What it means
Most businesses have costs that cannot be traced straight to a product, such as rent, power, supervision and equipment depreciation. These are overheads, and they must be spread over the products in some sensible way.
A single company-wide rate is simple but can distort costs when departments work very differently. Suppose one department is full of expensive machinery and another is mostly manual assembly.
A company-wide rate would charge both the same amount per hour, even though the machine department generates far more overhead. A departmental rate reflects that difference by giving each department its own rate.
To calculate the rate, the business first allocates overheads to each department, then divides by that department's chosen activity base. Machine-intensive departments often use machine hours, while labour-intensive ones use direct labour hours.
The result is a cost per hour that can be applied to each job passing through. Departmental rates improve pricing and profitability analysis.
A job that spends many hours in the high-overhead department will carry a larger share of costs, which protects the business from underpricing complex work. It also helps managers see which departments are expensive to run.
The cost is extra effort, because the business must track overheads and activity by department. For simple operations with similar departments, a single rate may be good enough.
More detailed methods, such as activity-based costing, take the idea further by using many cost drivers. Rates are normally set in advance, using budgeted overhead and expected activity.
At the end of the year the business compares the overhead it absorbed with the overhead it actually incurred, and any difference is adjusted as over-absorbed or under-absorbed overhead. This keeps product costs fair without waiting for the final figures.
In practice
Real-world examples.
Example
A furniture maker uses a machine-hour rate in its cutting department and a labour-hour rate in its upholstery department. A custom desk that needs long machine time is priced with the higher cutting overhead built in.
Example
A print shop discovers that its digital printing department carries much higher overhead than its binding department. The manager changes quotes to reflect each department's rate, and previously underpriced digital jobs become profitable. The binding department's quotes fall slightly, which helps the shop win more of that work.
Example
A hospital laboratory calculates separate overhead rates for its imaging and pathology departments. The rates are used to set internal charges to other hospital units, so each pays for the resources it uses. Unit managers can now see the cost of requesting more tests and think twice about routine orders.
Formula
Calculation
Departmental overhead rate = Departmental overhead cost / Departmental activity base
Suppose the machining department has overhead of $360,000 and 12,000 machine hours, so its rate is 360,000 / 12,000 = $30 per machine hour. The assembly department has overhead of $150,000 and 10,000 labour hours, giving a rate of 150,000 / 10,000 = $15 per labour hour. A job uses 20 machine hours and 8 labour hours, so its overhead is (20 x 30) + (8 x 15) = 600 + 120 = $720.Case study
Seen in the real world.
Oakmere Components is an illustrative, fictional manufacturer that used a single factory-wide overhead rate of $22 per direct labour hour. The owner noticed that jobs requiring heavy machining were earning thin margins, while simple assembly jobs were very profitable.
The cost accountant calculated departmental rates, finding $30 per machine hour in machining and $15 per labour hour in assembly. When the machining-heavy jobs were repriced, their true overhead was clearly higher than the single rate had suggested.
The illustrative company raised prices for the complex work by about 6% and kept its assembly prices unchanged. Profit improved and the sales team could explain price differences to customers with a clear cost rationale. The cost accountant also agreed to refresh the rates every January using the new year's budget. Sales managers were also trained to quote by looking at which department a job would spend most time in.
Watch out
Common mistakes.
- Using a single plant-wide rate for departments with very different cost structures, which distorts product costs and pricing.
- Choosing an activity base that does not drive costs, such as labour hours in a highly automated department.
- Failing to update the rates when overheads or activity levels change significantly, so costs gradually drift away from reality.
Questions
People also ask.
When should a company use departmental rates?
They are most useful when departments differ in how much overhead they generate or in the activity that drives it. If every department looks and behaves alike, the extra work of separate rates adds little.
Is a departmental rate the same as activity-based costing?
No, because activity-based costing uses many cost drivers across the whole business, while a departmental rate uses one base per department.
How often should rates be reviewed?
Most businesses review them at least annually, and again whenever there is a major change in costs, equipment or production volumes.
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