Direct costs -- including direct materials and direct labor -- can easily be allocated to the product they were used to make. However, manufacturing overhead is made up of indirect costs that cannot be allocated so easily. The indirect costs must be pooled and allocated by calculating an overhead rate.
Sales revenue minus manufacturing costs -- called cost of goods sold -- equals gross profit. Manufacturing costs can be separated into direct materials, direct labor and manufacturing overhead. Manufacturing overhead includes indirect materials, indirect labor and factory overhead. Examples of these types of expenses include nails and screws, the salary of an assembly line supervisor, factory utilities and insurance on factory equipment.
Since overhead expenses cannot be easily allocated to products produced, overhead costs are grouped into a cost pool. This method of allocation is called volume-based costing -- or peanut butter costing -- because of how the indirect costs are spread over all products produced. This method works best when only one type of product is being produced, because different products would use different amounts of the pooled resources. When many different products are produced, an activity-based costing system would be more accurate, but is much more complex to track.
In volume-based costing, the indirect expenses in the cost pool are allocated using an appropriate cost driver. Using a cost driver is a way to allocate indirect costs to products, jobs, departments or facilities. Direct labor is an example of a cost driver, because it creates a cause-and-effect relationship with other costs. For example, increasing direct labor hours will most likely require having more supervisor hours.
After determining that direct labor hours will be used as the cost driver to allocate indirect costs, you can divide total indirect costs in the cost pool by total direct labor hours. This will give you an overhead rate per direct labor hour. For example, if there were $30,000 of indirect manufacturing costs and 10,000 direct labor hours, your overhead rate would be $3 per direct labor hour. If it takes one hour to produce one unit, each unit produce would receive an allocation of $3 out of the total overhead costs.
