Sometimes a single predetermined overhead rate causes costs to be misallocated.
Imagine you are renting an apartment with three friends. The rent is $600 per month, cable is $150 per month, and groceries are $450 per month. You decide to take the $1,200 cost and divide it evenly by the four of you. That would be $300 each. After a few months, you and your friends become annoyed with this scenario. You don’t watch TV so you don’t think it’s fair you have to pay for cable. One of your friends rarely eats at home so he thinks it is unfair to pay for groceries. Clearly, the $300 per person rate is not working. You feel that too much of the cost of cable is being allocated to you and your friend feels that too much of the cost of groceries is being allocated to him. Your other two roommates are underpaying for the resources that they are consuming.
There needs to be a better way and there is.
In managerial accounting, rather than using one overhead rate to allocate all of the overhead costs, we can break up overhead costs by department. By using departmental overhead rates, we have the flexibility to use a different activity or cost driver for each department. Some departments rely heavily on manual labor but other departments rely heavily on machinery. Direct labor hours might been a good indicator of cost in some departments but machine hours might work better for others.
The process for calculating the rates is exactly the same as when we calculated predetermined overhead rates. The only difference here is that it is important to pay attention to which driver is being used in each department. Because you are working with multiple drivers, it is really important to label your rates here. If you do a calculation based on machine hours label your rate as $x/MH. That tells you that the rate is dollars per machine hour. That way when you go to apply the rates, you’ll know to use machine hours and not something else.
When calculating and departmental overhead rates:
1. Calculate the rate for each department using the correct driver:
Departmental overhead rate = Estimated overhead for the department / Estimated activity for the department
2. Label the rate so you know which activity you used to calculate each rate.
3. Apply overhead to jobs or activities using the rate for each department and the actual activity:
Applied overhead for each department = Departmental overhead rate x Actual activity (using the same driver used to calculate the rate)
If you used estimated machine hours to calculate the rate, use actual machine hours. If you used direct labor hours to calculate the rate, use actual direct labor hours.
4. Add up the overhead from each department to calculate the total overhead applied.
The related video shows an example problem and the calculations required. It also shows how plantwide overhead rates can skew the numbers.
Calculating and Applying Departmental Overhead Rates