Let's look at overhead allocation in more detail. When you need to allocate overhead cost objects, like products, it might be helpful to think of that process in 4 steps. Step 1 is to determine the total amount of overhead cost that need to be allocated. You might decide to divide the total mount of overhead cost into several cost pools to be treated separately. But for now, let's just assume that we have one pool of overhead costs. This would be the $26,000 for the t-shirt example we just looked at. Step 2 is to choose a basis for allocating those overhead costs. For the t-shirt example we just looked at, we used units as the allocation base. Step 3 is to calculate an overhead rate that will be used to allocate the overhead. That rate is calculated as the relation between overhead to be allocated and the allocation base. Step 4 is to use that overhead rate to allocate overhead as products are being made. Now let's talk a little bit more about step 3, calculating that allocation rate. In determining this overhead allocation rate, organizations typically use budgeted information. Now why would they do that? Well, take a look. Here, we have the beginning of the period, like a year, and the organization has an estimate or a budget of the overhead costs that it expects to incur during the upcoming year. And then here, we have the end of the period. And it's only at that time that we know how much actual overhead has been incurred. We could wait until that point and allocate actual overhead to the products. However, managers need to make good management decisions during this timeframe. For example, it's really hard to know what price to set if you don't know what the product's cost is. So we typically allocate overhead based on estimates by using information from the budget. Now as a side note, we hope our estimates are relatively accurate, but no doubt, there'll be some differences between the actual and the budgeted amounts. So for financial accounting purposes, once we know the actuals, we must correct for the difference between actuals and estimates in the books. Doing that particular accounting correction is beyond the scope of this particular course. But in this meantime, as long as we have relatively good estimates, we can use those estimates to make management decisions. So back to the process of allocating overhead. Let me amend our previous picture to note that we determine a budgeted overhead allocation rate based on the relation between budgeted overhead and the budgeted amount of the allocation base. Okay, let's go back to our t-shirt maker. Step 1 is to determine the amount of overhead costs that need to be allocated. That's the $26,000. Step 2 is to choose a basis for allocating that overhead. We'll talk about how to choose one of these later. But for now, rather than units in our previous example, let's assume that the company decided to use direct labor costs as its overhead allocation base. Then step 3 is to calculate an overhead rate based on the relation between the overhead to be allocated and the allocation base. The amount of overhead to be allocated is $26,000. And the amount of the allocation base direct labor costs is also $26,000. Now how did I know that? How did I know that it was $26,000? Well, we have an estimated 10,000 basic t-shirts times the $2 direct labor per shirt. And then for the deluxe t-shirts, we have an estimated 2,000 t-shirts times the, $3 in direct labor per shirt. And that gives us our $26,000 in estimated direct labor cost. So then dividing the 26,000 in estimated overhead by the 26,000 in estimated direct labor cost gives us an overhead rate of 100%. So in other words, for every $1 in direct labor that a t-shirt requires, it will be allocated $1 in overhead. So finally, step 4 is to use that overhead rate to allocate overhead as the t-shirts are being made. Since a basic t-shirt requires $2 in direct labor, It is allocated $2 in overhead. And since the deluxe t-shirt requires $3 in direct labor, It is allocated $3 in overhead. So the total cost of the basic t-shirt here is $8, and the total cost of the deluxe t-shirt is $11. And at this point, management has estimates of the cost of each t-shirt that it can use in making decisions throughout the year. [BLANK AUDIO]
