Question

why do most companies use departmental overhead rates instead of a plantwide overhead rate?

Answer 1

Simply speaking, when a single rate is calculate for all the activities of the plant on the basis of total estimated cost and total estimated activity level, it is known as plantwide overhead rate. However when overhead rate is calculated for each department on the basis of their estimated cost and estimated activity level, it is known as departmental overhead rate.

The plantwide overhead rate is a single overhead rate that a company uses to allocate all of its manufacturing overhead costs to products or cost objects. It is most commonly used in smaller entities with simple cost structures. Often the plant-wide rate is an amount per machine hour, an amount per labor hour, or a percentage of a product's direct costs. Using a plant-wide rate is logical when there is one root cause of the indirect production costs and the company manufactures similar products. For example, a company with a simple manufacturing operation that produces similar products could have a plant-wide overhead rate of $40 per machine hour if it has budgeted $800,000 of total manufacturing overhead costs and it expects to produce 20,000 machine hours of good output.

On the other hand, if the company manufactures diverse products, some of which use expensive equipment while some use only inexpensive equipment, a plant-wide rate is not appropriate. In response to this situation, manufacturers have use departmental overhead rates. Thus, only the products that use the expensive equipment in a specific department will be assigned a higher overhead rate of perhaps $70 per departmental machine hour. The products requiring a simpler operation such as assembling may be assigned overhead at a rate of perhaps $20 per direct labor hour.

Departmental overhead rates are preferable to plantwide overhead rates because plantwide overhead rates do not provide:-

• framework for reviewing overhead costs on a departmental basis, identifying departmental cost overruns, or taking corrective action to improve departmental cost control.
• sufficient information about product profitability, thus, increasing the difficulties associated with management decision-making.

Conclusion: Departmental overhead rates are used by many manufacturers instead of using a single, plant-wide overhead rate. The reason for departmental overhead rates is that a manufacturer is likely to produce many diverse products which use different processes (each of which has different costs).