Calculating overhead is an essential part of determining the true cost of goods and services in a business. Overhead costs are indirect costs, such as rent, utilities, and insurance, necessary to keep a business running.
The traditional method of calculating overhead allocates these costs to products or services based on a predetermined rate, such as a percentage of direct labour costs. While this method has been widely used for many years, it has pros and cons that businesses should consider carefully.
This blog post will explore the traditional method of calculating overhead in detail, including its pros and cons.
What is the Traditional Method of Calculating Overhead?
The traditional method of calculating overhead is a system in which indirect costs are allocated to products or services based on a predetermined rate. The rate is typically calculated by dividing the total overhead costs by a chosen allocation base, such as direct labour hours or machine hours. The resulting rate is then applied to the actual amount of the allocation base used by each product or service to determine the overhead cost.
For example, if a company has total overhead costs of $100,000 and uses direct labour hours as the allocation base, it may calculate an overhead rate of $10 per direct labour hour. If Product A requires 10 direct labour hours to produce, it would be allocated $100 of overhead costs based on the overhead rate.
Pros of the Traditional Method of Calculating Overhead
Simplicity: The traditional method of calculating overhead is relatively simple and easy to understand. It requires minimal data input and can be easily implemented by small businesses with limited resources.
Predictability: Since the overhead rate is predetermined and applied consistently to all products or services, it provides a predictable cost structure for businesses. This allows businesses to more accurately forecast their costs and plan their budgets.
Cost control: The traditional method of calculating overhead provides a clear breakdown of indirect costs, allowing businesses to identify areas where they can reduce costs and improve their bottom line.
Standardization: The traditional method of calculating overhead provides a standardized approach to allocating costs, allowing for consistency in reporting and comparison of financial performance across different periods or companies.
Cons of the Traditional Method of Calculating Overhead
Lack of accuracy: The traditional method of calculating overhead may not accurately reflect the true cost of producing a product or service. It relies on predetermined rates, which may not accurately reflect the actual amount of overhead incurred by each product or service.
Inflexibility: The traditional method of calculating overhead may not be flexible enough to accommodate changes in the business environment. For example, if a business introduces new products or services that require different allocation bases, the traditional method may not be able to accurately allocate overhead costs.
Overhead allocation disputes: The traditional method of calculating overhead can lead to disputes among departments or business units over allocating indirect costs. This can create tensions and undermine collaboration within the organization.
Inefficient resource allocation: The traditional method of calculating overhead may result in inefficient resource allocation. For example, suppose a product or service is allocated too much overhead cost. In that case, it may lead to a misallocation of resources, such as excess staffing or equipment, which can increase costs and reduce profitability.
The traditional method of calculating overhead has both pros and cons that should be considered by businesses. While it provides a simple and predictable cost structure, it may not accurately reflect the true cost of producing a product or service. Additionally, it may not be flexible enough to accommodate changes in the business environment and can lead to disputes over the allocation of indirect costs.