Companies put machinery to use in processing, refining and converting raw materials. Workers also supply labor and talent in making manufactured products. These inputs used in manufacturing are known as overhead, and they are instrumental in determining the value of finished products. Since large companies have vast amounts of overhead to calculate, there are a number of methods for estimating the overall costs of production. The departmental overhead rate method is an estimate where labor and machine hour rates are calculated by department.
Determining overhead rates for each department level decentralizes control of production costs and delegates it to department managers. This allows for quicker decision-making with regards to keeping costs in line. It also makes it easier to identify trends leading to higher costs when compared to a method involving company-wide overhead rates. This flexibility can allow departments to allocate costs more accurately.
If a company makes multiple products, having separate overhead rates can be an advantage. Product differentiation means that departments will differ on the amount of labor and machine hours used for their given operation. Since overhead rate is an estimate used to calculate the value of cost of goods sold and inventory, large differentiation in overhead inputs will skew calculations. For example, if there are significant labor hours in one department where labor costs are cheap, a departmental rate would prevent a case where labor is overvalued because of a much higher company-wide rate.
Activity-based costing involves allocating and determining overhead based on the functions being performed. These functions can span multiple products, but they must be similar in nature. For a large organization, tracking each individual function is costly and complex. Departmental allocation is more streamlined and easier to measure without a detailed tracking system.
The departmental overhead rate will skew when each department is responsible for multiple products varying in labor and machine hours. This is likely to occur when departments are large. This also creates redundancy since each department must measure and calculate its respective rate. Departmental overhead rates assume that costs can easily be separated from one department to another.