In essence, overhead costs were grouped into cost pools, appropriate drivers were chosen, allocation rates were calculated, and user department allocations were estimated based on the amount of the cost driver consumed.

A simpler method of cost allocation involves the use of a ratio called the overhead ratio, which is defined generically as Overhead costs / Revenue. The specific definition of this ratio depends on the setting in which it is used: for example, hospital versus medical practice versus long-term care facility. The values of these ratios also vary by type of provider but usually fall in the range of 50 to 70 percent.

Here’s how the shortcut works. Assume that an orthopedic practice has total revenues of $10,000,000 and total overhead costs of $5,000,000. Using the generic definition of the overhead ratio, the practice’s overhead ratio is $5,000,000 / $10,000,000 = 0.50, or 50%. Now assume that the clinical services core, one of the divisions of the practice, has revenues of $6,000,000. To estimate the overhead allocation for that division, simply multiply the division’s revenues by the overhead ratio: $6,000,000 x 0.50 = $3,000,000. Thus, based on this “down and dirty” allocation, the clinical service core has $6,000,000 - $3,000,000 = $3,000,000 available to cover the division’s direct costs.

What do you think about this shortcut method of cost allocation? What are its advantages and disadvantages relative to the traditional method ?