Managerial Accounting 3.2: Overhead Allocation Methods - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video outlines three different  approaches to allocating manufacturing overhead  

to products. We are going to focus on two of those  three approaches very specifically in this video  

and then the third called activity-based costing  will be in a separate video. Before we get started  

with how to allocate manufacturing overhead, let's  review what we mean by manufacturing overhead.  

Remember that manufacturing overhead costs are  related to production but it is all costs other  

than other than direct materials and direct labor.  So these are all the production costs that are not  

easily traced to individual products. Examples are  below things like factory rent, factory utilities,  

indirect labor, indirect materials, equipment  depreciation in the factory, any maintenance on  

the factory, all those costs that are not easily  traceable to the different products that we are  

manufacturing within the factory. The goal then is  to come up with a way to allocate those overhead  

costs to our individual products and that is we  are going to be talking about in this video and  

in other videos as well. There are three basic  approaches that are typically used to allocate  

overhead to products. And you will see those here,  we have the plantwide allocation approach, the  

department allocation approach, and what we call  activity-based costing. Activity-based costing  

will be in a separate video. We are really  going to focus on the first two approaches  

in this video, the plantwide approach and the  department approach. The plantwide method uses  

one predetermined overhead rate for the entire  company to allocate overhead to products. And  

if you take a look at the videos that have been  posted related to job costing, we get into this  

in a fair amount of detail, so this is a bit of  a review here. So again we use one predetermined  

overhead rate for the entire company, it is  typically based on direct labor hours, direct  

labor costs or machine hours, it is up to the  company to determine what they want to use as the  

allocation base. The predetermined overhead rate  calculation is shown in the second bullet point  

here, and we take our estimated overhead costs, divided  by the estimated activity in the allocation base,  

and as I mentioned that allocation base can be  a number of different bases, but if we are using  

a plantwide method, we pick a base and stick with  it for the entire company. This tends to work  

well for companies that have simple operations and  simply produce a few similar products. So let's in  

the next slide talk more about how this would work.  I will be using this example, the SailRite example,  

for the three different methods of allocating overhead. So we'll start that example here. Let's  

assume that our company name is SailRite and  that we produce two different types of boats,  

two different types of sail boats. We produce a  Basic sailboat that you see here, and we produce  

a Deluxe sailboat. And as you can imagine the Basic  sailboat is a no-frills boat that doesn't have a  

lot of fancy features, relatively low cost from  our perspective as a manufacturer, and the Deluxe  

sailboat has all of the features, all of the fancy  features and is more expensive to produce. What  

you see then in this circle is the total overhead  cost that we expect to incur, and that's the

$8,000,000 that you see right here. This is establishing our predetermined  

overhead rate. And we're going to allocate our  overhead, one plantwide rate, right plantwide allocation, we  

are going to allocate our overhead based on direct  labor hours, and that is what you see here. So we  

have 250,000 direct labor hours that we expect  our workers to work, let's say for this coming  

year. And that gives us when you take $8,000,000 in  estimated overhead cost divided by our estimated  

activity base level, that is the 250,000 direct  labor hours, that gives us a rate, the predetermined  

overhead rate, of $32 per direct labor hour. And  again this is reviewing our job costing videos we  

get into this in more detail. But what that tells  us is for every direct labor hour that is worked  

on either one of our boats that we produce,  $32 in overhead gets allocated to that boat.

Now we want to take that predetermined overhead  rate and use it, along with our direct materials  

and direct labor cost information, to determine  the product cost per unit for each boat that we  

produce. And remember that the product cost  includes direct materials, direct labor and  

manufacturing overhead. So the direct material and  direct labor costs are going to be given for this  

example, and we are going to take a look at this  $32 per direct labor hour rate and use that to  

help us determine the overhead cost per unit, and  then we will add it all together to get a product  

cost per unit for each boat that we produce. Here  is the detail that shows us the product cost per  

unit for each boat that we produce. And this is  very important information for most companies.  

They want to know how much it costs to produce  their individual products. So here is our product  

cost per unit again, product cost per unit includes  direct materials, direct labor, and overhead all

add it together. Here are the two boats that we  produce the Basic and the Deluxe. You are given the  

direct materials cost information, so it is $1000  for the Basic sailboat and $1,300 for the Deluxe  

sailboat. Again go back to our job costing videos  if you'd like to see where that information comes  

from in general. Direct labor is also given for  each product, $600 for the Basic sailboat you see  

that right here, and $750 for the Deluxe sailboat.  And then the overhead which again is the focus  

of what we are doing here, the overhead cost per  unit works out to $1,280 for the Basic sailboat  

and $1,600 for the Deluxe sailboat, and you'll  see in these footnotes down here exactly how  

those numbers are calculated. The 1,280 is  calculated by taking the $32 per direct labor hour  

rate, times the number of direct labor hours that  are required to produce that particular boat or  

that product. So $32 per direct labor hour, times  40 hours is $1,280. And that is our overhead cost  

per unit. So the total cost per unit, product  cost per unit, for the Basic sailboat is right  

here, 2,880, and the total product cost per unit  for the Deluxe sailboat is right here $3,650.  

Now that we know how to figure out the overhead  cost per unit using the plantwide allocation  

approach, let's look at another method. And this  would be used independently from the plantwide 

approach. So let's say that we are not using  the plantwide approach and now we decide we want  

to go ahead and use the department allocation  approach. Well now what we do is, is instead of  

using one predetermined overhead rate for  the entire company, we are going to use one  

predetermined overhead rate for each production  department. And the rate is still calculated the  

same way, that you'll see in the second bullet  point here, we take the estimated department  

overhead costs, rather than company-wide overhead  costs, it's by department, divided by the estimated  

activity in the allocation base. And we can use, in  the third bullet point you'll see this, we can use  

different allocation bases for each department.  So it provides for a little more flexibility and  

hopefully more accurate overhead cost information  for each of our products, when it's all said and  

done. And this works well for companies with simple  operations within each department, but companies  

have different activities across departments. And  we'll take a look at an example of this for SailRite  

next. There is a lot of information in this  slide that we'll go through in a fair amount of  

detail. So what we're looking at here is an example  of using the department allocation method for SailRite

to allocate overhead to the two products  that SailRite produces, the two different sailboats,  

the Basic sailboat and the Deluxe sailboat. This  pie chart still represents, as it did before with  

a plantwide approach, $8,000,000 in overhead that  has to be allocated. So let me see if I can show  

you that here, and we have two different  predetermined overhead rates that we are going  

to be using. But if you look at this 5,000 right  here, and I don't want to mark this up too much, but there is  

$5,000,000, and you look at  this $3,000,000 right here, add those up, that's our  

$8,000,000. So we will come back to that in just  a second. We have two different departments within  

production, we have the Hull Fabrication department  and we have the Assembly department. So look at  

the Hull Fabrication department as a somewhat  automated process where the hulls for the boats  

are produced, and look at the Assembly department  as somewhat labor intensive, where you've got lots  

of workers putting these sailboats together. So  then going back to the Hull Fabrication department  

here, we are going to establish one predetermined  overhead rate for this department based on machine  

hours, rather than labor hours, because there's  a lot of machinery involved and it would make  

sense then that our overhead, most of our overhead  costs are related to machinery and are related to  

the use of machinery. So the rate that we have  here is, the predetermined overhead rate, is  

determined by taking $3,000,000 that is related in  overhead, related to this department, and dividing  

it by 60,000 machine hours, that's what we project  we'll be using in this coming year. So $3,000,000,  

divided by 60,000 machine hours, gives us a rate of  $50 per machine hour for this department. What that  

tells us is if we are building a Basic sailboat  and we use 1 machine hour in this department  

for that Basic sailboat, we get charged $50  in overhead costs for that boat that we're  

working on. In the Assembly department we have a  different rate, so look over here at the Assembly  

department. In this area as I mentioned before we  use a lot of direct labor hours. So we are going to

come up with a rate per direct labor hour, and  we determined that rate by taking $5,000,000  

those are the overhead costs associated with the  Assembly department, dividing it by our projected  

direct labor hours, 217,000 direct labor hours, and  that gives us an overhead rate of $23 per direct  

labor hour. What that tells us then is if we are building a Basic sailboat and it is in  

the Assembly department, when one worker spends 1 direct labor hour on that boat then we get charged  

that boat gets charged $23 in overhead costs. The  goal here is to use, I am looking at the second  

bullet point on the left here, the goal here is  to you the allocation base, that is machine hours  

or direct labor hours in this case, that best  drives overhead costs for each department. So  

again in the Hull Fabrication department, it's  it's machine intensive so it makes sense to go  

ahead and allocate overhead based on the use  of machine hours. In the Assembly department, a  

lot of direct labor going on there and so it makes  sense to use direct labor hours as the allocation  

base. So we have got two rates here, it could be  three or four, it just depends on the number of  

departments that we have as a company, but we kept  it fairly simple here. But we have a rate for each  

department that is used to allocate overhead  to the individual products. I am going to have  

a separate video that relates to how to allocate  overhead using activity-based costing. It is a bit  

more complicated than this, although not a whole  lot more complicated, but a bit more complicated  

than this, and somewhat effective, so we'll take  a look at that separately in a separate video.