Back to the on-screen lesson · Print

Spreading indirect cost

One pool, a base you choose, and the rate that follows — plus what changes about the business when you change the base, which is nothing.

Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.

1. What you will learn

You will spread a month's indirect cost over units by choosing a base, working out the rate and giving each unit its share, check that the shares add back to the pool, and build a full cost from a direct cost and that share. You will also say what changed about the business when the base changed, and why a full cost quoted without its method and its volume is only half a number.

2. What you already have

You can total the costs that belong to a unit — materials, the hours inside it at a rate — and you know that some costs belong to no unit at all: the rent, the insurance, the phone, the website. They still have to be paid for, and a price that ignores them fails even when every unit is costed correctly. This lesson spreads them over the units, and shows exactly what that spreading can and cannot tell you.

3. Words this lesson uses

4. One pool, one base, one rate

Indirect cost cannot be traced, so it gets allocated: divided up by a rule you choose.

$$\text{rate} = \frac{\text{the pool}}{\text{total of the base}}, \qquad \text{share of a unit} = \text{rate} \times \text{that unit's base}$$

The arithmetic is one division and one multiplication. The judgment is the base, and it is a real judgment: the base should track whatever actually drives the spending. Rent and power in a workshop follow time, so labor or machine hours usually fit. A delivery cost follows orders. Sharing everything equally over units is the simplest base and it quietly assumes every unit uses the building equally, which is false whenever one product is slow and another is quick.

What allocation cannot do is create or destroy cost. Every base spreads the same pool. Change the base and one product's share rises by exactly what another product's falls. So a full cost is always an answer to spread how?, and quoting one without the method is quoting half a number.

5. The method, step by step, and how to check it

Fix the period and total the pool. A month is usual. List the costs that belong to no unit — rent, power, insurance, phone, software, accountancy — and add them. Leave out anything already traced to a unit, or it will be counted twice.

Choose the base. Ask what makes these costs grow. If a busier workshop uses more power and needs more space, time is the driver, and labor or machine hours fit. If the products all take about the same time, units are fine and simpler. Write the choice down.

Total the base across every product. All the hours on every product, or all the units of every product. Dividing by one product's base is the common arithmetic error, and it gives a rate far too high.

Divide, then multiply. Pool over base total gives the rate. Each unit's share is the rate times the amount of base it uses: three hours at 10 an hour is 30.

Check that the shares add back to the pool. Multiply each product's share by its units and add: the answer must be the pool exactly. If it is more, some cost has been counted twice; if less, some units were left out of the base.

Then add the share to the direct cost to get the full cost, and label it with its base and its volume: 14.20 full cost, overhead by labor hours, at 400 units a month.

6. Why the base decides which product looks good

Two products can use a building very differently. A catering platter that takes two hours to assemble uses the kitchen far more than a lunch box that takes six minutes. Spread the rent equally over units and the platter is charged like a box; its full cost looks low, its price looks generous, and the owner is tempted to push catering. Spread the rent by hours and the platter carries its real use of the kitchen; the catering line suddenly earns much less than it seemed to.

Neither figure is false, but only one describes how the kitchen is really used. This is the practical reason to choose the base with care: a poor base does not change the total, but it can make a business favor the product that is quietly being subsidized by the other. Large firms have a whole method for this — activity-based costing, which uses a separate pool and driver for each kind of indirect activity — and it grew up exactly because single, simple bases were sending companies after the wrong products.

7. What allocated cost is good for, and what it is not

Full cost answers one question well: over a normal month, does the price of each product carry its fair share of everything the business has to pay? If the prices do not, the business loses money even when every product sells.

It answers another question badly: should I take this one extra order? The rent is paid whether or not the order is taken, so the extra order's real cost is its variable cost, not its full cost. A business that refused every order priced below full cost would turn away work that adds to the month's income. The pricing unit develops this into contribution; for now, remember that a full cost is for setting normal prices, not for judging one-off work.

And full cost moves with volume. The pool is fixed for the month, so the rate per unit rises when the month is quiet. Quote a full cost with its volume, or the figure will surprise you in January.

8. Choosing a base: a short guide

The right base follows the cost driver. A few common pairings:

When several costs follow different drivers, a small business can still keep it simple: put the costs into two or three pools, each with its own base, rather than one pool with a base that fits none of them. The extra effort is worth it when products differ a lot in how they use the business — very quick and very slow jobs, or bulky and small goods. When the products are alike, one pool and a units base is honest enough, and far easier to keep up to date.

9. In the world: a print shop's machines

A small print shop has 6,000 dollars a month of indirect cost: the lease on its unit, the maintenance contract on two presses, power and insurance. It prints two kinds of job. Business cards are quick — 40 jobs a month, each taking about half an hour of press time. Large posters are slow — 20 jobs a month, each taking about 4 hours on the wide-format press.

Spread equally over jobs, each of the 60 jobs carries 6,000 ÷ 60 = 100 dollars. The cards look expensive and the posters cheap. But the presses and the power are used by the hour, so the owner spreads by press hours instead: 40 × 0.5 + 20 × 4 = 20 + 80 = 100 hours, a rate of 60 dollars an hour. Now a card job carries 30 and a poster job 240.

The difference changes his pricing. On the jobs base he had been undercutting rivals on posters and losing card work on price; on the hours base he can see that posters were being subsidized by cards all along. He raises poster prices a little, lowers card prices, and the month's total overhead is covered exactly as before — with the prices now matching how each job uses the shop.

10. In the world: allocation in hospitals and universities

Large organizations spread indirect costs every day. A hospital allocates the cost of its buildings, cleaning and administration to departments, often by floor area or by patient days; a university spreads its library and estates costs across faculties by student numbers or space used. Arguments about which base is fair are common and heated, because the base decides which department appears to lose money — exactly the effect this lesson shows on two products.

11. Where this goes wrong

A different base means a different cost. It means a different allocation. The business spent the same money either way.

There is a correct base. There is a better and a worse one for a given purpose, and no true one. State which you used; change it deliberately, not by accident.

Dividing by one product's base. The rate uses the whole base across every product; otherwise the shares add up to far more than the pool.

Full cost is the floor for a price. Over a month, yes. For one extra order with the rent already paid, the floor is the variable cost — full cost would have you turn down work that pays for itself. Which floor applies is a question about the decision, not about the product.

The rate is a fact about the unit. It is a fact about the pool and the volume. Halve the volume and every rate doubles, without a single thing changing on the workbench — which is the whole reason lesson 13 makes you state the volume before quoting a price.

12. Cleans at Bright Home Cleaning

1. Total the pool: insurance, phone and van for the month.

   $\text{pool} = 900$

   These belong to no single clean.

2. Choose units as the base and total them: 30 standard and 15 deep cleans.

   $30 + 15 = 45$

   The simple base counts every clean equally.

3. Divide the pool by the base.

   $900 \div 45 = 20$

   Each clean carries 20 dollars on a units base.

4. Check the shares add back to the pool.

   $45 \times 20 = 900$

   The whole pool is spread and no more.

5. Label the share with its base and volume.

   $20 \text{ a clean, units base, at 45 cleans}$

   A share without its method and volume is half a number.

13. The same cleans by hours

1. Write the hours: a standard clean takes 2 hours and a deep clean 4.

   $30 \times 2 = 60; \quad 15 \times 4 = 60$

   The van and phone are used for as long as the job lasts.

2. Total the hours base.

   $60 + 60 = 120$

   The base covers both kinds of clean.

3. Divide the pool by the hours.

   $900 \div 120 = 7.50$

   The rate is per hour of cleaning.

4. Give each kind of clean its share.

   $2 \times 7.50 = 15; \quad 4 \times 7.50 = 30$

   The deep clean uses twice the time, so it carries twice the share.

5. Check the shares add back to the pool.

   $30 \times 15 + 15 \times 30 = 450 + 450 = 900$

   Same pool, shared differently.

6. Compare with the units base.

   $\text{standard } 20 \to 15; \quad \text{deep } 20 \to 30$

   The base moved 5 from each standard clean onto each deep clean.

14. A kitchen with two lines, and a quiet month

1. Total the pool and the units: 1800 dollars of rent and power, 600 lunch boxes and 300 platters.

   $1800 \div 900 = 2 \text{ a unit}$

   The simple base charges a box and a platter the same.

2. Switch to hours: the boxes take 60 hours and the platters 120.

   $1800 \div 180 = 10 \text{ an hour}$

   The base that follows time in the kitchen.

3. Give one box its share.

   $10 \times 60 \div 600 = 1$

   The boxes' hours at the rate, over the boxes.

4. Give one platter its share.

   $10 \times 120 \div 300 = 4$

   The platters use twice the hours with half the units.

5. Check the shares add back to the pool.

   $600 \times 1 + 300 \times 4 = 1800$

   The platters looked cheap only because they were charged like boxes.

6. Now a quiet month: the same pool, the hours halve to 90.

   $1800 \div 90 = 20 \text{ an hour}$

   The pool does not shrink when the work does.

7. Find a platter's share in the quiet month.

   $20 \times 60 \div 150 = 8$

   Nothing on the bench changed and the share doubled; this is why allocated cost is a poor guide to a price.

15. Your turn: 1200 dollars over mugs and bowls by hours

1. 300 mugs took 75 hours and 100 bowls took 75 hours. Total the base.

   $75 + 75 = 150$

   All the hours across both products.

2. Divide the pool by the hours.

   $1200 \div 150 = 8$

   The rate per labor hour.

3. Your turn: work this step out. Its working is at the end of the packet.

   Give one bowl its share.

16. Guided practice

At Northside Repairs, one board repair carries $12$ dollars of indirect cost on a per-unit base and $18.75$ on a labor-hour base. What has changed about the business?

• Nothing — the same total is being divided up a different way
• The board repairs have become more expensive to make
• The month's indirect cost has gone up
• One of the two figures must be an arithmetic error

17. Guided practice

Complete the worked solution: a workshop has $1125$ dollars of overhead. It made $50$ small pieces taking 1 hour each and $25$ large pieces taking 3 hours each. Spread the overhead by labor hours.

1. Add all the labor hours.

   $50 \times 1 + 25 \times 3 =$ _h

   The base is the whole of the hours, across both products.

2. Divide the pool by the hours.

   $1125 \div (\text{hours}) =$ _t

   The rate is the pool over the total of the base.

3. Give one small piece its share.

   $(\text{rate}) \times 1 =$ _a

   A small piece uses one hour of the base.

4. Give one large piece its share.

   $(\text{rate}) \times 3 =$ _b

   A large piece uses three hours, so it carries three times as much.

5. Check that the shares add back to the pool.

   $50 \times (\text{one-hour share}) + 25 \times (\text{three-hour share}) = 1125$

   Allocation spreads the pool exactly; nothing is created or lost.

18. Guided practice

Neighborhood Kitchen has $1800$ dollars of indirect cost this month and makes $600$ lunch boxes and $300$ catering platters. Spreading it equally over every unit, how many dollars does one unit carry?

Answer:

19. Practice

Neighborhood Kitchen spreads its $1800$ dollars of indirect cost by labor hours. The lunch boxes took $60$ hours and the $300$ catering platters took $120$ hours. How many dollars does one catering platter carry?

Answer:

20. Practice

One deep clean at Bright Home Cleaning has $7$ dollars of direct cost in it. Give its full cost under each way of spreading the indirect cost, in dollars.

21. Practice

Maya's Ceramics has $1200$ dollars of indirect cost for the month. It made $300$ mugs using $75$ labor hours and $100$ large bowls using $75$ hours. Spread the cost both ways, in dollars.

22. Somewhere new

A hair salon pays $3296$ dollars a month in rent, power and insurance and spreads it by chair time. Last month it did $184$ cuts taking half an hour each and $57$ colors taking two hours each. How many dollars does one color carry?

23. Lesson test

Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.

24. Test question

Bright Home Cleaning has $900$ dollars of indirect cost for the month. It made $30$ standard cleans using $60$ labor hours and $15$ deep cleans using $60$ hours. Spread the cost both ways, in dollars.

25. What you can do now

You can allocate a pool of indirect cost over a base, check it, and build a full cost from it. Tell someone why your full cost per unit rises in a quiet month when nothing about the unit has changed. Next: what to charge, starting with the difference between markup and margin.

Working for the steps left to you

15. Your turn: 1200 dollars over mugs and bowls by hours, step 3