Allocated Overhead: How to Fairly Assign Shared Costs to Products (2026)

Allocated overhead is the share of shared, non-traceable cost assigned to a product, service line, or department. Rent, administration, insurance, and management salaries do not attach to any single unit, so a base — an allocation driver — is chosen to spread them. The total profit of the business is unaffected by that choice; which products appear profitable is affected enormously.

The Five Bases and What Each One Rewards

A good base is the one that causes the cost. If overhead rises because more labour hours are worked, labour hours is the correct driver; if it rises with order count, use orders.

The Same Overhead, Two Bases, Opposite Conclusions

Standard line: 12,000 units, $600,000 revenue, 6,000 labour hours
Custom line: 1,500 units, $300,000 revenue, 9,000 labour hours
Revenue-share base: standard 66.7% = $120,000, custom 33.3% = $60,000
Per unit: standard $10.00, custom $40.00
Labour-hour base: $180,000 / 15,000 hours = $12.00 per hour
Standard: 6,000 x $12 = $72,000, or $6.00 per unit
Custom: 9,000 x $12 = $108,000, or $72.00 per unit
Custom overhead per unit differs by $32 depending only on the base chosen

The custom line consumes 60% of the labour hours while generating 33% of revenue. Revenue-share allocation understates its cost by $48,000 a year, which is often the difference between a line that looks like the future of the business and one that is quietly subsidised by the standard range.

Choosing and Testing a Base

1. List the overhead pools separately — facilities, administration, selling, technology — rather than treating overhead as one number.
2. For each pool, ask what makes it grow: floor space, headcount, order count, machine time, or engineering changes.
3. Pick the driver you can measure without a new system; a slightly imperfect measurable driver beats a perfect unmeasurable one.
4. Run the allocation under two different bases and compare the product rankings.
5. If the ranking flips, investigate before acting — the flip means the decision depends on an accounting choice, not on the business.
6. Document the base and revisit it annually, because automation and product mix both change what drives cost.

What the Tax Rules Require

For businesses that produce or resell goods, allocation is not purely a management choice. The IRS uniform capitalization rules require certain indirect costs to be capitalised into inventory rather than expensed as incurred, and they permit several allocation methods, including specific identification, burden rate, and standard cost, provided the method is applied consistently. The practical consequence is that most product businesses already maintain an allocation for tax purposes, and the cheapest path is to reuse a defensible driver for both purposes rather than maintaining two incompatible views.

Keep contribution and allocated profit on the same report, in adjacent columns. Decisions about pricing and product deletion belong to the contribution column; decisions about long-run capacity belong to the allocated one.