Product costs are the total of direct materials, direct labor and indirect manufacturing overhead.
Recall that direct costs, like direct materials and direct labor, are traced to the finished product
whereas indirect costs, like manufacturing overhead, are allocated to the finished product.
There are three common ways to allocate manufacturing overhead to products. The most common is the plant-wide rate.
This is what we earlier described as the predetermined overhead rate.
Another method is departmental rates.
Finally, the most refined method is activity-based costing.
This video will focus on the departmental rate method.
Direct materials is a concept most understand because they end up in the product or product packaging.
Direct labor is also fairly understandable because it is the labor cost to directly assemble or manufacture the products.
Manufacturing overhead is slightly more complicated.
In short, it is all the costs in a manufacturing plant that aren’t either direct materials or direct labor.
Examples include depreciation, utilities, maintenance, supplies, insurance, and indirect labor like supervision, setup, cleanup, and testing.
Many companies choose to refine, or improve, their method of overhead allocation to try to achieve more accurate product costs.
This is because plant-wide rate method does not do a good job of matching the costs of overhead resources with the products.
Additionally, more simple allocation systems result in “overcosting” & “undercosting” their products.
This is commonly referred to as cost distortion.
So rather than have one pool of overhead to allocate with a plant-wide rate,
we can refine the process by breaking out overhead by departments.
Departments can be actual departments or product lines,
or products, like I’ve shown here.
Once overhead has been divided into departments, the process is similar to the predetermined overhead rate.
We estimate the overhead by department and divided that by the department’s allocation bases.
So let’s look at an example of a dairy plant. A dairy plant estimates its overhead by department and assumes the following:
Half Gallons: $1,000,000 Gallons: $1,500,000
It allocates overhead with departmental rates using direct labor hours as the allocation bases
for half gallons and machine hours for the more automated gallon production.
Notice that a more refined system can use different allocation bases for different departments.
So let’s assume the following:
The half gallons are estimated to have 80,000 direct labor hours and the gallons are estimated to have 150,000
machine hours.
We can see that half dollars will be allocated $12.50 of overhead per direct labor hour.
For each direct labor hours used to manufacture milk,
$12.50 of overhead will be allocated.
If the plant can produce 1,000 ½ gallons per hour, then each ½ gallon will be allocated $.0125 of overhead.
The gallons will be allocated $10 of overhead per machine hour.
For each machine hour used to manufacture milk, $10 of overhead will be allocated.
If the plant can produce 2,500 gallons per hour, then each gallon will be allocated
$.004 of overhead.