Departmental Overhead Rate

A departmental overhead rate is a predetermined rate that a manufacturer uses to assign manufacturing overhead to products, calculated separately for each production department. Each department divides its own budgeted overhead by its own measure of activity, such as machine hours in a machining department or direct labor hours in an assembly department. Products then pick up overhead from each department they pass through, at that department's rate.

Departmental rates sit between a single plantwide rate and activity-based costing (ABC) in their level of detail. They are widely used in job order costing and process costing systems, where they form part of the burden rate used to build up the full cost of a product under absorption costing.

Picture a furniture workshop with a cutting room full of expensive machines and a finishing room where people sand and polish by hand. Running the cutting room costs a lot per hour of machine time; the finishing room mostly costs labor. Charging every table the same overhead per hour, wherever that hour was spent, would treat both rooms alike when they are not.

Departmental rates fix this by giving each room its own price tag. A table that spends a long time on the machines pays more of the cutting room's costs, and a table that needs a lot of hand finishing pays more of the finishing room's costs. The total overhead is the same; it is just shared out more fairly.

Each department's rate is set at the start of the year from budgeted figures:

The budgeted overhead includes the department's own indirect costs, such as supervision, machine depreciation, power and indirect materials, plus any share of service department costs allocated to it, for example through the direct allocation method. The activity base should be the factor that best drives overhead in that department.

A manufacturer has two producing departments. Machining has budgeted overhead of $480,000 and expects 16,000 machine hours, giving a rate of $30 per machine hour. Assembly has budgeted overhead of $270,000 and expects 18,000 direct labor hours, giving a rate of $15 per direct labor hour.

Job 214 uses 5 machine hours in Machining and 8 direct labor hours in Assembly. Its applied overhead is 5 times $30 plus 8 times $15, or $150 plus $120, a total of $270. The entry debits Work-in-Process Inventory and credits Manufacturing Overhead for $270. This is how applied overhead is built up job by job.

Compare a single plantwide rate. If the plant's total budgeted overhead of $750,000 were spread over 25,000 direct labor hours across both departments, the rate would be $30 per labor hour. If Job 214 used 10 labor hours in total, it would be charged $300. The $30 difference arises because the plantwide rate ignores the fact that this job spent relatively little time on the costly machines.

• Better product costs. Where departments differ sharply in how costly they are to run, departmental rates track the cost each product actually causes more closely than one plantwide rate.
• Better pricing and product decisions. More accurate costs support bids, pricing and decisions about which products to emphasize.
• Responsibility accounting. Each department is a cost center with its own budget, so separate rates let managers compare the overhead applied in their department with the actual overhead incurred and explain the difference.
• Moderate effort. Departmental rates need more record-keeping than a plantwide rate but far less than a full ABC system with dozens of activity pools.

Because the rates rest on estimates, the overhead applied during the year rarely matches the overhead actually incurred. At year-end each department's difference is calculated. Under-applied overhead means products were charged too little; over-applied means too much. Small differences are usually closed to cost of goods sold, while large ones are spread across work in process, finished goods and cost of goods sold in proportion to the overhead each contains.

A departmental rate still uses one activity base for everything that happens in a department. If a department carries out several distinct activities, such as machine setups and quality inspections, whose costs depend on batches rather than hours, a single departmental rate will still distort product costs. Companies with diverse product lines and high overhead often move to activity-based costing for this reason. Departmental rates also depend on reliable budgets: if expected activity is badly overestimated, the rate will be too low and products will be under-costed throughout the year.

• Institute of Management Accountants