What is a Departmental Overhead Rate?

A departmental overhead rate is a standard charge based on the units of activity produced by a business segment. Overhead rates at the departmental level are usually applied in a more refined cost allocation environment, where there is a need to apply overhead costs as precisely as possible. Most organizations do not use departmental overhead rates, preferring instead to apply a simpler factory-wide overhead rate. If this method is used, the standard cost allocation approach is to multiply a standard departmental overhead rate by the number of units of activity consumed.

Departmental rates are applicable in traditional costing systems, where they represent an intermediate step towards activity-based costing (ABC). In ABC systems, costs are assigned based on multiple activities, which may include departmental costs

The Characteristics of a Departmental Overhead Rate

A departmental overhead rate has a number of characteristics associated with it, which are as follows:

Specific to the department. Each department within an organization has its own unique overhead rate. This allows for more accurate cost allocation since different departments (e.g., manufacturing, assembly, packaging) often have different types and levels of costs.
Derived from activity level. The rate is usually based on a measure of activity that best reflects the department's workload, such as machine hours, labor hours, or units produced. For instance, in a machining department, overhead might be applied based on machine hours.
Enhanced cost accuracy. Compared to a plant-wide rate, departmental rates can offer improved cost accuracy. Since each department has its unique rate, it better reflects the specific overhead costs and operational needs of each department, which improves cost allocation precision.
Supports decision-making. By providing more accurate cost information, departmental rates can aid managers in pricing, budgeting, and efficiency analysis. Managers can understand the true cost of operating each department and can identify areas for cost reduction or process improvement.
Increased tracking complexity. Departmental overhead rates are more complex than a single plant-wide rate. They require tracking costs and activities separately in each department, which can increase the administrative burden and data requirements.

Example of a Departmental Overhead Rate

As an example of a departmental overhead rate, if a machining department charges $30 of overhead per machining hour, and a job uses 2.5 hours of machine time, then the overhead allocation will be $75. As another example, a janitorial department charges $500 per 1,000 square feet cleaned per month. A using department has 3,000 square feet, so it is charged $1,500 per month.