Overhead Allocation

Overhead allocation is the practice of assigning indirect costs to the products, services, projects or departments that benefit from them. Overhead includes costs that support the whole organization but cannot be traced to any single output, such as rent, utilities, executive management, finance, human resources and shared technology. Without allocation, these costs sit outside product and department budgets, and the true cost of each output remains unknown.

In manufacturing, overhead allocation has long been used to calculate product costs for pricing and inventory valuation. In services and technology, it is used to show the full cost of delivering a service or running a business unit. For IT financial management, overhead allocation matters in two directions: allocating IT costs as overhead to the business, and allocating IT's own overhead, such as management and facilities, to the technology services it provides.

Definition of Overhead Allocation

Overhead allocation is the assignment of overhead costs to cost objects using an allocation base. The base is a measure, such as labor hours, machine hours, headcount or floor space, that is believed to relate to how cost objects consume overhead resources.

The allocation is often expressed as an overhead rate, calculated by dividing total overhead by total units of the allocation base. Each cost object then receives overhead equal to the rate multiplied by its use of the base.

Predetermined Overhead Rates

Many organizations use a predetermined overhead rate, set at the start of the year from budgeted overhead and budgeted activity. This allows overhead to be applied throughout the year, before actual totals are known, which supports timely pricing and reporting.

At year-end, applied overhead is compared with actual overhead. The difference, known as under-applied or over-applied overhead, is adjusted in the accounts. The same idea appears in IT chargeback, where fixed annual rates are set and reconciled with actual costs through a year-end true-up.

Single and Multiple Rates

The simplest approach uses one plant-wide or organization-wide rate for all overhead. This is easy to calculate but can distort costs when different products or services use overhead in very different ways.

More precise approaches use separate rates for different departments or cost pools, or use activity-based costing, which assigns overhead based on the specific activities each cost object consumes. More rates mean more accuracy, at the price of more data and effort.

In technology, multiple rates are common. A Technology Business Management (TBM) model effectively uses many rates, one for each tower and solution, each built from the costs and consumption specific to that part of the technology estate. This gives a far more accurate picture than a single rate applied to all IT spending.

Importance of Overhead Allocation in IT Financial Management

Technology is a major source of overhead for most organizations, and how it is allocated shapes how the business sees it. Allocating IT as a single overhead charge hides what drives it, while allocating it by consumption shows each unit the cost of its own demand.

Within IT, allocating overhead such as management, architecture and facilities to individual services is necessary to calculate their full cost and unit cost.

Full Cost of Services and Products

Without overhead allocation, the cost of a technology service includes only its direct costs, such as dedicated staff and licenses. Adding a share of shared infrastructure, management and facilities gives the full cost, which is the right figure for pricing, benchmarking and comparisons with outside providers.

The same applies to products and business units. A product line's profitability looks very different once its share of IT, finance and HR overhead is included, which affects decisions about investment and pricing.

Behavior and Accountability

How overhead is allocated influences behavior. A broad allocation, such as by revenue, gives business units no reason to manage their use of IT. A consumption-based allocation, such as by devices or users, gives them a direct incentive to reduce unnecessary demand.

Allocation also supports accountability within IT. When each service carries its fair share of overhead, service owners can see the full cost of what they deliver and be held responsible for its efficiency.