Allocating direct costs to production is pretty straightforward — you know what the materials and direct labor costs. The hard part is determining the amount of overhead to allocate to finished goods inventory. Overhead expenses are those indirect costs, like staffing the front office, paying for office supplies, the cost of the employee Christmas party and Internet access expenses, that are not directly input into the production of the goods, but are necessary to stay in business. The key to allocating overhead costs is in deciding on the appropriate allocation method for your business.
Predetermined Overhead Rate
1 Determine the most stable cost driver in the production of your goods. Often the cost drivers are based on labor hours or machine hours expended on production, depending whether the product is labor intensive.
2 Calculate the total cost of the overhead.
3 Multiply the cost driver by the total overhead to allocate a portion of the overhead to each product. For example, if 1,000 man-hours goes into the production of 100,000 items, then 1 percent of the man-hours goes into each product. The 1 percent is the cost driver, so multiply it by the total overhead to derive a reasonable overhead allocation to each item.
4 Record the overhead allocation by the means of a journal entry that increases the expense of the finished goods inventory.
Activity Based Costing
1 Calculate multiple cost drivers based on such factors as the number of product lines you manufacture; the amount of direct resources that goes into each product line and the related costs; and how much individual overhead items are indirectly related to each production line. This method of allocating overhead is much more complicated but it is more accurate and takes into account that different product lines should actually absorb more or different overhead expenses than others.
2 Divide overhead costs out into spreadsheet columns, based whether the overhead expense should be applied to all product or selected products. For example, if goods are produced in the Denver plant, overhead costs for that plant would be allocated to all the goods in that plant as well as a shared portion of the costs from the corporate office.
3 Apply the appropriate cost driver to each column. Record the allocation of overhead through a journal entry to the finished good inventory.