ESTABLISHING DEPARTMENTAL OVERHEAD RATES: Factory overhead is usually applied on the basis of direct labor dollars or hours when one factory overhead rate is used for the entire plant, since this procedure is considered most convenient and acceptable. The use of departmental overhead rates require a distinct consideration of each producing department’s overhead which often results in the use of different bases for applying overhead for different departments. For example, it is possible to use a direct labor hour rate for one department and a machine hour rate for another. A further refinement might possibly lead to different bases and rates for cost centers within the same producing department.
In establishing departmental overhead rates for producing departments, all factory overhead, whether of general nature or of service departments, must eventually find its way into the producing departments. Overhead chargeable directly to a producing or service department can be obtained from past records or from new or revised estimates prepared by the budget or cost department in consultation with the department head. General factory expenses, such as heat, power, water, rent, etc., must first be allocated to either producing and service departments or perhaps merely to producing departments. The method depends upon management’s decision.
In establishing departmental overhead rates, service departments costs should then be distributed equitably to either producing departments and service departments or just to producing departments. The distribution might be based on number of employees, kWh consumption, HpH consumption, floor space, asset value, cost of materials to be requisitioned, etc. After service department expenses have been distributed, producing department overhead rates can be calculated in terms of direct labor hours, direct labor costs, machine hours, or some other appropriate basis.
At the end of the fiscal period actual costs of producing and service departments as well as those of general indirect nature are again assembled in the same manner as for estimated factory overhead at the beginning of the year. When all overhead has been assembled in the producing departments, it is then possible to compare actual with applied overhead and to determine the over- or under-applied factory overhead.