There are three methods of overhead allocation 1. The single plant wide overhead rate method (as discussed in Chapter 2) Single overhead rate = Total budgeted overhead for the plant / Total budgeted base With base being direct labor cost, direct labor hours or machine hours 2. The departmental overhead rate method Each department will calculate its own overhead rate based on department’s overhead and its own base 3. The activity-based costing method. Overhead rate is calculated base on each activity or task.
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.
Let’s look at two products manufactured by the same company. Product 123 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 789, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 123, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 789 will be allocated an enormous amount of