Overhead cost centers are not the same as overhead from a financial accounting perspective, which is operating costs or expenses, such as rent, electricity, or taxes. In cost allocations, the concept of overhead refers to manufacturing overhead—the indirect, factory-related production costs that come from making an item. The material and labor costs that are not easily traceable to the product still need to be included in the overhead costs. These include electricity and air conditioning, equipment maintenance and repair, and depreciation (decreases in the value of machinery and equipment as they age). General administrative and selling expenses are not included in manufacturing overhead. The overhead allocation will become part of the value of work in process inventory, and general administrative and selling expenses cannot be included as inventory.
While it isn't easy to trace overhead costs to a product, it is necessary to include them in the product's cost. To allocate the manufacturing overhead to the product, the company needs to calculate a way to assign overhead to products. The most common method is to use a predetermined overhead rate—an estimated amount paid that a business calculates by dividing the estimated manufacturing overhead costs for the accounting period by the allocation base.
The first step in developing a predetermined overhead rate is to select an allocation base, which is a standard unit that provides the system for the way overhead costs of a product or service are divided. In other words, the organization needs to calculate how to divide up the overhead costs of each product or service. There are no requirements relating to what can be an allocation base, but it should relate to all products manufactured. The most common choice for an allocation base relates to direct labor or machine hours. This is because the allocation base needs to be something that will be part of the cost of every product or service.At the beginning of the accounting period, the organization sets the predetermined overhead rate. To do this, the company must estimate the total manufacturing overhead for the period. The allocation base also needs to be calculated. If the organization is using direct labor hours as the allocation base, then its accountants or other leaders will need to project the number of direct labor hours needed. Then the accountant divides the estimated manufacturing overhead cost by the allocation base amount to get the predetermined overhead rate.