Overhead allocation is the rule that shares a shop’s indirect costs (rent, office, estimating, quality, supervision, software) across the jobs it quotes. The usual methods are a burden rate per labour hour, a burden rate per machine hour, or a split into several cost pools with their own drivers, known as activity-based costing. The method you choose can change the overhead charged to a single job many times over, so it decides which work looks profitable and which work you win.
Key points
- Every allocation method recovers the same total overhead; they differ in which jobs carry it.
- A labour-hour rate under-charges machine-heavy, lightly attended work. A machine-hour rate under-charges hand work.
- Splitting overhead into two or three pools with their own drivers removes most of the distortion.
- Per-order costs (estimating, purchasing, invoicing) are best charged per order, not per hour.
- Rates are set on planned hours. Sell fewer hours and part of the overhead is never recovered.
What counts as overhead?
Overhead is every cost you cannot trace to a single job. In a typical job shop it includes:
| Overhead item | Behaves like | Natural driver |
|---|---|---|
| Rent, heating, lighting of the shop floor | Machine-related | Machine hours or floor area |
| Maintenance staff, compressed air, power infrastructure | Machine-related | Machine hours |
| Supervision, training, canteen, personal protective equipment | People-related | Labour hours |
| Estimating, purchasing, scheduling, invoicing | Order-related | Number of orders |
| Quality system, inspection equipment, certification | Mixed | Labour hours or orders |
| Office, management, accounts, software, insurance | General | Any of the above, or a percentage |
Some of these may already sit inside your machine-hour rate, such as the floor space a machine occupies. Whatever is in the rate must not be allocated a second time. How to calculate a machine-hour rate separates the machine’s own costs from the shop’s general overhead.
The traditional methods
Absorption costing is the name for the general approach: decide a base, divide the year’s budgeted overhead by the budgeted quantity of that base, and charge every job the resulting burden rate for each unit of the base it uses. The common bases are:
- Per direct labour hour. Overhead ÷ planned labour hours.
- Per machine hour. Overhead ÷ planned machine hours.
- As a percentage of direct labour cost. Overhead ÷ planned labour cost.
- As a percentage of total direct cost. Simple, and the base of most cost-plus pricing, but it loads overhead onto expensive material that causes almost no overhead.
All of them recover the same total if the plan is met. They differ in which jobs pay.
One shop, two jobs, three answers
Take an example shop with €360,000 of overhead a year, planned at 12,000 direct labour hours and 9,000 machine hours, handling about 1,200 orders a year. Two jobs arrive:
- Job A is hand-finished work: 10 labour hours and 2 machine hours.
- Job B is a long unattended machining run: 1 labour hour and 20 machine hours.
Worked example: the same overhead allocated three ways (example figures)
| Method | Rate | Job A | Job B |
|---|---|---|---|
| Per labour hour | €360,000 ÷ 12,000 h = €30.00/h | 10 h × €30 = €300 | 1 h × €30 = €30 |
| Per machine hour | €360,000 ÷ 9,000 h = €40.00/h | 2 h × €40 = €80 | 20 h × €40 = €800 |
| Activity-based, machine pool | €180,000 ÷ 9,000 h = €20.00/h | 2 h × €20 = €40 | 20 h × €20 = €400 |
| Activity-based, people pool | €108,000 ÷ 12,000 h = €9.00/h | 10 h × €9 = €90 | 1 h × €9 = €9 |
| Activity-based, order pool | €72,000 ÷ 1,200 orders = €60/order | €60 | €60 |
| Activity-based total | €190 | €469 |
The three pools add back to the total: €180,000 + €108,000 + €72,000 = €360,000.
Under a labour-hour rate, Job B carries €30 of overhead for 20 hours of machine time in a heated, lit, insured building with maintenance staff. Quote it on that basis and you will win a lot of long machine runs at a price that does not pay for the shop they run in, while hand-finished work looks expensive and goes elsewhere. Under a machine-hour rate the error reverses. The activity-based split lands between the two, and it charges every order €60 for the estimating, purchasing and invoicing it causes, which neither single rate does.
Light activity-based costing
Full activity-based costing, with dozens of activities and drivers, is rarely worth the effort in a small shop. A light version usually is:
- Take last year’s overhead from the accounts.
- Sort each line into three or four pools: machine-related, people-related, order-related, general.
- Pick one driver per pool: machine hours, labour hours, number of orders.
- Spread the general pool over the others in proportion to their size, or add it as a percentage.
- Divide each pool by its planned driver quantity.
The order-related pool is often the most revealing. A €60 per-order charge is trivial on a €5,000 order and decisive on a €40 one, which is the arithmetic behind a minimum order value.
Under-absorption: the hole in the plan
Burden rates are set on planned hours. If the shop sells fewer hours, the rate is charged fewer times and part of the overhead is never recovered.
Worked example: under-absorbed overhead in a quiet year
| Line | Calculation | Amount |
|---|---|---|
| Budgeted overhead | €360,000 | |
| Machine-hour rate set on plan | €360,000 ÷ 9,000 h | €40.00/h |
| Machine hours actually sold | 7,500 h | |
| Overhead recovered | 7,500 h × €40.00 | €300,000 |
| Under-absorbed overhead | €360,000 − €300,000 | €60,000 |
| Rate needed on actual hours | €360,000 ÷ 7,500 h | €48.00/h |
Every quote that year looked profitable on paper. The €60,000 gap appears only when the accounts close. The reverse happens in a busy year: over-absorption, and a pleasant surprise.
The trap in raising the rate
The obvious response, raising the burden rate to €48 to cover the shortfall, makes quotes dearer at exactly the moment work is scarce. Dearer quotes win less work, hours fall further, and the rate rises again. Before raising rates in a quiet period, ask whether the hours you are losing would be won back at the old rate, and whether a lower price on marginal work still covers its direct cost and contributes something to overhead. A job that pays its direct cost and part of the overhead is better than an idle machine that pays none.
How often to reset the rates
Set burden rates once a year from the budget, and check them each quarter against actual hours and actual overhead. A small gap is normal and evens out. A gap that grows quarter after quarter means the plan was wrong, and the rates should be reset rather than waiting for the year end. Reset them, too, when something structural changes: a new building, a second shift, a new machine group, a large new customer whose orders behave differently from the rest.
Keep the old rates alongside the new ones for a while. Re-pricing a handful of recent jobs at both shows which kinds of work the change makes dearer or cheaper, before the market tells you.
Checking your allocation
| Symptom | Likely cause |
|---|---|
| You win most long machine runs and few hand-finished jobs | Labour-hour rate under-charging machine time |
| You win hand work but lose every machining job on price | Machine-hour rate over-charging machine time |
| Small orders look profitable but the office is swamped | No per-order charge |
| Quotes look profitable, year-end profit does not | Under-absorption from optimistic planned hours |
| Prices on material-heavy jobs are uncompetitive | Overhead as a percentage of total cost, including material |
Compare the overhead each job was charged with what it plausibly caused. Your utilisation records tell you whether the planned hours were realistic.
Where overhead sits in the quote
Overhead is one line in the cost build-up, after direct costs and before risk and margin, as shown in how to quote a manufactured part. Margin is then applied to the full cost including overhead; margin vs markup covers that last step and the mistakes in it.
Quotometry keeps facility overhead as its own setting in the shop’s configuration, separate from the machine hourly rate and the named labour rates, as described on the pricing engine page.
Questions people ask
What is the difference between overhead and direct cost?
A direct cost can be traced to one job: the material in it, the machine hours it used, the labour spent on it. Overhead is a cost the shop carries whatever it makes: rent, the office, estimating, quality, supervision, software, insurance. Overhead still has to be recovered, so it is shared out across jobs by an allocation rule, which is what a burden rate is.
Should I allocate overhead by labour hours or machine hours?
Use the driver that best matches what causes your overhead. In a shop where most value is added by people, labour hours work well. In a shop where machines run with little attendance, labour hours load almost nothing onto machine-heavy jobs, so machine hours are the better base. Many shops use both, with separate pools for machine-related and people-related costs.
What is under-absorbed overhead?
It is the overhead your burden rates failed to recover because fewer hours were sold than planned. If the rate assumed 9,000 machine hours and the shop sold 7,500, a sixth of the overhead was never charged to any job. It shows up at year end as a gap between the profit your quotes promised and the profit you made.
Is activity-based costing worth it for a small shop?
A full activity-based system usually is not. A light version usually is: split overhead into two or three pools, such as machine-related, people-related and per-order costs, and give each its own driver. That takes an afternoon with last year's accounts and fixes the largest distortion, which is small orders paying too little for the administration they cause.
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