To appropriately price your services, you need to know what it costs. It is easy to determine the costs of items that directly go into a product or service. For example, in a product business you know the cost components you need to purchase your products (direct material) and the cost of time it takes to assemble those component (direct labor). In a service business, direct costs will mostly consist of labor cost (this includes the cost of the owners labor). However, everyone who is in business knows there are other costs incurred which does not directly go into the product but we pay for anyway. These other items are called overhead. So how do you include the cost of overhead into your total cost of producing a unit of service or product? In this article I will be discussing 2 ways in each you can assign costs.

Using a predetermined overhead rate

One way to assign costs to a unit of product or service is called predetermined overhead rate. A predetermined overhead rate is established at the beginning of the accounting period. This is usually done during the budgeting process where the overhead for the upcoming year is determined. At the same time overhead is determined, the cost driver which is the activity that causes overhead to go up is determined. The overhead costs is then divided by the cost driver to get the predetermined overhead rate. As the actual number of cost-driver units used on a job becomes known, it is multiplied by the predetermined overhead rate.

For example, a custom furniture business determines that in the coming year overhead will be $200,000. The activity that is most directly linked to overhead is labor costs and they expect 2,000 labor hours. To determine the predetermined overhead rate, the furniture store will divide $200,000 by 2,000 which gives $100 of overhead per unit produced.

A predetermined overhead rate is preferred to actual costs because it allows management to make informed decisions. Imagine if a construction company had to wait to incur actual costs before determining estimated for potential customers. Predetermined overhead can also be used to determine the overhead cost per project for service businesses.

Activity based costing

The problem with using a predetermined overhead rate is it often distorts the costs of doing business. With competition being fierce, knowing what your true cost of doing business is really important. If you estimate your cost to be much higher or lower, it becomes more difficult to stay competitive. A better way to determine cost is to use activity based costing (ABC). ABC is a 2 stage system. The first stage is to identify the significant activities involved in producing the final product or service. After identify significant activities, then overhead costs is assigned to each activity. This is called an activity cost pool. In stage 2, overhead costs are assigned from each activity cost pool to each product in proportion to how much resources it uses.

The major difference between using predetermined overhead rate and activity based costing is each activity has its own cost driver. Assigning a cost driver to each activity as opposed to using the same cost driver for all activities, allows management to get a better picture of cost.

Summary

Every business has overhead and this overhead could be a very important part of producing your services. Costing your product or service too low, can cause you to make erroneous decisions. It’s worth your while to hire a professional to ensure your product and service have been assigned the appropriate costs.