Overhead allocation per unit:
formula and worked example

Giving each unit its share of the building

Some costs do not change with output: rent, factory supervision, insurance, equipment depreciation, administrative salaries. To price a product or judge its margin, those costs have to be attached to the units somehow. Overhead allocation per unit does that by spreading a period's fixed overhead evenly across the units produced in the same period.

It is a simple, widely used way to get from direct cost to full cost. Its weakness is that fixed costs have not actually been caused by any individual unit, so the allocation is an accounting convenience. It tells you what each unit must contribute to cover the fixed base, not what that unit cost to produce.

The figure feeds several decisions: setting a selling price, valuing closing stock, comparing products, and judging whether a contract covers its share of the base. Because each use can need a slightly different volume assumption, it helps to know which one you are doing before you pick the denominator.

Formula and its inputs

• Fixed overhead: costs that stay roughly constant regardless of output within the relevant range, for the chosen period.
• Units: output over the same period, or planned output if you are setting a standard rate in advance.

Variable costs such as materials and piece-rate labour do not belong in the numerator. They are already traced to each unit directly, and adding them again would double count.

Worked example: 90,000 of overhead over 1,500 units

A small bakery workshop pays 90,000 a month in rent, equipment lease, insurance and salaried staff. It produces 1,500 units of its packaged product in the month.

1. 1Add the month's fixed overhead: 90,000.
2. 2Count units produced in the same month: 1,500.
3. 3Divide: 90,000 ÷ 1,500 = 60.
4. 4Each unit carries 60 of overhead.

If direct material and labour come to 140 per unit, full cost is 200, and the price needs to exceed that to leave any profit after fixed costs.

What the 60 is telling you

Think of the figure as a break-even contribution target per unit, rather than a cost that changes with each unit made.

• If you sell below direct cost plus 60, the business is not covering its fixed base at this volume.
• Doubling output to 3,000 would bring overhead per unit down to 30, with the same total spend.
• Halving output to 750 would push it to 120, which is why seasonal dips can make full-cost margins look alarming.
• Because it depends on volume, prices set on last year's volume may be wrong this year.

Treat a sharp change in the allocated figure as a question about volume or about the cost pool. If overhead per unit jumps while fixed costs are unchanged, output has fallen, and the issue is demand or production planning. If it jumps with volume steady, then a cost has crept into the pool, and that cost needs a closer look.

How higher overhead feeds each unit

Overhead rising by 10% moves the allocation from 60 to 66 per unit, a rise of exactly 10% when volume is steady. The sensitivity to volume is stronger in practice: a 10% fall in units raises the allocation by about 11%, because the same pool is divided by fewer units. 90,000 ÷ 1,350 = 66.67, so a quieter month can matter as much as a price rise on the lease.

Where allocation goes wrong

• Including variable costs in the overhead pool, so unit cost is double counted.
• Using a plant-wide rate for products that use very different machine time or support effort, which makes simple products look expensive and complex ones cheap.
• Mixing periods, such as annual overhead divided by a single month's units.
• Using actual output for pricing decisions, so prices rise in slow months precisely when demand is weakest.

Finally, decide how to treat unused capacity. If the plant can produce 2,000 units but made 1,500, charging all 90,000 to the 1,500 units loads them with the cost of idle capacity. Some firms charge only the share of overhead matching normal output to units, and show the unabsorbed remainder as a separate cost of under-utilisation. This keeps product costs stable and makes the price of spare capacity visible to management.

A decision this helps with

Suppose a customer asks for 500 extra units at 170 each, below your full cost of 200. If the plant has spare capacity and the fixed overhead is already paid, the real cost of the order is the direct cost of 140, so it adds 30 per unit of contribution, or 15,000 in total. Looking only at the full cost of 200 would reject a profitable order. The allocation is for pricing the base, not for every incremental decision.

For businesses with several products, a single average rate can mislead. A product that needs little machine time but receives the same 60 per unit as one that occupies the plant for hours is being over-charged, and the heavy product is flattered. Allocating on machine hours or labour hours instead is a small change that often reshapes which lines look profitable.