What is the Allocation Base?
Allocation base is the measuring system by which the overhead cost of the business or the department is decided and can be measured in terms of hours worked, systems used, employees operational, square foot etc.
How to Calculate Allocation Base?
Step 1: Determine the total reach of the support department.
Say for a large outsourcing company; the main support team will be the IT Team that provides technical support to all the employees. Consider that the organization has 10,000 active desktops and 5,000 active laptops that need assistance. The desktops and laptops are used by several departments, but the support is being provided by a single support team. The total reach of the support team is 10,000 desktops and 5,000 laptops.
Step 2: Find the Allocation Base.
The support team is responsible for providing support to 10,000 desktops and 5,000 laptops. Therefore, 15,000 will be considered as the total reach for the support Team and thus the Allocation base. Whatever overhead expense based on support needs to be added to the individual project will have 15,000 as their base.
Step 3: Allocating Overhead to the individual project.
When a company calculates the cost of an individual project, say project A, then support overhead is a part of the overall overhead for the project. If the project is using 1000 desktops, and the total cost of maintaining the support team is $500,000. Then the support overhead that will be allocated to project A will be
Support Overhead Allocated to Project A = Total Cost of Support Team * (Number of Desktops Used by Project A / Total Computers Supported by Support Team)
- Support Overhead allocated to Project A = $500,000 * (1000 / 15,000) = $33,333
So while calculating the cost of project A, the support overhead should be $33,333.
Company XYZ has its own building. There are ten projects running in that building. The company is trying to find the overhead costOverhead CostOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. of the pantry and administrative support for project A. The pantry supplies to all the ten projects, and the total cost of pantry service is $500,000 for a year. The support service is also shared by all the projects. The administrative support service is $20,000 and is being shared by all the projects.
So when the company tries to find the overhead cost of project A., Then Allocation Base of Pantry and Administrative Support will be $500,000 and $20,000 respectively
The Overhead Cost of Pantry for Project A = Total Cost of Pantry / Number of Projects
- The overhead cost of the pantry for project A = $500,000 / 10 = $50,000
- So for one project, the overhead cost will be $50,000
The Overhead Cost of Administrative Support for Project A = Total Cost of Administrative Support / Number of Projects
- Administrative Support for Project A= $20,000 / 10 = $2,000
- $2,000 overhead cost of Administrative Support for Project A
Total Overhead Cost of Project A = Overhead Cost of Pantry for Project A + Overhead Cost of Administrative Support for Project A
- Total Overhead cost of Project A = $50,000 + $2,000
- Total Overhead cost of Project A = $52,000
So the total overhead cost for project A is calculated by using the Allocation Base of Pantry and Administrative Support.
Allocation Bases for Factory Overhead
The factory runs on machine and labor. So the Allocation base for machine and labor will be machine hours and labor hours. Suppose the cost of a machine is $100,000, and the machine has a life of 500 hrs. So when the overhead cost of producing the finished product will be calculated, then the cost of the machine will have the base of 500 hrs, and per hour cost will be $100,000 / 500 = $200
If a finished good take 10 hours of machine usage, then the overhead machine cost of that goodwill be = Number of Hours Used * Cost per hour
- Overhead Machine Cost of Goodwill = 10 * 200 = $2,000
In a similar way, the total labor cost can be used as the Allocation base for Labour overhead to produce a single well. It helps companies to fix a selling price for the good, as the cost of producing the good is determined using this base.
How is Allocation Base Used in Setting Allocation Rates?
Consider a warehouse that is rented to produce cars. In a month, 100 cars are produced in the warehouse. Rent of the warehouse is $10,000 monthly. Now the allocation base of the warehouse is $10,000. If 100 cars are produced in a month, then each car will share an overhead rent cost of = Number of Cars / Monthly Rent.
- Car will Share an Overhead Rent Cost = 10,000 / 100 = $100
So $100 is the Allocation rate. Each car is using $100 of warehouse rent to finish itself.
- It acts as the measuring base to allocate the overhead expense to individual products or projects. Without deciding the allocation base, it would be really difficult to assign systematic overhead expenses.
- The decision regarding the cost of the manufactured product or service is easily calculated with the help of this base, which in turn helps to decide the Selling price.
- At times it is difficult to calculate as the product or service is used by several departments irregularly, and there is no fixed expense for the services.
- As different services have different Allocation Bases, so it makes an accounting of the overhead expense tricky and time-consuming. It increases the cost of accounting as high-end software, storage, and auditing team is required.
Allocation Base is the most important technique to allocate the overhead expense to different projects and products. Without this, the cost of service and product will be really difficult to calculate. Proper measures should be used in order to calculate this base and use it in accounting.
This has been a guide to what is Allocation Base and its definition. Here we discuss how to calculate allocation base along with an example, advantages, and disadvantages. You may learn more about financing from the following articles –