Manufacturing overhead, also known as factory overhead, refers to the indirect costs incurred in the production process of a product. These costs cannot be directly traced to a particular product, but they are necessary for the manufacturing process to occur. Examples of manufacturing overhead include rent, utilities, depreciation, and indirect labor costs. Since these costs cannot be directly traced to a product, manufacturers use a costing system to allocate them to products. Let’s explore the three methods of allocating manufacturing overhead to products.
- Plantwide Overhead Rate Method The plantwide overhead rate method is the simplest method of allocating manufacturing overhead costs to products. In this method, the total manufacturing overhead costs are divided by the total number of direct labor hours or machine hours for all products. The resulting overhead rate is then used to allocate the overhead costs to each product based on its direct labor hours or machine hours. For example, if the total manufacturing overhead cost is $100,000, and the total number of direct labor hours for all products is 10,000, the overhead rate will be $10 per direct labor hour. If Product A requires 100 direct labor hours, $1,000 ($10 x 100) of manufacturing overhead costs will be allocated to Product A.
- Departmental Overhead Rate Method The departmental overhead rate method is more complex than the plantwide overhead rate method. In this method, the manufacturing overhead costs are divided into different departments, and each department is assigned an overhead rate. The overhead rate for each department is calculated by dividing the department’s total manufacturing overhead cost by the department’s total direct labor hours or machine hours. The overhead costs are then allocated to each product based on the departmental overhead rate for the department in which the product is manufactured. For example, if the machining department has a total manufacturing overhead cost of $50,000 and a total of 5,000 direct labor hours, the overhead rate for the machining department will be $10 per direct labor hour. If Product A requires 10 direct labor hours in the machining department, $100 ($10 x 10) of manufacturing overhead costs will be allocated to Product A.
- Activity-Based Costing Method The activity-based costing method is the most accurate method of allocating manufacturing overhead costs to products. In this method, the manufacturing overhead costs are allocated based on the activities that consume the resources. The activities are then assigned to cost pools, and the overhead costs are allocated to products based on their use of the activities. This method requires a detailed analysis of the activities performed in the manufacturing process and their associated costs. For example, if the manufacturing process involves three activities: machining, assembly, and inspection, the overhead costs associated with each activity are assigned to separate cost pools. The overhead costs are then allocated to each product based on its consumption of the activities. If Product A requires more resources in the assembly activity, it will be allocated more overhead costs from the assembly cost pool.
In conclusion, manufacturers use different methods to allocate manufacturing overhead costs to products. The plantwide overhead rate method is the simplest method, but it may result in overcosting or undercosting of products. The departmental overhead rate method provides a more accurate allocation of overhead costs, but it requires more administrative effort. The activity-based costing method is the most accurate method, but it requires a detailed analysis of the activities performed in the manufacturing process. Choosing the appropriate method of allocating manufacturing overhead costs depends on the manufacturer’s needs and the complexity of the manufacturing process.