of costs that are not directly assignable to a product. During the production process, these costs are essential to the development and creation of goods. However, the expenses must be allocated to products to be property reflected in the cost of producing the good.

Examples of Manufacturing Overhead

During the manufacturing process, incidental goods such as glue, nails, paint, or stain are overhead. Although glue may be necessary to produce a good, it is not feasible to count exactly how much glue is used for each good and to determine the cost of that glue. The same concept relates to labour. It is not feasible to track each minute of work for a good from a production supervisor, manager, or quality inspector. Rent, machine maintenance and repair, quality checking costs, and selling costs are other examples of manufacturing overhead.

Allocation Process

There are a few steps in allocating manufacturing overhead. First, all relevant costs must be gathered and aggregated. For example, rent for the period is determined to be $1,000. The second step is to select a cost driver to allocate the costs. If the rent expense is allocated based on the number of finished goods and the number of finished goods is 100, divide the expense by the cost driver quantity to find the allocation per unit. In this situation, $10 or $1,000/100 is allocated to the cost of each good. A journal entry is necessary to move the costs from manufacturing overhead, which is a general asset pool, to finished goods, which is a more specific asset account.

The example above can be expanded to show the true importance of allocating the overhead. Instead of selling only one product, imagine a company sells two different items. All items are produced in the warehouse that cost $1,000 to rent. How should these costs be allocated among the different products? The allocation occurs based on the selection of cost drivers.

Selecting Cost Drivers

Overhead can be allocated in any way management chooses based on the underlying calculation driver. In the example above, you need to allocate $1,000 across two goods. If one product takes up 70% of the warehouse, the square footage can allocate the costs at $700 for one good and $300 for the other. If one product produces 90% of the finished goods quantity, the costs are allocated $900 to $100. If management chooses to allocate evenly to each item, the allocation is $500 for each one. With the method chosen above, the dollar amount assigned to each item changes, all based on the cost driver.

Impact on Balance Sheet

Why does it matter whether a product is assigned $900 or $500 of the costs in the example above? One important aspect relates to the balance sheet. All manufacturing overhead items are classified on the balance sheet in a general asset account. However, as these costs are assigned, they are transferred to a specific asset account for each item. This inventory balance is important to report as this is the valuation of the goods available for sale. Anything not sold remains on the balance sheet. Therefore, if $900 is assigned to a product that is not sold, $900 stays on the balance sheet. If only $700 is assigned to a product that is not sold, this means the balance sheet reports $200 less inventory simply because of the costs assigned to the good.

Impact on Income Statement

The ultimate impact of assigning overhead costs is reflected on the income statement, as manufacturing overhead has a direct impact on net income. This occurs through the cost of goods sold account because this figure is derived from what is reported on the balance sheet. Based on the balance of the finished goods on the balance sheet, the costs that flow through to the income statement change.

In the situation above, say the company allocated $900 to one product and $100 to another. All of the first product was sold, while none of the second product was sold. In this example, the $900 that is now in finished goods inventory is reassigned to cost of goods sold. The expense recognized is the total cost of goods sold, including the $900. In another example for comparison, the manufacturing overhead above was split $500 for the goods that were sold and $500 for the goods that were not sold. Therefore, the cost of goods sold is the total expenses of the goods in addition to the $500. Expenses are $400 less, net income is $400 higher, and income taxes are higher because of higher income.

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