You determined a departmental rate for each cost pool as follows:

Now, let’s check our logic by applying the rate to each product line. If our calculations are correct, we should be allocating all $188,000 of the overhead based on two rates instead of one.

Here is another way to look at it:

This shows that based on our standard hours and standard labor costs, all overhead will be allocated. Now let’s look at the allocations for each purse.

MOH Allocated to Basic Purse

Our basic purse takes 9 machine hours to produce (MHR) and we allocate $3 per machine hour of overhead, so the assembly department overhead allocation per purse is $27.

Our basic purse takes 4.125 hours of labor at a standard cost of $20 for a total labor cost per basic purse of $82.50. Our allocation rate for the finishing department is $0.125, so we allocate $10.3125 of finishing department overhead to each basic purse.

MOH Allocated to Deluxe Purse

Our deluxe purse takes 32.5 machine hours to produce (MHR) and we allocate $3 per machine hour of overhead, so the assembly department overhead allocation per purse is $97.50.

Our deluxe purse takes 10 hours of labor at a standard cost of $20 for a total labor cost per basic purse of $200.00. Our allocation rate for the finishing department is $0.125, so we allocate $25.00 of finishing department overhead to each basic purse.

We’ll round the allocated overhead cost to the basic unit from $37.3125 to $37.31. Notice that under this more sophisticated system of allocation, at $532.50, the deluxe purse appears to cost more to produce than the $515 it sells for. Also, notice that variable costs like direct material and direct labor (and variable manufacturing costs, which we have not included in this simulation) do not change on a per-unit basis.

Product Manufacturing Costs

Let’s compare these results to our single-rate computations by looking at the gross profit per unit.

Using multiple (departmental) allocation rates, we see that sales of the deluxe purse are actually hurting our bottom line:

If the sales manager thinks we can sell more basic purses, would it make sense to shift production away from deluxe purses?

If it takes 32.50 machine hours to produce one deluxe purse, and we are producing 560 per month, we could free up 18,200 machine hours by discontinuing the deluxe model. That would then allow us to produce at least 2,000 more basic models, which could increase the bottom line by over $50,000 ($25.19 * 2,000). However, discontinuing the deluxe model only frees up 5,600 labor hours (560 * 10 hours) which, according to our standards, only allows us to produce 1,357 more basic purses (1,357 * 4.125 hours per basic purse = 5,600 hours), so we would either be limited by that, or we would have to hire more employees to finish the increased production of basic purses (up to 15 more, in fact).

You’ve now seen one example of the various ways to allocate costs for the Yore Company. Let’s look at another example in this video:

You can view the transcript for “Departmental Overhead Rates” here (opens in new window).

Although our information is becoming more detailed and sophisticated, and we hope more accurate, we still have one more option, Activity-Based Costing (ABC), that may give us yet more insight. However, before you tackle ABC, check your understanding of allocating fixed manufacturing overhead using multiple departmental rates.