In a standard cost system, accountants apply fixed manufacturing overhead to the goods produced using a standard overhead rate. They set the rate prior to the start of the period by dividing the budgeted manufacturing overhead cost by a standard level of activity (called the base). Common activity bases include units of output, machine-hours, and direct labor-hours.

For Yore Company, dividing total fixed manufacturing overhead by units produced gave a bit of a skewed number according to the production manager because deluxe purses take twice as much effort to produce as a basic purse. In theory, the deluxe purse should “absorb” a larger share of fixed costs.

For example, Yore Company produced 3,760 purses in October, and fixed overhead runs a fairly constant $188,000 per month. One simple way to allocate the fixed overhead would be to divide the overhead of $188,000 by a base of 3,760 purses. The standard overhead rate for fixed manufacturing overhead would then be $188,000 / 3,760 = $50 per purse.

However, the production manager wants to see if there are other, more rational ways to allocate overhead that take into account the longer and more intense production time and energy to produce the deluxe purse.

Here is information from the production manager:

As a managerial accountant, you have several other choices available to you for allocating fixed manufacturing overhead. The most common are based on:

• Direct Machine Hours (DMH)
• Direct Labor Hours (DLH)
• Direct Labor Dollars (DL$)

The basic formula for all of these is the same:

Total fixed manufacturing overhead / total base

For example:

1. Based on a production level of 3,200 basic purses and 560 deluxe, and using DMH as a base:

• Direct machine hours for basic purses = 9 hours per purse X 3,200 purses = 28,800 hours
• Direct machine hours for deluxe purses = 32.5 hours per purse X 560 purses = 18,200 hours
• Total direct machine hours = 28,800 for basic + 18,200 for deluxe = 47,000 total

Applying our formula, we get $188,000 in fixed overhead divided by the base of 47,000 total direct machine hours for an allocation rate of $4 per machine hour.

For every hour a machine runs, we allocate $4 in fixed overhead to that item.

2. Based on a production level of 3,200 basic purses and 560 deluxe, and using DLH as a base:

• Direct labor hours for basic purses = 4.125 hours per purse X 3,200 purses = 13,200 hours
• Direct labor hours for deluxe purses = 10 hours per purse X 560 purses = 5600 hours
• Total direct labor hours = 13,200 for basic + 5,600 for deluxe = 18,800 total

Applying our formula, we get $188,000 in fixed overhead divided by the base of 18,800 total direct labor hours for an allocation rate of $10 per labor hour.

For every hour a line worker records directly creating a purse, we allocate $10 in fixed overhead to that item.

3. Based on a production level of 3,200 basic purses and 560 deluxe, and using DL$ as a base:

• Direct labor hours for basic purses = 4.125 hours per purse X $20 per hour X 3,200 purses = $264,000
• Direct labor hours for deluxe purses = 10 hours per purse X $20 per hour X 560 purses = $112,000
• Total direct labor cost = $264,000 for basic + $112,000 for deluxe = $376,000 total

Applying our formula, we get $188,000 in fixed overhead divided by the base of $376,000 total direct labor dollars for an allocation rate of $0.50 per machine hour.

For every dollar in direct labor wages and benefits paid, we allocate $0.50 in fixed overhead to that item.

Here is a video explanation of how rates are determined and applied (which is covered in the next section):

You can view the transcript for “Allocating overhead using a predetermined overhead rate” here (opens in new window).

Before we examine how to apply these different methods to determine the cost of our product, let’s review the basic formula for creating a standard overhead allocation rate.