Departmental Overhead Rate
A departmental overhead rate is a method used by businesses to allocate overhead costs to specific departments based on the activities they perform. Overhead costs are the indirect costs that can’t be easily traced to specific products or services, such as rent, utilities, or administrative salaries.
The departmental overhead rate is calculated by dividing the total overhead costs of a department by a chosen allocation base. The allocation base can be direct labor hours, machine hours, direct labor cost, or any other meaningful measure of activity for that department.
For example, if a department’s total overhead costs are $100,000 and the total direct labor hours are 10,000, then the departmental overhead rate would be $10 per direct labor hour ($100,000 ÷ 10,000 hours).
This rate can then be used to allocate overhead costs to specific products or services based on the amount of direct labor hours they require. This is a part of cost accounting and helps businesses understand the true cost of their products or services, which in turn can inform pricing decisions, profitability analysis, and budgeting.
It’s worth noting that the departmental overhead rate is a simple and straightforward method, but it may not be accurate in situations where different products or services use resources in a disproportionately different way. In such cases, more sophisticated cost allocation methods, such as activity-based costing, might be more appropriate.
Example of a Departmental Overhead Rate
Let’s consider a manufacturing company that makes furniture and has two departments: the Carpentry Department and the Finishing Department.
- Carpentry Department: This department cuts and assembles the wood into furniture. The overhead costs for this department include things like the depreciation of equipment, rent for the space, and the salaries of the supervisors. Let’s say the total overhead cost for the Carpentry Department is $500,000 for a year. During this year, the employees in the Carpentry Department worked a total of 25,000 direct labor hours. So, the departmental overhead rate for the Carpentry Department would be $500,000 ÷ 25,000 hours = $20 per direct labor hour.
- Finishing Department: This department applies the finish to the furniture, such as paint or varnish. The overhead costs for this department include things like the cost of the paint booth, rent for the space, and the salaries of the supervisors. Let’s say the total overhead cost for the Finishing Department is $300,000 for a year. During this year, the employees in the Finishing Department worked a total of 15,000 direct labor hours. So, the departmental overhead rate for the Finishing Department would be $300,000 ÷ 15,000 hours = $20 per direct labor hour.
Now, let’s say the company is producing a chair. If the chair requires 2 hours of work in the Carpentry Department and 1 hour of work in the Finishing Department, then the overhead cost allocated to the chair would be:
- Carpentry Department: 2 hours x $20/hour = $40
- Finishing Department: 1 hour x $20/hour = $20
So, the total overhead cost allocated to the chair would be $60. This would be added to the direct costs (like the cost of wood and the direct labor cost) to determine the total cost of producing the chair.