Overhead Allocation Methods Explained
Advanced accounting people want truly departmentalized income statements that break-out overhead by department using some type of calculation method. All overhead is driven (or created) by sales activity, labor expenses, or MESO expenses (material, equipment, sub-contractor, and other direct expenses).
While overhead can be arbitrarily allocated to each department as a percentage of the total (e.g.: 25% of rent goes to the service department), a far more accurate method is allocated overhead based on sales, labor or MESO. This is commonly referred to as Activity Based Overhead Allocation.
Using Overhead Allocation
The more employees you have the larger your facilities need to be. The more field labor you have the more gasoline you will need. The more your sales are, the higher your credit card processing fees.
Credit card fees (charged to the company) are driven by sales activity. The higher the company’s sales, the higher there credit card fees. This should be calculated based on a percentage of sales.
Gasoline is driven by direct labor expenses. The more you pay for direct (field) labor, the more you will pay for Gasoline. This should be calculated by a percentage of Direct Labor.
If you know Total Sales, Department Sales, Total Gasoline Expenses, you can calculate how much of the gasoline should be applied to each department. Consider this example:
Overhead Allocation Setup
- Go to Edit | Preferences | Chart of Accounts | Company Preferences – Check “Use Department Overhead Allocation”
- Go to Company | User List/Security – Edit any user and check to View the preference for “Income Statement – Overhead Allocated” under the Reports section.
- Go to Banking | Chart of Account List – Edit each Expense and Other Expense type account. Select the “Overhead Allocation Method” that you want to use. (See explanation below of each method).
- When ready to view the report go to Reports | Financials | Income Statement – Overhead Allocated. This report has the ability to view up to four different date ranges at a time as well as view all Departments or only one selected department.
Note: Once you have turned the feature on it will assign all Expense Accounts to the “Direct Labor (% of total direct labor) Allocation Method automatically. Be sure to check each Expense account to be sure it is set to the correct Allocation Method that you want to use.
Department Overhead Allocation Selection List
A new selection will be added to the COA form after you have turned on the Preference. It will be called Department Overhead Allocation. Only Expenses and Other Expenses types will include this new control.
There will be four selection options:
Income (% of sales)
Not recommended. When this option is selected on an Expense or Other Expense account it calculates the percentage (%) of sales for the department. It will then take the Total Expense amount times (x) that percent to give you the amount of the Expense on the report for that department.
Direct Labor (% of total direct labor)
When this option is selected on an Expense or Other Expense account it is calculated by taking the Total dollar amount to all Cost of Goods Sold (COGS) accounts with a Job Costing Type = “Payroll and Labor Only” to all Departments. It then finds the Total dollar amount to all Cost of Goods Sold (COGS) accounts with a Job Costing Type = “Payroll and Labor Only” to that particular department. By dividing these amounts it determines the percentage of Labor for the Department. It will take the Total amount of the expense times (x) that percent to get the dollar amount for that department.
MESO (% of non-labor direct expenses)
When this option is selected on an Expense or Other Expense account it is calculated by taking the Total dollar amount to all Cost of Goods Sold (COGS) accounts with a Job Costing Type = “Parts and Material, Serialized Inventory or Sub Contractor” to all Departments. It then finds the Total dollar amount to all Cost of Goods Sold (COGS) accounts with a Job Costing Type = “Parts and Material, Serialized Inventory or Sub Contractor” to that particular department. By dividing these amounts it determines the percentage of Labor for the Department. It will take the Total amount of the expense times (x) that percent to get the dollar amount for that department.
When set to Manual, the Overhead Allocated income statements will look at the transaction, row by row. It will not allocate the expenses using any of the other three allocation methods (income, labor, or MESO).
Consider a check for $5000.00. Each row in the Expenses tab points to a chart of account called Rent. That account’s Overhead Allocation Method has been set to Manual. There are five rows with five different departments selected for each row. We will look at each row, get the department name, and allocate the Amount of that row to that department. This method does not include children of that COA, unless those accounts are also set to Manual.
Overhead Allocation Tips
- Default Selection: The default selection will be “Direct Labor (% of Total Direct Labor)”. This is automatically assigned when you turn the preference on.
- If you add up all of you departmentalized income statements, they will likely not match the totals found in other company wide income statements.
- Note: If a Department Overhead Allocation selection has not been made on a chart of account, these expenses will not appear on the Income Statement – Overhead Allocated or Income Statement – Dept. Wide.
Overhead Allocation FAQ
Q: Which income statements offer the Overhead Allocation option?
A: There are two reports: 1. Income Statement – Overhead Allocated. 2. Income Statement – Dept. Wide.