To be able to fully cost a job, the overhead for a job must be calculated.
As the overhead cost is an indirect cost, the item is costed to the product by ‘allocating the overhead’.
To allocate an overhead, a rate is applied to a ‘cost driver’. This cost driver is an indicator of activity such as units of production or direct labour hours.
Full costing of the job is only an approximation, as part of the business costs cannot be directly attributed to a job.
Allocating overhead costs is made using the proportion of amount of direct labour hours, units produced or the machine hours used for a job compared to the totals for all jobs.
Once the business decides how the overhead will be applied, the selected activity (direct labour hours, units produced, machine hours) is multiplied by a budgeted overhead rate.
This calculates the amount that must be applied to each job so as to cover the indirect costs.
Recovery of overhead costs is a plan or budget
Too much or too little overhead can be allocated to a job.
If too little overhead is applied to a job, there was an under-recovery of overhead costs.
where too much applied, there is an over-recovery of overhead costs.
Examples of methods to recover overhead costs
To understand this complicated topic, here is an example.