Using departments as cost pools, we can allocate manufacturing overhead for each department using whatever driver makes sense for that cost pool.

Assembly Department

In our example, the assembly department sees machine hours as the logical cost driver, because it is highly automated, the costs accumulated in the pool are mostly due to the machines (depreciation, repairs, and maintenance, etc.).

Budgeted machine hours for the month of October were:

Basic purses = 9 hours per purse x 3,200 purses = 28,800 total machine hours for basic

Deluxe purses = 32.5 hours per purse x 560 purses = 18,200 total machine hours for deluxe

Therefore, total machine hours = 28,800 + 18,200 = 47,000.

The total overhead cost in that pool is $141,000, according to the accounting records. Remember, these costs are the ones that can’t be attributed directly to the product. They are things like facility rent, insurance, depreciation on equipment, repairs and maintenance, and supervisory salaries and wages.

The allocation rate for the assembly department would be the cost of that pool divided by the number of units of the cost driver (machine hours):

Cost pool / cost driver = rate

$141,000 / 47,000 = $3 per machine hour.

Finishing Department

In our example, the finishing department sees labor hours as the logical cost driver, because it is labor-intensive. In other words, the costs accumulated in the pool are mostly due to the hand labor done by skilled workers. However, instead of using hours worked, we have decided to use wages and benefits at $20 per hour. Remember that by using labor $, we would take into account the relative skill level of the employees, assuming that more skilled workers made more per hour. In this example though, we are assuming we pay all employees the same rate.

Budgeted labor hours for the month of October were:

Basic purses = 4.125 hours per purse x 3,200 purses = 13,200 total direct hours for basic

Deluxe purses = 10 hours per purse x 560 purses = 5,600 total direct labor hours for deluxe

Therefore, budgeted labor dollars for October were:

Basic purses = 13,200 total direct hours X $20 per hour = $264,000 direct labor dollars for basic

Deluxe purses = 5,600 total direct hours X $20 per hour = $112,000 direct labor dollars for deluxe

Therefore, total direct labor dollars = $264,000 + $112,000 = $376,000.

The total overhead cost in that pool is $47,000 according to the accounting records. Remember, these costs are the ones that can’t be attributed directly to the product. They are things like facility rent, insurance, supervisory salaries and wages, tools, and some minimal depreciation on equipment.

The allocation rate for the finishing department would be the cost of that pool divided by the number of units of the cost driver (labor $):

Cost pool / cost driver = rate

$47,000 / $376,000 = $0.125 per machine hour.

You now have both the allocation rate for the assembly department, $3 per machine hour, and the finishing department of $0.125 per machine hour. In the next section, we’ll use these to determine unit costs.

Before you apply the rates to the products to determine the cost of each unit, check your understanding of how to calculate departmental rates.