To calculate overhead recovery, small manufacturing concerns use the standard costing approach in which indirect costs are divided and incorporated into the price of every unit, explains Jackie Lohrey of the Houston Chronicle. In contrast, service-related businesses typically rely on an activity-based costing approach in which costs are directly assigned to the activity that generates them.
Activity-based costing is usually more accurate and eases the process of overhead cost recovery, notes Lohrey. However, activity-based costing is resource-intensive and may prove too expensive for some businesses. In addition, the costing method does not conform to generally accepted accounting principles.
Standard costing conforms to required accounting principles, according to Lohrey. This eases the process of preparing financial statements. Another benefit of standard costing is that it requires minimal resources, making it suited to even very small businesses. However, due to the imprecise nature of costing inherent in this method, determining certain costs can be problematic. That can make overhead cost recovery more difficult.
Both costing methods are a way of estimating indirect costs, states Lohrey. Unlike direct costs such as labor and raw materials, indirect costs are harder to estimate and recover. In addition, indirect costs such as property taxes, insurance and depreciation are accrued even when a business is not operating.