The process involves dividing estimated total overhead costs for a specific period by the estimated total amount of the allocation base. The allocation base, often direct labor hours or machine hours, represents the activity thought to drive overhead costs. The result is a rate used to apply overhead to products or services. For example, if a company estimates $500,000 in overhead costs and anticipates 25,000 direct labor hours, the rate would be $20 per direct labor hour.
This rate is critical for cost accounting. It allows businesses to assign indirect manufacturing costs to individual jobs, products, or services, aiding in accurate product costing and pricing decisions. Understanding this rate contributes to better inventory valuation, improved budgeting, and more informed managerial decisions. Historically, its adoption helped companies move towards more precise costing methodologies in manufacturing.
