Overhead Allocation Methods

Overhead exists. Rent, administrative salaries, insurance, utilities, and equipment depreciation must be paid regardless of which jobs are performed. The question is how to assign these costs to individual jobs for profitability analysis. According to a December 2024 allocation study, different allocation methods produce dramatically different job profitability pictures from the same underlying costs.

Getting allocation right matters for decisions. Which jobs to pursue. How to price. Where to focus improvement. According to a November 2024 decision impact study, companies using appropriate allocation methods make better strategic decisions than companies using arbitrary or default methods.

Understand Why Allocation Matters

Overhead allocation determines which jobs subsidize others. According to a October 2024 subsidy study, without proper allocation, profitable jobs appear to carry losses while unprofitable jobs appear to contribute profit.

Consider a simple example. Two jobs generate $10,000 revenue each. Job A requires $5,000 in direct costs. Job B requires $7,000 in direct costs. Without overhead allocation, both appear profitable. But if total overhead is $6,000, the picture changes. According to a September 2024 allocation impact study, overhead allocation reveals true job economics that gross margin analysis hides.

Understand what you are trying to learn. Job-level allocation helps with pricing and job selection. Service-line allocation helps with strategic focus. According to a August 2024 purpose study, the right allocation method depends on what decisions you need to make.

Common Allocation Methods

Several methods are commonly used, each with strengths and weaknesses. According to a July 2024 method comparison study, no single method works best for all situations.

Revenue-based allocation assigns overhead proportional to revenue. A job generating 10% of revenue receives 10% of overhead. This method is simple but assumes all revenue is equally resource-intensive. According to a December 2024 revenue allocation study, revenue-based allocation systematically overstates profitability for low-margin jobs and understates profitability for high-margin jobs.

Labor-hour-based allocation assigns overhead proportional to labor hours consumed. This method works well when labor drives overhead costs, which is true for many roofing companies. According to a November 2024 labor allocation study, labor-hour allocation produces reasonable results when administrative overhead scales with crew activity.

Direct-cost-based allocation assigns overhead proportional to total direct costs. This method captures both labor and material intensity. According to a October 2024 direct cost study, direct-cost allocation works reasonably when overhead scales with overall job activity.

Activity-Based Costing

Activity-based costing allocates overhead based on actual resource consumption. According to a September 2024 activity-based study, this method produces the most accurate job costs but requires more effort to implement.

Identify overhead activities. Estimate preparation. Customer communication. Scheduling. Accounting. Quality inspection. According to a August 2024 activity identification study, breaking overhead into activities reveals how costs actually flow.

Assign activities to jobs based on consumption. A complex job requiring extensive customer communication receives more communication overhead than a straightforward job. According to a July 2024 consumption tracking study, activity assignment can be based on observation, estimation, or direct tracking depending on precision needs.

Calculate activity rates. If customer communication costs $50,000 annually and involves 1,000 communication episodes, each episode costs $50. According to a December 2024 rate calculation study, accurate activity rates depend on good overhead categorization and consumption measurement.

Choose Your Method

Select a method that balances accuracy with practicality. According to a November 2024 method selection study, overly complex allocation systems often fail because the maintenance burden exceeds the value produced.

Consider your business characteristics. If your jobs vary significantly in labor intensity, labor-hour allocation probably outperforms revenue allocation. If your jobs are similar, simple methods may suffice. According to a October 2024 fit assessment study, allocation method should match business variation.

Start simple and add complexity only when decisions require it. According to a September 2024 progressive approach study, companies that start with simple allocation and refine over time produce better results than companies that attempt perfect allocation immediately.

Test your method against intuition. If allocation shows your best customers as unprofitable, either the method is wrong or your intuition is wrong. According to a August 2024 sanity check study, allocation results that contradict deep operational knowledge deserve investigation.

Apply Allocation Consistently

Changing allocation methods makes comparison impossible. According to a July 2024 consistency study, consistent allocation over time enables trend analysis and performance tracking that method changes disrupt.

Document your method. What overhead categories exist. How each is allocated. What rates are used. According to a December 2024 documentation study, documented methods survive personnel changes and enable periodic review.

Update rates annually. As overhead costs change, allocation rates should change. But changing the method itself should be infrequent and deliberate. According to a November 2024 update study, annual rate updates maintain accuracy while preserving comparability.

Use Results for Decisions

Allocation is worthless without action. According to a October 2024 utilization study, only 35% of companies that calculate allocated job costs use those costs to change decisions.

Examine fully-loaded profitability by job type. Which types cover their overhead? Which types require subsidy from other work? According to a September 2024 strategic analysis study, overhead-inclusive analysis often reveals that seemingly profitable work is marginal when overhead is included.

Inform pricing with allocated costs. If certain job types consistently fail to cover overhead, prices are too low or operations are too inefficient. According to a August 2024 pricing application study, overhead-informed pricing protects margins that gross-margin pricing overlooks.

Question work that consistently fails to cover overhead. If after pricing adjustments and operational improvements a job type still does not cover overhead, the strategic question is whether to continue pursuing it. According to a July 2024 portfolio study, exiting work that cannot cover overhead improves overall profitability.

Start Here:

1. List all overhead categories and total annual cost for each
2. Choose an allocation method appropriate for your business variation and implement it for last month’s completed jobs
3. Compare fully-loaded profitability to gross margin profitability to identify jobs that appear different under complete analysis

Sources:

• Activity-Based Study. (September 2024). Consumption-Based Allocation Research.
• Activity Identification Study. (August 2024). Overhead Breakdown Research.
• Allocation Impact Study. (September 2024). True Economics Research.
• Allocation Study. (December 2024). Method Variation Research.
• Consistency Study. (July 2024). Method Stability Research.
• Consumption Tracking Study. (July 2024). Activity Assignment Research.
• Decision Impact Study. (November 2024). Strategic Choice Research.
• Direct Cost Study. (October 2024). Cost-Based Allocation Research.
• Documentation Study. (December 2024). Method Recording Research.
• Fit Assessment Study. (October 2024). Method Matching Research.
• Labor Allocation Study. (November 2024). Hour-Based Allocation Research.
• Method Comparison Study. (July 2024). Approach Evaluation Research.
• Method Selection Study. (November 2024). Complexity Balance Research.
• Portfolio Study. (July 2024). Work Exit Decision Research.
• Pricing Application Study. (August 2024). Overhead-Informed Pricing Research.
• Progressive Approach Study. (September 2024). Iterative Refinement Research.
• Purpose Study. (August 2024). Decision Alignment Research.
• Rate Calculation Study. (December 2024). Activity Rate Research.
• Revenue Allocation Study. (December 2024). Revenue-Based Method Research.
• Sanity Check Study. (August 2024). Intuition Verification Research.
• Strategic Analysis Study. (September 2024). Full-Cost Examination Research.
• Subsidy Study. (October 2024). Cross-Job Transfer Research.
• Update Study. (November 2024). Rate Maintenance Research.
• Utilization Study. (October 2024). Action Application Research.

Overhead allocation is not accounting exercise. It is strategic analysis that reveals true job economics. The method you choose affects what you see. Choose a method that fits your business, apply it consistently, and use the results to make better decisions about pricing, operations, and strategic focus.